International Trade, Capital Flows, and Exchange Rates

International Trade and Capital Flows

The Flow of Goods and Services

International trade involves the movement of goods and services across borders. The balance between exports and imports is a key indicator of a country's trade position.

• Exports: Domestically produced goods and services sold abroad.

• Imports: Foreign-produced goods and services purchased domestically.

• Net Exports (NX): Also known as the trade balance, calculated as the value of exports minus the value of imports.

Trade Surplus: Occurs when exports exceed imports (NX > 0). Trade Deficit: Occurs when imports exceed exports (NX < 0). Balanced Trade: Occurs when exports equal imports (NX = 0).

The Flow of Capital

Capital flows refer to the movement of financial assets between countries. The net capital outflow (NCO) measures the difference between domestic purchases of foreign assets and foreign purchases of domestic assets.

• Net Capital Outflow (NCO): Domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets. Also called net foreign investment.

• Forms of Capital Flow:

  • Foreign Direct Investment: Domestic residents actively manage foreign investments (e.g., a US company opens a branch abroad).

  • Foreign Portfolio Investment: Domestic residents purchase foreign stocks or bonds, supplying loanable funds to foreign firms.

• Capital Outflow: NCO > 0, domestic purchases of foreign assets exceed foreign purchases of domestic assets.

• Capital Inflow: NCO < 0, foreign purchases of domestic assets exceed domestic purchases of foreign assets.

The Equality of Net Exports and Net Capital Outflow

There is an accounting identity in macroeconomics: every transaction that affects net exports also affects net capital outflow by the same amount.

• Identity: $\text{NCO} = \text{NX}$

• When a foreigner purchases a US good, US exports and NX increase, and the US acquires foreign assets, causing NCO to rise.

• When a US citizen buys foreign goods, US imports rise and NX falls; the other country acquires US assets, causing NCO to fall.

Saving, Investment, and International Flows

National income accounting links saving, investment, and international flows of goods and assets.

• National Income Identity: $Y = C + I + G + NX$

• Rearranged: $Y - C - G = I + NX$

• Since $S = Y - C - G$, then $S = I + NX$

• Since $NX = NCO$, then $S = I + NCO$

• When $S > I$, excess loanable funds flow abroad as positive net capital outflow.

• When $S < I$, foreigners finance some domestic investment, and NCO < 0.

Exchange Rates

The Nominal Exchange Rate

The nominal exchange rate is the rate at which one country's currency can be exchanged for another's. It is typically expressed as units of foreign currency per unit of domestic currency.

• Nominal Exchange Rate (e): Foreign currency per unit of domestic currency.

• Examples (as of July 7, 2025, per USD):

  • Canadian dollar: 1.37

  • Euro: 0.86

  • Japanese yen: 146.44

  • Mexican peso: 18.62

Appreciation and Depreciation

Exchange rates fluctuate, leading to appreciation or depreciation of currencies.

• Appreciation: An increase in the value of a currency; it can buy more foreign currency.

• Depreciation: A decrease in the value of a currency; it can buy less foreign currency.

• Example: In 2007, the US dollar depreciated 9.5% against the Euro and appreciated 1.5% against the South Korean Won.

The Real Exchange Rate

The real exchange rate measures the rate at which goods and services of one country can be exchanged for those of another, adjusting for price levels.

• Formula: $\text{Real Exchange Rate} = e \times \frac{P}{P^*}$

• P: Domestic price level (e.g., GDP deflator, CPI).

• P*: Foreign price level.

• If the real exchange rate appreciates, domestic goods become more expensive relative to foreign goods.

The Law of One Price

The law of one price states that identical goods should sell for the same price in all markets, assuming no transportation costs and free trade.

• Arbitrage: Buying goods in a market where they are cheaper and selling them where they are more expensive, which equalizes prices.

• Example: If coffee sells for $10/pound in Seattle and $12/pound in Boston, arbitrage opportunities exist until prices equalize.

Purchasing-Power Parity (PPP)

PPP is a theory of exchange rates based on the law of one price. It suggests that a unit of currency should buy the same quantity of goods in all countries.

• PPP Formula: $e \times P = P^*$

• Solve for e: $e = \frac{P^*}{P}$

• PPP implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries.

• Example: If a Big Mac costs $5 in the US and 600 yen in Japan, PPP exchange rate is$e = \frac{600}{5} = 120$ yen/USD.

PPP and Its Implications

PPP implies that the nominal exchange rate between two countries should equal the ratio of their price levels. Exchange rates change over time due to differences in inflation rates.

• If inflation is higher in Japan than in the US, $P^*$ rises faster than $P$, so $e$ rises—the dollar appreciates against the yen.

• If inflation is higher in the US than in Japan, $P$ rises faster than $P^*$, so $e$ falls—the dollar depreciates against the yen.

Limitations of PPP Theory

PPP does not always hold due to practical limitations.

• Many goods cannot easily be traded (e.g., haircuts, movie tickets).

• Price differences on such goods cannot be arbitraged away.

• Foreign and domestic goods are not perfect substitutes; consumer preferences may differ (e.g., preference for Toyotas vs. Chevys).

• Price differences may reflect taste differences rather than arbitrage opportunities.

Summary Table: Key Concepts in International Trade and Exchange Rates

Concept	Definition	Formula	Example/Application
Net Exports (NX)	Exports minus imports	$\text{NX} = \text{Exports} - \text{Imports}$	US exports $100B, imports $80B: NX = $20B
Net Capital Outflow (NCO)	Domestic purchases of foreign assets minus foreign purchases of domestic assets	$\text{NCO} = \text{Domestic purchases of foreign assets} - \text{Foreign purchases of domestic assets}$	US buys $50B foreign assets, foreigners buy $30B US assets: NCO = $20B
Nominal Exchange Rate (e)	Rate at which currencies are exchanged	Foreign currency per unit of domestic currency	1 USD = 146.44 Yen
Real Exchange Rate	Relative price of goods between countries	$e \times \frac{P}{P^*}$	If e = 120, P = $5, P* = 600 yen: Real exchange rate = 120 x 5 / 600 = 1
Purchasing-Power Parity (PPP)	Exchange rate equalizes price of basket of goods	$e = \frac{P^*}{P}$	Big Mac Index: e = price in Japan / price in US

Additional info: The notes expand on the accounting identities and exchange rate concepts, providing formulas and examples for clarity. The summary table consolidates key definitions and applications for exam review.