6.5 Net Exports and Capital Flows

Balance of Payments Basics

A country's international transactions are tracked in the balance of payments, split into the current account (mainly net exports: exports minus imports) and the capital/financial account (flows of financial assets like stocks, bonds, and real estate). These two accounts must offset each other, since a deficit in one is matched by a surplus in the other.

Net Exports and Capital Flows Relationship

When a country runs a current account deficit (imports > exports), it must run a capital account surplus — meaning foreigners are investing more in that country than it invests abroad, financing the deficit. Conversely, a current account surplus requires a net capital outflow, as the country invests its excess earnings abroad.

Loanable Funds and Net Capital Inflow

Net capital inflow (KFI) links to the domestic loanable funds market: foreign investment supplies funds, affecting real interest rates. Higher real interest rates domestically attract foreign capital, increasing net capital inflow, appreciating the currency, and worsening net exports — showing how financial and goods markets are interconnected in an open economy.

Key terms

Balance of Payments

A record of all international transactions, made up of the current account and the capital/financial account, which must sum to zero.

Current Account

Tracks net exports (exports minus imports) of goods and services, plus net income and transfers.

Capital/Financial Account

Tracks flows of financial assets (stocks, bonds, real estate) between a country and the rest of the world.

Net Capital Inflow (KFI)

The net flow of foreign funds into a country, financing a current account deficit; linked to the loanable funds market.

Relationship between accounts

A current account deficit is offset by a capital account surplus (net capital inflow); a current account surplus is offset by a net capital outflow.

Try an AP-style question

A country with a trade deficit must…

1. raise interest rates to zero
2. run a trade surplus
3. stop importing
4. borrow or sell assets abroad