Trade and Capital Flows

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This is an article from Macroeconomics. To get back to the list of all topics click here.

[1]This article discusses the connection between international trade (imports and exports) and international capital flows (loans and asset acquisitions/disposals). Both of these are recorded in the balance of payments, which consists of the Current Account and Capital Account. The link between these accounts gives insight into why countries (like Australia) borrow so much from other countries.

Contents

Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 419-434 (Chapter 15).

Balance of Payments

[2]Simply speaking, the balance of payments is a bookkeeping exercise that records all the transactions between one country and others. The types of transactions it records (amongst others) are:

  • Imports
  • Exports
  • Monetary gifts sent/received internationally
  • International borrowings/lending

The balance of payments consists of two main accounts: the Current Account and the Capital Account.

The Current Account

[3]The current account consists of any exchange in commodities, or direct transfer of income between countries. The biggest components are imports and exports, though other components such as royalty payments, interest, dividends, foreign aid and insurance payments are recorded as well.

To calculate the balance in the Current Account, the following formula is applied:

Balance in Current Account = Net Exports + Net Services + Net Income + Net Current Transfers

Where:

Net Exports (NX) = Exports - Imports (X - M)
Net Services = payments for services performed by a foreign country (like net exports, any inflow of cash is positive, any outflow is negative)
Net Income = interest, labour and property income, dividends and royalties
Net Current Transfers = foreign aid, migrant funds, monetary gifts across countries

A positive Current Account balance is known as a current account surplus while a negative balance is known as a current account deficit.

The Capital Account

[4]The capital account records any transactions that involve the acquisition of assets or liabilities internationally. It has two components:

  1. Official Sector which includes the Reserve Bank and the Government's operations
  2. Non Official Sector which includes private sector firms, financial institutions and household operations

To calculate the balance in the Capital account, the following formula is used:

Balance in Capital Account = Net Capital Transfers + Net Acquisition/Disposal of non produced, non-financial assets + Balance on Financial Account

Where:

Net Capital Transfers = cancellation of debts of poor countries, funds taken in and out by migrants
Net Acquisition/Disposal of non produced, non-financial assets = sales of embassy lands, patents and copyrights
Balance on Financial Account = investment by foreigners in a country and by that country in other countries, changes in RBA holdings of foreign exchange and gold

International Capital Flows

[5]International Capital Flows are purchases and sales of real and financial assets across international borders. Purchases of domestic assets by foreigners are seen as inflows while purchases of foreign assets by domestic buyers are seen as outflows. The difference between the two (inflows - outflows) is known as net capital flows.

Capital Flows and the Current Account Balance

[6]An important relationship to keep in mind between the current account and the capital account is that their sum is always equal to zero. That is:

CAB - KAB = 0 or
CAB = -KAB

Where:

CAB = Current Account Balance
KAB = Capital Account Balance

To understand why, consider what happens if the domestic buyer buys an imported good for $100. The buyer then buys an import and the money is sent to the exporter's bank within the same country. Now the exporter has two main options:

  1. Leave the money in the country to buy goods and services with. In this case the exporter is effectively buying "exports" from the country, so that the CAB is zero, since the import value is equal to the export value. n addition, since no assets were bought or sold, KAB = 0 and hence the equation above is satisfied.
  2. Buy domestic assets. In this case, the import reduces the current account, so that CAB = -$100, but the acquisition of domestic assets by a foreigner increases the capital account so that KAB = $100, and hence the equation above holds.

In reality there is a third option, which is for the exporter to trade the $100 for another currency. However then the buyer of the $100 has the same two options as above so that the equation still holds.

In addition, it should be noted that the equation only holds for economies with a flexible exchange rate and not for those with fixed exchange rates. This is because economies with fixed exchange rates involve the Central Bank buying and selling currency which offsets the KAB.

Determinants of Capital Flows

[7]The reason people are interested in investing internationally is the ability to make returns on assets. These returns are determined by the interest rate in those countries. For Australia's purposes, a higher interest rate will encourage foreign investments in Australia (Capital Account inflows), while low interest rates will reduce foreign investment (Capital Account outflows). A higher interest rate also means that residents are less likely to invest overseas, and hence the capital outflows are seen as zero. Hence the relationship between capital inflows and the real interest rate can be seen to be an upward sloping curve.

Shifts in the curve mainly occur due to the change in the risk associated with investment in the country. Higher risk will shift the curve to the left, while a lower risk will shift the curve to the right.

One more note: in small open economies (like Australia), the domestic interest rate is usually the same as the prevailing interest rate around the world.

Savings, Investment and Capital Flows

[8]Recall from Savings and Investment that in a closed economy, savings equal investment (in equilibrium). However in the open economy, this may no be true, and instead we say that net savings and capital inflows equal investment since capital inflows give more available money to invest. Hence we can say that:

NS + KI = I

Where:

NS = National Savings
KI = Capital Inflows
I = Investment

Now for a small economy, like australia, the interest rate is the same as around the world. Suppose this world interest rate is below what Australia's equilibrium interest rate should be. Under such circumstances, the amount of investment, I, demanded is greater than the amount of savings, NS, demanded. The difference between the two, I - NS = KI (from the above equation) which suggests that the economy does not have to be in equilibrium (where NS = I). Conversely, if the prevailing interest rate around the world is above the equilibrium point for Australia, then savings exceed demand, and the difference I - NS <0, implying that KI < 0, i.e. negative capital inflows (or positive capital outflows). This suggests that in such a situation, Australian will be more inclined to save overseas rather than domestically, and these outflows will balance NS with I.

National Accounting Identity and Capital Flows

[9]Countries often run trade deficits, that is, imports exceed exports. The reason for this, from an economic perspective, is that these countries have a low rate of national savings. To see why, recall the national accounting identity:

Y = C + I +G + NX

Rearranging yields:

Y - C - G - I = NX

But, Y - C - G = NS, hence

NS - I = NX

Therefore, if we keep investment constant, then a high level of national savings will yield higher next exports (and hence larger exports) while a low level of savings means low (or negative) net exports. This makes sense, since a country with low savings means higher spending, part of which goes into imports.

References

"Textbook" refers to Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011).

  1. Textbook p.419
  2. Textbook p. 420
  3. Textbook p. 420
  4. Textbook p. 425
  5. Textbook p. 426
  6. Textbook p. 427
  7. Textbook p. 429
  8. Textbook p. 430
  9. Textbook p. 433
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