Question

Question 1: Based on the material of the chapter “money growth and inflation” of your text book explain how inflation starts in an economy? Why multinational companies feel unsafe to invest in those countries that have high inflation rate? Write your answer the light of your text book materials.

Question 2: Explain why and how net exports and net capital flow are related to each other. Does trade deficit necessarily create trouble for a county’s economic growth? Discuss.

Question 3: Suppose a country was facing the problem of budget deficit and by reducing government expenditures the government has achieved the target of balanced budget. With the help of appropriate diagrams explain how a country’s shift from budget deficit to balanced budget would affect its investments, economic growth, net capital outflow and currency exchange rate?

Answer 1

As the first question requires reference from external sources/materials, and as per rules of answering one question, Iam answering the next question in the sequence. Thank you!

Q2) A country engages in both exports and imports, wherein exports are products or services which are produced domestically, but sold abroad and imports are products and services produced abroad and brought into the country for sale. Now, Net Exports are the difference between the monetar value of a nation's exports and imports over a given time period. It is also termed as Balance of Trade and can be determined by the formula:

NX = X - M, where X = exports, M = imports,

When M> X, i.e. NX <0, the country is said to be in a trade deficit,

When X> M, i.e. NX >0, the country is said to be in a trade surplus,

And when X = M, NX = 0, the trade is said to be balanced.

Now, Net Capital Flow (NCO) is the net flow of funds/money being invested by a nation abroad during a given period of time. If there is more outflow of funds to abroad as compared to the inflow of funds from abroad, i.e. a positive net capital flow, it implies that the nation invests more money abroad than the world invests in the nation.

The NCO curve is often plotted having the quantity of the domestic currency on the x-axis and the country's domestic real interest rate on the y-axis. The NCO curve is downward sloping, as an increase in the domestic interest rate would mean an incentive for savers to save a greater amount at home and invest lesser abroad.

If we look at the GDP/ National Income perspective, we know:

Y = C + I + G - NX , where C = Consumer Spending, I - investment spending, G = government spending, NX = net exports,

When we solve for NX , we see: NX = Y - C - I - G

We also know, Y - C - I = National Savings 'S'

So, we see, S - I = NX

Capital Inflow: Foreigns are bringing inflow of capital into our country in order to purchase assets in our country.

Capital Outflow: Residents of our country are taking capital out of the country to buy foreign assets.

Now, when we have national savings and also have the amount of investment in the country, if S>I, then the rest of it has to go outside the country, or else it would be included in the domestic I,

So, S-I is a net capital outflow = NCO ,

So, we see NCO = NX,

This is because the value of net export is always equal to the amount of capital that is spent abroad, i.e. there is a cash outflow for goods which are imported. So, the value of exports produced domestically is always matched by the value of reciprocal payments of the assets paid by buyers in other countries to the domestic producers. So, this is how and why NX and NCO are related to each other.

Now trade deficit implies that a country's cost of imports are greater than cost of its exports. A trade deficit can inherently neither be considered as good nor bad. A trade deficit can both be a sign of a strong economy as well as a vulnerable economy. For example, large trade deficits may imply higher rates of economic growth as the domestic nation is importing capital to expand its production capacity. However, at the same time, it could also reflect a lower level of domestic savings which would make the country more vulnerable to external economic shocks, like dramatic or sudden reversals of capital inflows. So, though superficially, it would seem like the trade deficit is hurting job creation and slowing down the economic growth, it is not always the case. If the employment is hurt in specific sectors, there may be offsetting job growth in other sectors. So, a strong trade surplus does not necessarily mean a strong economic growth and neither does a strong trade deficit necessarily create trouble for the economy.