10.3 Trade Balances and Flows of Financial Capital
5 min read•june 24, 2024
International trade and finance shape global economic relationships. Countries exchange goods, services, and capital, creating complex networks of trade balances and financial flows. Understanding these dynamics is crucial for grasping how economies interact on a global scale.
Comparative advantage drives international trade, with nations specializing in goods they can produce most efficiently. This concept, based on opportunity costs, explains why countries trade and how they benefit from it. Trade balances and foreign investment are closely linked, influencing each other and shaping global economic integration.
International Trade and Finance
Trade balances and capital flows
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Difference between a country's exports and imports determines its
Positive trade balance (surplus) when exports exceed imports
Negative trade balance (deficit) when imports exceed imports
International financial involve movement of money across borders for investment
when foreign investors buy domestic assets or lend to domestic economy
when domestic investors buy foreign assets or lend to foreign economies
Trade balances and international financial capital flows are interconnected
financed by net capital inflows from abroad
Country must borrow or attract foreign investment to pay for excess imports
balanced by net capital outflows to other countries
Country can lend or invest in foreign assets with surplus
Exchange rates influence trade balances and capital flows
A stronger currency makes exports more expensive and imports cheaper, potentially leading to trade deficits
A weaker currency has the opposite effect, potentially leading to trade surpluses
Comparative advantage through opportunity costs
Comparative advantage is ability to produce a good or service at lower than another country
Opportunity cost is value of next best alternative forgone when making a decision
Calculating comparative advantage using opportunity costs:
Determine opportunity cost of producing each good in each country
Country with lower opportunity cost for a good has comparative advantage in producing it
Each country should specialize in producing good for which it has lower opportunity cost
Trade balance vs foreign investment
Balanced trade and its impact on foreign investment and capital movements:
Balanced trade means net exports (exports minus imports) equal zero
Implies country's savings equal its investments
Savings = Domestic Investment + Net Exports
If Net Exports = 0, then Savings = Domestic Investment
No net foreign investment or net capital movements in this case
Trade imbalances and their impact on foreign investment and capital movements:
Trade deficit (negative net exports) implies country's savings less than investments
Country must attract foreign capital inflows to finance deficit
Can be foreign direct investment, portfolio investment, or borrowing
Trade surplus (positive net exports) implies country's savings exceed investments
Country can invest excess savings abroad, leading to capital outflows
Can be foreign direct investment, portfolio investment, or lending
Relationship between trade balances, foreign investment, and capital movements ensures BOP always balances
Trade deficit (current account deficit) offset by capital and financial account surplus (net capital inflows)
Trade surplus (current account surplus) offset by capital and financial account deficit (net capital outflows)
International Economic Systems and Policies
has increased economic interdependence between countries through trade, investment, and financial flows
The facilitates global trade and investment by providing a framework for currency exchange and international payments
involves government policies that restrict international trade to protect domestic industries, potentially affecting trade balances and capital flows
Key Terms to Review (21)
Absolute Advantage: Absolute advantage refers to the ability of a country, individual, or firm to produce a good or service more efficiently than another, using fewer inputs of labor and resources. This concept is central to understanding international trade and the gains that can be achieved through specialization and exchange.
Balance of Payments: The balance of payments is an accounting record that systematically summarizes all transactions between a country and the rest of the world over a specific time period. It tracks a country's imports and exports of goods, services, and capital, as well as financial transfers, to determine if the country has a surplus or deficit in its international transactions.
Balance of Trade: The balance of trade is the difference between a country's imports and exports of goods and services. It represents the net flow of trade between a country and the rest of the world, indicating whether a country is a net exporter or a net importer.
Capital Account: The capital account is a record of a country's net international investment position, which includes the net flow of capital, such as foreign direct investment and portfolio investment, as well as changes in reserve assets. It is a key component of a country's balance of payments, which measures the economic transactions between a country and the rest of the world.
Capital Flows: Capital flows refer to the movement of money for the purpose of investment, trade, or business operations across international borders. This term is closely tied to the dynamics of trade balances, financial capital, exchange rates, and national saving and investment patterns.
Capital Inflows: Capital inflows refer to the movement of foreign capital, such as investments or loans, into a domestic economy. This influx of capital can have significant implications for a country's trade balance and fiscal policy.
Capital Outflows: Capital outflows refer to the movement of financial capital out of a country or economy. This involves the transfer of assets, investments, or funds from domestic sources to foreign destinations, often driven by factors such as higher returns, political or economic instability, or diversification of investment portfolios.
Current Account: The current account is a record of a country's transactions with the rest of the world, including the balance of trade (exports minus imports of goods and services), net income from abroad, and net current transfers. It is a key measure of a country's economic performance and its relationship with the global economy.
Exchange Rate: The exchange rate is the price of one currency in terms of another currency. It determines the value of a country's currency relative to other currencies and plays a crucial role in international trade, financial flows, and macroeconomic conditions.
Financial Account: The financial account is a component of a country's balance of payments that records the net change in ownership of foreign assets and liabilities. It reflects the flow of capital into and out of a country, capturing both private and official transactions related to investments, loans, and other financial instruments.
Foreign Direct Investment: Foreign direct investment (FDI) refers to the investment made by an entity or individual in one country into business interests located in another country. This can involve establishing new operations, acquiring or merging with an existing company, or expanding the operations of an existing foreign-owned business.
Globalization: Globalization refers to the increasing interconnectedness and interdependence of economies, societies, and cultures around the world. It is a multifaceted process that has transformed the way goods, services, capital, people, and ideas move and interact across national borders.
International Monetary System: The international monetary system refers to the framework of rules, institutions, and practices that govern the use of different national currencies in international transactions and the flow of capital across national borders. It determines how exchange rates are set, how countries manage their balance of payments, and how the global financial system operates.
Law of Comparative Advantage: The law of comparative advantage states that countries should specialize in producing and exporting goods and services in which they have the lowest opportunity cost, and import goods and services in which they have the highest opportunity cost. This allows countries to maximize their total output and consumption through international trade, even if they are less efficient at producing certain goods than other countries.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be forgone when making a choice. It represents the trade-offs individuals, businesses, and societies face when allocating scarce resources to different uses.
Portfolio investment: Portfolio investment refers to the purchase of financial assets, such as stocks and bonds, in a foreign country. It allows investors to diversify their holdings and potentially earn higher returns while minimizing risk through asset allocation. This type of investment plays a significant role in the flow of financial capital between countries and can influence trade balances by affecting currency values and international capital movements.
Protectionism: Protectionism refers to government policies and actions aimed at restricting or regulating international trade to protect domestic industries and workers from foreign competition. It involves the use of tariffs, quotas, subsidies, and other trade barriers to make imported goods less competitive compared to domestically produced goods.
Terms of Trade: The terms of trade refer to the ratio of a country's export prices to its import prices. It measures the exchange rate at which a country's goods are traded for goods from other countries. The terms of trade are an important indicator of a country's economic performance and its ability to purchase imports with its export earnings.
Trade Balance: The trade balance is the difference between a country's exports and imports of goods and services. It represents the net flow of a country's international trade, indicating whether a country is a net exporter or a net importer.
Trade Deficit: A trade deficit occurs when a country's imports exceed its exports, meaning the country is spending more on foreign goods and services than it is earning from the sale of its own goods and services to other countries. This imbalance in trade flows is an important economic indicator that can have significant implications for a country's economy.
Trade Surplus: A trade surplus occurs when a country's exports exceed its imports, resulting in a positive balance of trade. This term is closely related to the measurement and analysis of a country's trade flows, as well as its broader economic implications and policy considerations.