When we are discussing international trade, we are focusing on the flow of goods and services, as well as capital, among countries.
Now, this is not a new occurrence; it has been taking place throughout history, though its importance increases more and more every decade, with certain impacts:
So, how do we measure the economic impact of international trade on a nation? Well, one way is to measure the balance of payments. This involves comparing our demand and supply of foreign exchange or foreign currency.
The balance of payments is a record of all monetary transactions that flow across a country's border. The two major components are the current account and the capital account.
Let's briefly review this idea of foreign exchange.
Our demand for foreign exchange increases when we want to buy things in other currencies.
EXAMPLEFor example, when Americans vacation in Mexico, or buy a German car, or invest in stock issued by a Japanese company, in all of these situations, they would need to purchase the foreign currency. This is because they need to supply their U.S. dollars in order to purchase these items in those currencies, whether it is in the yen, the euro, or the peso.
Our supply of foreign exchange increases when we sell our stuff to foreigners.
EXAMPLEConsider these examples:
As mentioned, the balance of payments is composed of the current account and the capital account. Let's begin by discussing the current account, which represents the sum of all recorded transactions, including traded goods and services, income, and net transfer payments.
The current account is essentially the sum of our balance of trade. It shows how much a nation has spent on foreign goods, services, income, and transfer payments compared to how much it has earned in those things.
EXAMPLEHere are some examples of the current account activities:
Now, this is the point where trade surplus and deficit come into play.
A trade surplus occurs when our exports exceed our imports, meaning our net exports is positive.
X - M > 0
A trade deficit occurs when our imports are greater than our exports, meaning the net exports is negative.
X - M < 0
Now, exports are going to credit the current account and create a surplus. This will cause a nation's currency to appreciate over time because, in this situation, that nation's currency is being demanded in order to purchase these things measured in the current account.
EXAMPLEWhen Europeans vacation here, they are demanding U.S. dollars and supplying their euros. Therefore, our nation's currency, the U.S. dollar, would be appreciating over time.
On the other hand, when we import things, this creates a deficit in the current account, which will cause a nation's currency to depreciate over time. When we are supplying a lot of our U.S. dollars in order to get other nation's currencies, then ours will lose value or depreciate against the other currencies.
Every transaction that is occurring in the current account is offset by an equal and opposite activity in the capital account, which captures investment and financing flows.
Whereas exports in the current account have an appreciating impact on a currency, now it is inflows in the capital account that will have an appreciating impact on a currency. Outflows have an opposite effect, or depreciating impact.
The capital account involves comparing a nation's ownership of foreign assets with foreign ownership of that nation's assets.
EXAMPLEExamples would include the purchase or construction of machinery, buildings, or plants in other nations, or the investment in a foreign nation's shares and bonds.
Now, when foreigners are investing in those kinds of things in our country, that represents an inflow into the capital account, which creates a surplus.
Conversely, if our citizens are investing in those things in foreign nations, this is an outflow which creates a deficit in the capital account.
Suppose you decide to buy a German car. What kind of impact does that have?
Well, first of all, if you buy a German car, that means that U.S. imports are increased by that car, which represents the impact in the current account.
On the other hand, foreign assets in the United States are also increased, which occurs in the capital account. You had to supply your dollars in order to purchase the car in euros. You are demanding euros, and therefore, foreign ownership in the U.S. is increased.
The net result is that the net wealth position of the U.S. compared to the rest of the world has decreased by the price of the car.
Clearly, one person's purchase of a car is not going to have a dramatic impact, but you can see that over time, being a net-exporting or net-importing nation can have a significant impact on a nation's currency and the current and capital accounts.
Source: Adapted from Sophia instructor Kate Eskra.