Net Exports, Capital Flows, and Exchange Rates in Open Economies

The Equality of Net Exports and Net Capital Outflow

An open economy interacts with the rest of the world through two fundamental channels: the world financial market and the world product market. Net capital outflow (NCO) measures imbalances in the financial market—it is the difference between the value of domestic assets purchased by foreigners and the foreign assets purchased by a country's residents. Net exports (NE), by contrast, represents the difference between a country's exports and imports. The two must always be equal (NCO = NE) because any transaction affecting the product market affects the financial market by an identical amount (Mankiw, 2014).

A concrete example illustrates this principle. Consider a US software programmer who develops a program and sells it to a Japanese consumer for 20,000 yen. This transfer is an export, increasing US net exports. What happens next to the 20,000 yen received?

First, the programmer could save the yen as a foreign asset. In doing so, he (a domestic resident) acquires a foreign asset, constituting a capital outflow and increasing America's net capital outflow by exactly the amount of the export.

Second, he could invest the 20,000 yen directly in Japan by purchasing a Japanese government bond. Again, the capital invested in foreign assets equals the increase in net exports from the software sale.

Third, and more realistically, he could use the yen to purchase a Japanese car, which becomes an import to the US. In this case, the increase in exports (software) equals the increase in imports (car), leaving net exports unchanged. Simultaneously, the foreign asset acquired by the domestic resident (the yen spent on the car) is offset by the domestic asset acquired by the Japanese car manufacturer (the dollar payment received from the US), so net capital outflow remains unchanged.

Real Interest Rates and Net Capital Outflow

In all scenarios, net capital outflow equals net exports. This identity holds because every international transaction involves both a product flow and a financial flow; they must balance by accounting necessity.

The real interest rate—the nominal rate adjusted for inflation—is determined by the supply and demand for loanable funds in an open economy. The demand for loanable funds reflects both domestic investment and net capital outflow (foreign investment by domestic residents), while the supply reflects national savings. Equilibrium occurs when savings equal the sum of domestic investment and net capital outflow.

When the real interest rate rises, domestic assets become more attractive relative to foreign assets. Investors then allocate more capital to domestic investments and fewer resources to foreign investment, reducing net capital outflow. Conversely, lower real interest rates make foreign assets relatively more attractive, raising net capital outflow.

This mechanism can be illustrated through the loanable funds market. Suppose savings in the economy decline, shifting the supply of loanable funds inward. With unchanged demand, equilibrium moves to a higher real interest rate. At this higher rate, borrowers reduce their demand for foreign loans and investment abroad. Net capital outflow falls from its initial level to a lower equilibrium, even though total investment in the economy may remain relatively stable.

Purchasing Power Parity and Exchange Rate Determination

The intuition is straightforward: higher returns on domestic investment discourage capital from flowing overseas. In an open economy, the real interest rate thus serves a dual function—it equilibrates the market for loans domestically while simultaneously determining the international allocation of capital.

According to Purchasing Power Parity (PPP), equilibrium exchange rates are determined by the ratio of countries' price levels. At the PPP rate, a unit of currency has equivalent purchasing power across countries; in other words, identical goods cost the same in both nations (Reinert et al., 2009).

PPP rests on the law of one price: absent transaction costs like transportation, a good's price should be identical across countries once expressed in a common currency. The absolute PPP relationship is expressed as:

S = P − P*

where S is the PPP exchange rate, and P and P* are domestic and foreign price indices respectively. If domestic prices rise faster than foreign prices, the domestic currency should depreciate proportionally to maintain PPP.