Capital flows and net international investment

Abstract

This paper analyzes the effect of stochastic terms of trade and commodity preferences on international capital flows and the net asset position of a country. Investors hold foreign assets if excess return from foreign bonds is positive. The demand for foreign assets to hedge against the unanticipated changes in terms of trade is an increasing function of expenditure on imports, if the product of relative risk tolerance and consumption expenditure elasticity of imports is less than the price elasticity of imports. The paper also shows that the net international investment in a country is a decreasing function of the excess return from foreign industry and the rate of change of the terms of trade but an increasing function of their variances, cross-price elasticity of domestic good, price elasticity and consumption expenditure elasticity of imports. An increase in the expenditure on imports may result in a decrease or increase in the net international investment depending on whether the product of relative risk tolerance and consumption expenditure elasticity of imports is less or greater than the price elasticity of imports. JEL: F36, G15.