Net exports and capital outflows

Let's take a look at our GDP equation for an open economy.

So, GDP is equal to national income, and that's going to be equal to consumption plus investment plus government spending. And since this is an open economy, plus net exports.

Now, the first thing I want to do is let's solve for net exports. So I'm going to subtract all of this stuff from both sides so I could get national income minus consumption minus government spending minus investment is equal to net exports. This is just a manipulation of what we just saw.

Now, what is national income minus consumption minus government spending? Well, this right over here is national savings. This is S. So another way we can think about it is national savings minus investment is equal to net exports.

So let's use this to think about capital flows. First of all, let's just make sure we know what a capital flow is. So let's think about a capital inflow. What does that mean? That means that foreigners are taking capital and taking it into our country to buy assets in our country.

And an outflow? That means that residents of our country are taking capital out of the country and buying foreign assets.

And so, do you think our savings minus our investment is going to be a capital inflow or capital outflow? Well, we've saved a bunch of stuff, and we are spending some of it on investment. So what do we do with the rest of it? Well, it's going to have to go outside of the country because if it was being invested inside the country, it would be in this I right over here.

And so this is a net capital outflow, and you'll sometimes see this abbreviated NCO. And so that sets up the identity that net capital outflows are equal to net exports. Let me just write it again for emphasis: net capital outflows are equal to net exports.

Now, why does this make sense? Well, let's say net exports are positive. That means more foreigners are buying our goods than we are buying their goods. Now, how are they going to pay for those goods? Well, they're going to have to pay for those goods.

And we're not going to go into the details of currency exchange and all that, but one way to think about how they pay for those goods is that they need to sell their foreign assets to folks in our country. So if it's folks in our country who are buying foreign assets so that the foreigners can buy our goods, that would be a net capital outflow from our point of view.

So hopefully that makes intuitive sense. Now, another way to think about this is we could rearrange this equation. If we subtract net exports from both sides and then add investment to both sides, we could get national savings minus net exports minus net exports is equal to investment.

Now, if net exports is equal to net capital outflows, what would be the negative of net exports? Well, this would be net capital inflows. So we could set up another equation, and these are all fairly straightforward algebra, but they give us a little bit of intuition of how to think about these different levers.

So we could say savings plus, I'll write the word out, net capital inflow is equal to investment.

Think about why this makes sense. If we have investment in our country, maybe we're building factories, we're building roads. Where is the capital for that investment coming from? It's either coming from domestic savings, national savings right over here, or it's coming from foreigners bringing capital into our country, which can be used for investment.

So I will leave you there. The big takeaway is we can just manipulate the GDP equation for an open economy here to get to this notion that net capital outflows are equal to net exports, or that the negative of net exports, which would be net imports, is equal to net capital inflows. Hopefully, this makes some intuitive sense.