Net Exports and Capital Flows

Introduction

The term capital flow refers to the movement of financial capital (money) between economies. Capital inflows consist of foreign funds moving into an economy from another country; capital outflows, or capital flight, is the opposite- domestic funds moving out of an economy to another country. For example, from the perspective of the U.S. economy, the construction of a new plant by a Japanese automobile manufacturer within the United States is an example of capital inflow. Likewise, when an American manufacturer finances the construction of a plant outside of the United States, it is an example of capital outflow.

How Capital Flows

The loanable funds market is used to analyze capital flows in an economy. Because financial capital affects the amount of money available for borrowers, changes in capital flows shift the supply curve for loanable funds.

Graphs demonstrating Capital Inflow and Capital outflow

The Open Economy

International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite and means the country is a net lender to the rest of the world.

The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources. If S is private saving, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit:

Supply of financial capital = Demand for financial capital

S + (M – X)= I + (G – T)

A recession tends to increase the trade balance (meaning a higher trade surplus or lower trade deficit), while economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit).

Watch the presentation below to learn more about capital flows.

Review

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In Summary . . .

What's Your takeaway? Icon

To analyze the macroeconomics of open economies, two markets are central—the market for loanable funds and the market for foreign-currency exchange.
In the market for loanable funds, the interest rate adjusts to balance supply for loanable funds (from national saving) and demand for loanable funds (from domestic investment and net capital outflow).
In the market for foreign-currency exchange, the real exchange rate adjusts to balance the supply of dollars (for net capital outflow) and the demand for dollars (for net exports).
Net capital outflow is the variable that connects the two markets.
A policy that reduces national saving, such as a government budget deficit, reduces the supply of loanable funds and drives up the interest rate.
The higher interest rate reduces net capital outflow, reducing the supply of dollars.
The dollar appreciates, and net exports fall.

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