Balance of Trade Concerns

Self-Check Questions

What do international flows of capital have to do with trade imbalances?

Hint:

Given the high level of activity in international financial markets, it is typically believed that financial flows across borders are the real reason for trade imbalances. For example, the United States had an enormous trade deficit in the late 1990s and early 2000s because it was attracting vast inflows of foreign capital. Smaller countries that have attracted such inflows of international capital worry that if the inflows suddenly turn to outflows, the resulting decline in their currency could collapse their banking system and bring on a deep recession.

Use the demand-and-supply of foreign currency graph to determine what would happen to a small, open economy that experienced capital outflows.

Hint:

The demand for the country’s currency would decrease, lowering the exchange rate.