Chapter 19: Problem 10

What do international flows of capital have to do with trade imbalances?

Short Answer

Expert verified

In conclusion, international capital flows and trade imbalances are interconnected, as the movement of capital across borders can be linked to global trade patterns. According to the balance of payments identity, a country's current account balance (which includes its trade balance) must be equal to the net of its capital and financial account. This means that a trade deficit must be offset by net capital inflows, while a trade surplus necessitates net capital outflows. Exchange rates can further influence this relationship by affecting the competitiveness of exports, imports, and foreign investments.

Step by step solution

Understand Trade Imbalances

Trade imbalance occurs when the value of a country's imports and exports are not equal. A trade surplus exists when the value of exports exceeds the value of imports, while a trade deficit occurs when the value of imports is higher than exports. This can be represented as: Trade balance = Exports - Imports

Understand Capital Flows

International capital flows are transactions related to the movement of capital across borders. Capital flows can be broken down into two main types: 1. Direct Investment: When a foreign company invests in a domestic company, buys assets, or acquires control of an existing business in the host country. 2. Portfolio investment: When a foreign investor buys financial assets, such as stocks and bonds, but doesn't take direct control over the company. Capital flows can be both inflows (when a domestic entity receives capital from abroad) and outflows (when a domestic entity invests capital abroad).

Relationship between Trade Imbalance and Capital Flows

Now that we understand the basic elements of trade imbalance and capital flows, let's see how they influence each other. According to the balance of payments (BOP) identity, a country's current account balance (which includes its trade balance) must be equal to the net of its capital and financial account. Current account balance + Capital and financial account = 0 The above equation implies that if a country has a trade deficit, it must have net capital inflows to offset it, or if a country has a trade surplus, it must experience net capital outflows.

Exchange Rates and Trade Imbalances

The relationship between international capital flows and trade imbalances can be impacted by exchange rates. When a country's currency value changes, it can affect both exports and imports. For instance, depreciation of a country's currency can make its exports more competitive and its imports more expensive, potentially decreasing its trade deficit. Simultaneously, a lower exchange rate can prompt foreign investors to invest in the country, as its financial assets become relatively cheaper. This can lead to capital inflows, which help finance the trade deficit.

Concluding Remarks

In conclusion, international capital flows and trade imbalances are interconnected, as the movement of capital across borders can be linked to global trade patterns. Based on the balance of payments identity, a country with a trade deficit requires capital inflows to offset its deficit, while a country with a trade surplus needs capital outflows. Various factors like exchange rates can also influence the relationship between trade imbalances and capital flows.