Open Economy - International Capital Flows and Trade Balance

International Capital Flows and Trade Balance

Begin with the identity

Subtract C and G from both sides to obtain

Y − C − G is national saving S, which equals the sum of private saving, Y − T − C, and public saving, T − G, where T stands for taxes. Therefore,

Subtracting I from both sides of the equation, we can write the national income accounts identity as

This shows that economy's net exports must be equal to the difference between savings and investment. Another name for net exports is the trade balance, as it tells us the difference between imports and exports from being equal.

The left-hand side of the identity is the difference between domestic saving and domestic investment, S − I,known as net capital outflow.Net capital outflow is equal to the amount that domestic residents are lending abroad minus the amount that foreigners are lending to home country.If net capital outflow is positive, the economy’s saving exceeds its investment, and lending the excess to foreigners. If the net capital outflow is negative, the economy is experiencing a capital inflow: investment exceeds saving, and the economy is financing this extra investment by borrowing from abroad.

The national income accounts identity shows that net capital outflow always equals the trade balance. That is, Net Capital Outflow = Trade Balance

If S − I and NX are positive, we have a trade surplus. In this case,since our exports are higher than our imports, we are net lenders in world financial markets. If S − I and NX are negative, we have a trade deficit. In this case, we are importing more goods than we are exporting.And hence we are net borrowers in the world markets. If S − I and NX are exactly zero, we are said to have balanced trade because the value of imports exactly equals the value of our exports.