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We have seen that an open economy interacts with the rest of the world in two ways-in world markets for goods and services and in world financial markets. Net exports and net capital outflow each measure a type of imbalance in these markets. Net exports measure an imbalance between a country’s exports and its imports. Net capital outflow measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners.

An important but subtle fact of accounting states that, for an economy as a whole, these variables must always be the same. That is, net capital outflow (NeO) equals net exports (NX):

This equation holds because every transaction that affects one side of this equation affects the other side by exactly the same amount. This equation is an identity-an equation that must hold because of the way the variables in the equation are defined and measured.

To see why this accounting identity is true, let’s consider an example. Imagine that you are a computer programmer residing in the United States. One day, you write some software and sell it to a Japanese consumer for 10,000 yen. The sale of software is an export of the United States, so it increases US. net exports. What else happens to make the identity hold? The answer depends on what you do with the 10,000 yen.

First, let’s suppose that you simply stuff the yen in your mattress. (We might say you have a yen for yen.) In this case, you are using some of your income to invest in the Japanese economy. That is, a domestic resident (you) has acquired a foreign asset (the Japanese currency). The increase in US. net exports is matched by an increase in the US. net capital outflow.

More realistically, however, if you want to invest in the Japanese economy, you won’t hold currency. More likely, you would use the 10,000 yen to buy stock in a Japanese corporation, or you might buy a Japanese government bond. Yet the situation is much the same: A domestic resident ends up acquiring a foreign asset. The increase in U.S. net capital outflow (the purchase of the Japanese stock or bond) exactly equals the increase in US. net exports (the sale of software).

Let’s now change the example. Suppose that instead of using the 10,000 yen to buy a Japanese asset, you use it to buy a good made in Japan, such as a Nintendo Gameboy. As a result of the Gameboy purchase, US. imports increase. The software export and the Gameboy import represent balanced trade. Because exports and imports increase by the same amount, net exports are unchanged. In this case, no American ends up acquiring foreign assets and no foreigner ends up acquiring US. assets, so there is also no impact on US. net capital outflow.

From this example, we can generalize to the economy as a whole.

• When a nation is running a trade surplus (NX > 0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of thecountry (NCO > 0).

• When a nation is running a trade deficit (NX < 0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services in world markets? It must be selling assets abroad. Capital is flowing into the country (NCO < 0). The international flow of goods and services and the international flow of capital are two sides of the sam coin

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