NET EXPORTS AND CAPITAL FLOWS
Cedric Chehab
09 Nov, 2013
Definition: Capital flows and net exports both indicate where money is going between countries.
In Other Words: Many factors impact capital flows and net exports, including interest rates, exchange
rates, production and institutions.
Why is this Important? In order to understand international economics, one must be able to understand
the connections that exist between net exports, capital flows, exchange rates, interest rates and output.
Net Exports
The main factor in determining net exports is the real exchange rate. If you remember from previous
lessons, the nominal exchange rate is defined by the foreign price level, P*, the home price level, P.
However the real exchange rate is defined in terms of baskets of goods. Put simply, it represents how
many foreign goods can be bought with one domestic good (from now on we’ll refer to domestic goods as
U.S. goods). Changes in the real exchange rate affect net exports because they reflect changes in the
prices of U.S. goods/services relative to foreign goods/services. Let’s say there is a rise in the real
exchange rate. This means if you were to trade a U.S. good for a foreign good, you would get more foreign
goods in return.
How would such a rise impact net exports? The real exchange rate has increased. If foreign goods are less
expensive now, relative to domestic goods, foreign consumer will want to buy fewer U.S. goods. Therefore
demand for U.S. exports goes down, lowering NX. This inverse relationship between the real exchange rate
and net exports explains the downward sloping curve:
Capital Flows
However international transactions are not limited to goods and services, but also assets. So demand for
foreign currency is a result of U.S. demand for goods/services and foreign assets such as bonds. We define
U.S. purchases of foreign assets as Capital Outflow and foreign purchases of U.S. assets as Capital
Inflow. Therefore, equilibrium would be when U.S. imports and capital outflow (CO) equal U.S. exports and
capital inflow (CI):
IM + CO = EX + CI
As with any equilibrium, the exchange rate adjusts until both sides are equal. So if imports and capital
outflow were greater than exports and capital inflow, the demand for dollars would be greater than the
supply and the exchange rate would have to go down.
We can rewrite this equation to pair imports with exports and capital inflow with outflow:
EX – IM = CO – CI
Economics > International Economics > Net Exports & Capital Flows
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NET EXPORTS AND CAPITAL FLOWS
Cedric Chehab
09 Nov, 2013
Which simplifies to net exports equals net capital flow:
NX = CF
Now that capital flows are a factor in determining the exchange rate, we also introduce the impact of the
real interest rate. If there is a high interest rate in the U.S., then more people will want to put their money
in U.S. banks, so capital outflows goes down and inflows go up and CF falls (CF=CO-CI). So there is an
inverse relationship between CF and the real interest rate (r).
MP-IS Curves
Now that we’ve introduced the interest rate, a crucial component in our understanding of NX and CF is the
MP-IS relationship. The IS curve shows the relationship between the real interest rate and output. It
relates to the planned expenditure curve, which you may have learned about in macroeconomics. That
curve consists of E= C + I + G, so any changes in C,I or G affect the IS curve. There is an inverse
relationship between IS and r because an increase in r reduces investment, thus output falls. MP stands
for Monetary Policy; this curve shows how the central bank (in the U.S., the federal reserve) uses monetary
policy in reaction to changes in output. When output rises, the fed worries the economy is growing too fast
so slows it down by raising the real interest rate, which encourages people to put their money in the bank
instead of spending it. When output falls, the fed lowers the rate to encourage people to spend money.
Thus we get the following relationship which determines the real interest rate:
Economics > International Economics > Net Exports & Capital Flows
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NET EXPORTS AND CAPITAL FLOWS
Economics > International Economics > Net Exports & Capital Flows
Cedric Chehab
09 Nov, 2013
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