Global Capital Flows encompass the movement of financial resources across countries. These flows can be categorized into foreign direct investment (FDI), portfolio investment, and other investments such as loans and banking capital. Understanding global capital flows is crucial as they affect a nation's balance of payments, influence exchange rates, and impact economic stability and growth.

Global capital flows are primarily divided into three components:

• Foreign Direct Investment (FDI): Involves long-term investments where investors acquire significant ownership in foreign companies, typically influencing management and strategic decisions.
• Portfolio Investment: Refers to investments in financial assets such as stocks and bonds. Unlike FDI, portfolio investments do not grant the investor control over the company's operations.
• Other Investments: Includes short-term capital movements like loans, bank deposits, and trade credits, which are more volatile and can quickly flow in or out of a country.

Several theories explain the mechanisms and effects of global capital flows:

• Capital Asset Pricing Model (CAPM): Assesses the relationship between systematic risk and expected return for assets, aiding in understanding portfolio investment flows.
• Interest Rate Parity: Suggests that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate, influencing capital flows.
• Purchasing Power Parity (PPP): States that in the long run, exchange rates should adjust to equalize the price of identical goods and services in different countries, affecting trade and capital flows.

Global capital flows have a direct impact on a country's real interest rates. When capital flows into a country, the increased demand for financial assets can drive up asset prices and lower real interest rates. Conversely, capital outflows can decrease asset prices and increase real interest rates. The relationship can be represented by the following equation:

Where:

• r: Real interest rate
• i: Nominal interest rate
• π: Inflation rate

This equation illustrates how changes in nominal interest rates and inflation influence real interest rates, which in turn affect capital flows.

Understanding global capital flows involves several key equations and models:

• Interest Rate Parity (IRP): $$\frac{1 + i_d}{1 + i_f} = \frac{F}{S}$$

  Where:

  • i_d: Domestic interest rate
  • i_f: Foreign interest rate
  • F: Forward exchange rate
  • S: Spot exchange rate

  This equation ensures that the expected returns on investments are equalized across countries, preventing arbitrage opportunities.

• Net Capital Flow (N): $$N = SFI - SOI$$

  Where:

  • SF: Savings of foreigners in the domestic country
  • SI: Savings of the domestic country in foreigners

  This represents the net amount of capital flowing into or out of a country.

• Global capital flows are essential for understanding international economic interactions.
• They comprise FDI, portfolio investments, and other short-term investments.
• Theoretical frameworks like CAPM and IRP help explain the dynamics of capital movements.
• Real interest rates are significantly influenced by the direction and magnitude of capital flows.
• A comprehensive comparison of investment types highlights their distinct characteristics and impacts.