When Is Free Movement of Capital Good for Growth - Coursework Example

Economic Growth Table of Contents Table of Contents 2 Introduction 3 International Capital Flows and Economic Growth 4 Managing Capital Inflows 5 Theories That Can Be Linked With Capital Flows 6 International Capital Flows And Challenges Faces By Countries 7 Productivity Growth and Capital Flows 8 Conclusion 9 References 10 Introduction Financial openness can be viewed as an important aspect for the economic growth of a nation. The advanced economies are expected to have high standard of living and following the approach of financial openness may result into long run benefits for the country. A free capital market allows the resources of the countries to flow from one nation to other resulting into economic growth as it reflects no barrier. In economic terms the export and import of the goods and services are recorded in the current account transaction whereas the cash flows between the countries are recorded in the balance of payments. The freedom of capital flows across the other countries creates opportunities for increased investments in stocks, bonds and other financial activities. It allows the investors to invest in the long run and so results into economic growth of the country. On the other hand, financial openness also improves the welfare by allowing the movement of goods and services between varied countries. However, trade flows and financial flows do not ensure that Gross Domestic Product (GDP) and flow of currency will rise. In some cases capital flows can be volatile in nature and this implies that the country may have to face the increased risk on the domestic economy. In some cases permitting financial flows may also weaken the monetary policy and exchange rate policy of the nation (Usher, 2007). Therefore, the objective of the paper is to elaborate on the aspect “When is free movement of capital good for growth”. International Capital Flows and Economic Growth The impact of globalization on economic progress and the addition of capital inflows to it have resulted in the growth of the developing nation. Openness in the financial markets reduces capital control with the improvements in the transaction process responsible for the growth of the country. The capital flows beyond the domestic boundary may also result in the growth of GDP and encourage international trade in industrial as well as developing nations. International financial flows permits more currency flow in the country and so encourages trade. On the other hand, reduced trade barriers results more import of goods, which implies that more choices are available to the consumers. Therefore, a financial flow raises the demands for more products and encourages smooth consumption among the individuals which in turn is beneficial for the economic growth of the country. This in turn also reduces the number of people living below the poverty line. Openness to financial flows also opens the opportunity for foreign competition. In order to face the increased competition the industries demands for more new advanced technology. This may also result in import of new innovative technology from other countries and so it also enhances the trade relations. An improved trade relation between the nations also encourages the flow of knowledge and skills that opens the opportunity for the individuals to work for other nations (Bekaert, & et. al., 2011). The capital flows to the underdeveloped nations can accelerate the growth process on a long term basis. Financial flows in form of Foreign Direct Investment (FDI) also encourage the flow of resources from the developed nations to the poor countries for growth. It also provides opportunities to the developing industries to grow at a faster rate and to compete with the other firms. The transfer of resources including technology, knowledge and work force also contributes to the economic development of the nation. The economic growth of many like Australia and Canada focuses on the role of capital flows as it has resulted in economic development of the nations. In the early stages of development, the United States also permitted the capital flow that has shown a positive impact on trade. The financial institutions within the home country are becoming more efficient and transparent with the increase in competition. As the countries are facing the outside capital markets and so this results changes in the ‘macroeconomic policies’ of the country (Alfaro, 2003). Increase in the foreign investments enhances the aggregate demand and so improves the economic conditions. This in turn reduces unemployment. The effect of aggregate demand depends on the type of economy. For example, if a country has high unemployment level and low growth, in that case investment from the foreign countries is more beneficial. On the other hand in case of a closed economy it may have a negative impact on the economy in terms of inflation. It also has a positive impact on the aggregate supply that raises investment in the industrial sectors and improved productivity. In order to fulfil the increasing demand the firms produces more units of products and this also reduces the problem of unemployment (Burnette, n.d.). Managing Capital Inflows One of the main challenges faced in the openness for the financial flows is to manage the capital flows in a manner that results into the economic growth of the country. Considering the macroeconomic risk, excess financial flows can also weaken the monetary policy of the country resulting in credit problem. The loss of monetary power may affect the price stability and give rise to the prices of the products. On the other hand, the export of the essential commodities along with the excess currency flow raises the demands for the products. In case the demand for the products is not fulfilled that results into inflation. So the monetary policies are to be strictly maintained in order to manage the international capital inflows. Flexibility in exchange rates can also assist in managing the capital flows within the domestic country as exchange rate depends on the inflow and outflow of currency between the countries. Therefore, control over the exchange rates can help to control the flow of currency and transaction process (Reinhardt & et. al., 2012). Theories That Can Be Linked With Capital Flows Financial inflows that results improved trade relations between the countries and so the demand for the product increases. The economic growth of the country results into better standard of living of the people. With the rise in income of the people their consumption power also increases. According to the “Keynes’ Theory”, consumption is quantity of goods and services that people will purchase for immediate consumption purpose. Consumption is a factor that determines the ‘aggregate demand’ of the economy that involves the total expenditure. Other factors that determine the demands are investments and expenditures made by the government. The theory suggests that in case of a closed economy the demand is influenced by the consumption behaviour of the individuals as well as government investments. Therefore, increase in capital flows encourages trade and also affects the consumption of the individuals. A financial flow also encourages FDI and in turn results in the economic growth of the country (Orlando, & et .al, 2008) Capital flows can also influence international trade. According to the ‘Theory of International Trade’ a country can gain ‘comparative advantage’ with improved trade relations if the firm can produce goods that involve lower opportunity cost as compared to the goods produced by the other nations. The ‘Hecksher-Ohlin Theory’ suggests that considering the’ theory of free trade’, the county with abundant capital is expected to produce the goods those are essential for the country itself and gain comparative advantage by exporting that good. This will result into increased export activities between different nations and so economic growth of the nation. On the other hand, if the barriers to trade are reduced by the government it can result into more improved trade relations and growth. According to the trade theory, better trade relations influence the country to specialise in the product they manufactures and to import the goods not produced within their domestic boundaries (Dippel, 2009). International Capital Flows And Challenges Faces By Countries Despite the fact that financial openness has resulted in the economic growth of the country, the fact have some limitations to it. The unstable nature of financial flows has negative impact on the domestic economy. The access to more international capital movements may affect the domestic financial stability. The positive or the good impact of financial flows and free trade depends on the capacity of the domestic system to maintain the balance between the foreign capital inflows and the existing financial capacity. The domestic system may not have the capacity to effectively utilize the large volume of inflows. The inflow of foreign capital is also required to be controlled so that in case of short term lending it does not result into loss for the domestic institutions. In addition to all this, increased financial flows from the foreign countries may also raise corruption. The individuals involved in various financial services may take the benefit of the international flows for their personal benefits (Carmignani, & et. al., 2007). Capital flows adds to demand as well as supply and so it can result into inflation due to the effect of free trade. An increased capital flow creates a pressure on the price of the goods due to the aspect of free trade. Although capital flows raises the supply goods, but in case if the inflow is mainly directed towards the purchase of the domestic products then this can lead to the rise in the prices of the products. On the other hand if the demand for the goods is already high the supply of cheap foreign products may not offset the demand (Yellen, 2011). Productivity Growth and Capital Flows Financial openness is expected to have a positive impact on the productivity of the firms. With the increase in financial flows the trade relations between the nations expands. This results into increased flow of currency in the country and in turn has a positive impact on the overall consumption level. In order to meet the increasing demands of the consumer the firms need to produce more quantity of products, which is possible with the help of free capital trade. With the improvements in the standard of living people wants access to new innovative products. Increase in financial flows encourages ‘Total Factor Productivity’ (TFP). The growth in TFP can provide improvements in the financial sectors because of increased capital inflows from other countries. Other indirect ways that results into the growth can be through the improvements in the monetary policies, improvements in exchange rates and so on. On the other hand ‘Foreign Direct Investment’ motivates the import of managerial and technical knowhow that also influences the growth of TFP (Saliola & et. al, 2011). These are the few conditions which help in enhancing the growth with the help of the free capital flow. Conclusion It can be concluded from the paper that openness to financial flows results in improvement of the economic position of the country. However, it also has its limitations and so the countries must improve their domestic financial system in order to take the advantages of the gains from the capital flows. Government should frame the monetary policies in such a manner that it does not result into any monetary losses for the countries due to the free capital flow. Expansion of trade relations means more transaction between the nations and so no strict exchange policies are to be maintained by the government for the growth. References Alfaro, L., 2003. Foreign Direct Investment and Growth: Does the Sector Matter. Abstract. [Online] Available at: http://www.grips.ac.jp/teacher/oono/hp/docu01/paper14.pdf [Accessed February 07, 2015]. Bekaert, G. & et. al., 2011. Financial Openness and Productivity. World Development 39 (1), pp. 1–19. Burnette, J., No Date. Aggregate Demand and Aggregate Supply. The Aggregate Demand Curve. [Online] Available at: http://people.rit.edu/jdbgse/Documents%20402/CN_intromacro_6.pdf [Accessed February 07, 2015]. Carmignani, F. & et. al., 2007. Does Financial Openness Promote Economic Integration. Discussion Paper Series. [Online] Available at: http://www.unece.org/fileadmin/DAM/oes/disc_papers/ECE_DP_2007-4.pdf [Accessed February 07, 2015]. Dippel, C., 2009. International Trade. Heckscher Ohlin. [Online] Available at: http://homes.chass.utoronto.ca/~cdippel/LNHOV.pdf [Accessed February 07, 2015]. Orlando, F., 2008. Behavioral Foundations for the Keynesian Consumption Function. Working Paper. [Online] Available at: http://dipse.unicas.it/files/wp200805.pdf [Accessed February 07, 2015]. Reinhardt, D. & et. al., 2012. International Capital Flows and Development: Financial Openness Matters. International and Development Studies Working Paper. [Online] Available at: http://graduateinstitute.ch/files/live/sites/iheid/files/sites/international_economics/shared/international_economics/publications/working%20papers/2012/HEIDWP11-2012.pdf [Accessed February 07, 2015]. Saliola, F., & et. al, 2011. Total Factor Productivity Across the Developing World. Productivity. [Online] Available at: http://www.enterprisesurveys.org/~/media/GIAWB/EnterpriseSurveys/Documents/EnterpriseNotes/Productivity-23.pdf [Accessed February 07, 2015]. Usher, J.A., 2007. The Evolution of the Free Movement of Capital. Fordham International Law Journal, Vol. 31, No. 5, pp 1. Yellen, J.L., 2011. Reaping The Full Benefits Of Financial Openness. BIS central bankers’ Speeches, pp.1-7. Read More