Lesson 7 of 8 · 11 min
Exchange rates, the trade balance and capital flows
A trade deficit must be financed by an equal capital inflow, so anything that moves the trade balance moves capital flows by the same amount, and in the short run it is capital flows that drive exchange rates.
In short
- A trade deficit must be matched by a capital account surplus (borrowing from or selling assets to foreigners); a trade surplus by a capital account deficit.
- Identity: . A trade surplus means the country saves more than it invests.
- Expected currency moves create incipient capital flows; because spending and goods prices adjust slowly, asset prices and exchange rates do most of the adjusting.
- Under a fixed regime the central bank offsets private flows and interest rates adjust; under a float the exchange rate moves quickly.
- Capital flows dominate exchange rate moves in the short to intermediate term; trade flows matter more in the long term.
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