Earlier this year, Greek citizens, fearing currency changes or capital controls,

Question

Earlier this year, Greek citizens, fearing currency changes or capital controls, took billions of euros out of their bank accounts. Some of it they sent to banks in other countries, and some of it they even hid in flower pots, freezers, and yes, under mattresses. Think about all of this money flowing out of Greek banks.

a. What effect will this have on Greece’s net capital outflows? Explain.

b. What effect will this have on the real exchange rate?

It will make the real exchange rate ____________________________.

c. Draw a graph showing the relationships among net exports, net capital outflows, and the real exchange rate, where the market is in equilibrium at *. Show the changes you described in part “a” and “b.” Be sure to label each axis, all curves, and the initial and final real exchange rates.

d. Net capital outflows were simultaneously affected by the response of foreigners to the Greek crisis. What happened to capital inflows into Greece?

Capital inflows _________________________________.

e. Did the change in part “d” offset or exacerbate the change in the real exchange rate? Explain.

Explanation / Answer

Solution A:

Net capital outflows (NCOs, also called net foreign investment) refers to the difference between the acquisition of foreign assets by domestic residents and the acquisition of domestic assets by non-residents.

An open economy can therefore buy and sell assets in the financial markets, generating flows of capital.

NCO = Acquisition of foreign assets by residents – Acquisition of domestic assets by nonresidents

Positive NCO : 100 - 80 = 20

Negative NCO : 80 – 100 = -20

When the net capital outflow is positive, domestic residents are buying more foreign assets than foreigners are purchasing domestic assets. When it’s negative, foreigners are purchasing more domestic assets than residents are purchasing foreign assets.

Imbalances in the net capital outflow (NCO) are associated with imbalances in the trade balance (or net exports, NX), following the identity NCO = NX. Each exchange that affects the net capital outflow, also affects net exports in the same amount. For instance, if an economy is running a trade deficit, it must be financing the net purchase of goods and services by selling assets abroad. If it’s running a trade surplus, the excess in foreign currency it receives is being used to buy assets from abroad.

Since net capital outflows are related to net exports, they are therefore related to gross domestic production. From the equation showing the relationship between the current account, savings and investment, we have:

S = I + NX = I + NCO

where

S = savings
I = domestic investment
NX = net exports
NCO = net capital outflows

Solution B:

NCO is linked to the market for loanable funds and the international foreign exchange market. This relationship is often summarized by graphing the NCO curve with the quantity of country A's currency in the x-axis and the country's domestic real interest rate in the y-axis. The NCO curve gets a negative slope because an increased interest rate domestically means an incentive for savers to save more at home and less abroad.

NCO also represents the quantity of country A's currency available on the foreign exchange market, and as such can be viewed as the supply-half that determines the real exchange rate, the demand-half being demand for A's currency in the foreign exchange market. As can be seen in the graph, NCO serves as the perfectly inelastic supply curve for this market. Thus, changes in the demand for A's currency (e.g. change from an increase in foreign demand for products made in country A) only cause changes in the exchange rate and not in the net amount of A's currency available for exchange.

Solution C:

Solution D:

A capital inflow will:
* help bid asset prices up
* drive the price of local dollars up
* to the extent that a country is supply limited and companies can't finance customer demands, it will increase revenues, but in examples like the US since Reagan, capital tends to inflow more in response to supply gluts than supply-limited periods.
* to the extent that an inflow makes foreign goods more cheap and local goods more expensive it will reduce long term revenues for local companies, thus reducing physical capital even as it drives up its price.
* Potentially trigger unemployment with higher export prices causing central bank reactions.

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