Exports, imports and capital flows
How an open economy trades goods and assets with the world, why net exports equal net capital outflow, and what that means for saving and investment.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Define net exports and net capital outflow
- Explain why the two are always equal
- Use S = I + NCO to link saving, investment and the trade balance
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The economy behind your investments: lesson 14 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 18
What it is
A closed economy does not interact with others; an open economy trades freely with the rest of the world. It interacts in two ways: it buys and sells goods and services in world product markets, and it buys and sells assets (shares, bonds, property) in world financial markets.
The flow of goods.
- Exports: goods and services produced at home and sold abroad.
- Imports: goods and services produced abroad and sold at home.
- Net exports (NX) = exports − imports, also called the trade balance. Positive is a trade surplus; negative is a trade deficit; zero is balanced trade.
Mankiw lists what affects net exports: tastes for home and foreign goods, prices at home and abroad, exchange rates, incomes, transport costs and government policies towards trade.
The flow of capital.
- Net capital outflow (NCO) = purchases of foreign assets by home residents − purchases of home assets by foreigners.
- It can take the form of foreign direct investment (a home firm opening and running a business abroad, such as a fast-food outlet in Russia) or foreign portfolio investment (buying shares or bonds of a foreign firm).
Quick check
Tap an answer to check it.
A country exports 500 and imports 650. What is its trade balance?
- Imports exceed exports
Show answer
A trade deficit of 150. NX = 500 − 650 = −150.
Why it matters
Net exports always equal net capital outflow: NX = NCO. Every international sale of goods is matched by a flow of assets. Mankiw's example: a US programmer sells software to a Japanese buyer for 10,000 yen. US exports rise. If she keeps the yen, or uses them to buy Japanese shares or bonds, US net capital outflow rises by the same amount. If she instead spends the yen on Japanese goods, US imports rise too, and both NX and NCO are back where they started.
So a country with a trade deficit (NX < 0) must be selling assets to foreigners, or borrowing from them (NCO < 0). A country with a trade surplus is buying foreign assets.
Saving, investment and the trade balance. In an open economy, Y = C + I + G + NX, and national saving S = Y − C − G. So:
S = I + NX = I + NCO
A country's saving finances either investment at home or the purchase of assets abroad.
- If saving is less than investment, the gap is financed from abroad: NCO and NX are negative (a trade deficit).
- If saving is more than investment, the country lends abroad: a trade surplus.
Is a trade deficit a problem? Mankiw discusses the US, which borrowed heavily abroad to finance trade deficits: in the 1980s and early 2000s mainly because of low saving, and in the 1990s alongside an investment boom. If a deficit follows a fall in saving, he sees no reason to deplore the deficit itself: without foreign funds, investment would have to fall instead. If it follows an investment boom, the borrowing is fine if the new capital earns a good return, less so if the projects fail. His conclusion: a trade deficit is not a problem in itself, but sometimes it is a symptom of one.
Worked example
An open economy (billions): GDP 1,000; consumption 650; government purchases 200; investment 220.
- National saving: S = 1,000 − 650 − 200 = 150.
- Saving (150) is less than investment (220), so NCO = S − I = −70: the country is selling 70 of assets to foreigners (or borrowing 70).
- NX = NCO = −70: a trade deficit of 70.
- Check with Y = C + I + G + NX: 650 + 220 + 200 − 70 = 1,000.
Common mistake
Treating the trade balance and capital flows as separate. They are two sides of the same transactions: a country that imports more than it exports must be paying with assets or borrowing, so its net capital outflow is negative by the same amount.
Key terms
- closed economy
- an economy that does not interact with other economies
- open economy
- an economy that interacts freely with other economies
- net exports
- the value of a country's exports minus its imports; also called the trade balance
- trade surplus
- exports greater than imports
- trade deficit
- imports greater than exports
- net capital outflow
- home residents' purchases of foreign assets minus foreigners' purchases of home assets
- foreign direct investment
- buying and actively managing a business abroad
- foreign portfolio investment
- buying shares or bonds of a foreign firm
Practise the key terms
Tap a card to turn it over. 8 cards.
| Front | Back |
|---|---|
| closed economy | an economy that does not interact with other economies |
| open economy | an economy that interacts freely with other economies |
| net exports | the value of a country's exports minus its imports; also called the trade balance |
| trade surplus | exports greater than imports |
| trade deficit | imports greater than exports |
| net capital outflow | home residents' purchases of foreign assets minus foreigners' purchases of home assets |
| foreign direct investment | buying and actively managing a business abroad |
| foreign portfolio investment | buying shares or bonds of a foreign firm |
Practice
Work it through
An open economy: national saving 300, domestic investment 260 (billions).
- S − I = 300 − 260
- NX = NCO
Quick quiz
Tap an answer to check it.
A country runs a trade deficit. What must be true?
- That goes with a trade surplus
Show answer
Its net capital outflow is negative: foreigners are buying more of its assets than it buys of theirs. NX = NCO.
In S = I + NCO, what happens if investment rises while saving stays the same?
- Saving is held constant here
Show answer
Net capital outflow falls, and so do net exports. More investment must be financed from abroad.
Which is foreign portfolio investment?
- That is foreign direct investment
Show answer
Buying shares in a company abroad. Portfolio investment is a more passive holding of foreign assets.
In short
- Net exports = exports − imports (the trade balance).
- Net capital outflow = home purchases of foreign assets − foreign purchases of home assets.
- NX = NCO, always.
- S = I + NCO: saving finances investment at home or assets abroad.
Mastery check
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Check yourself
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Define net capital outflow.
Show answer
Home residents' purchases of foreign assets minus foreigners' purchases of home assets.
Why does NX always equal NCO?
Show answer
Every international sale of goods is matched by an equal flow of assets in the other direction.
In the worked example, what is the trade balance?
Show answer
A trade deficit of 70.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 18.
- On this site: What GDP counts and Exchange rates and purchasing-power parity.
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