Question

Explain why, in any period, a country’s net capital inflows equal its trade deficit? Include examples.

Answer 1

Trade Deficit: It refers to the excess of the country's imports over exports.

Capital flows: It refers to the movement of capital for example FDI. Capital inflow means the movement of capital inside the country on the other hand capital outflow means the movement of capital out of the country.

The equation of GDP is as follows:

Y = C+I+G+NX

here, Y= national income,

C = consumption ; I= investment,

G= government spending

NX= Exports (X) - Imports(M)

Now, National Savings S=Y-C-G.............(1)

Y = C+I+G+NX

Y-G-C-I=NX

using equation (1)

S-I=NX ............................(2)

S-I is nothing but the net capital outflows (NCO) as it equals to the difference of capital inflows and capital outflows.

S-I=NX

or, S-NX=I

or, NCO=NX......................(3)

Now, suppose that the net exports are positive means exports are greater than imports in the country and to pay for their imports foreigners have to sell some of their foreign assets to domestic residents. In this case, the net exports of the domestic country will be equal to its capital outflow of the country.

Here, as NX=NCO so, negative of NX is net capital inflows

S+ Net capital inflow=I

Therefore, a country’s net capital inflows can be equal to its trade deficit.

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