Thus, net exports denote the difference what a country can produce and what it actually consumes. If the output it produces is insufficient to satisfy consumption, investment, and government expenditures, it will tend to source output from other countries.
On the other hand, the net capital outflow is the difference between domestic savings and domestic investment while the trade balance is shown as the total amount that the country receives for its net exports. Through the national income identity discussed above, it can be seen that net capital outflow is always equal to the country's trade balance. If the trade balance and the net capital outflow is positive, the country is running a trade surplus which means that it is a lender in the international financial market and that its exports is greater than its imports. However, if it is negative, it is running a trade deficit which means that it is a borrower in the financial market and imports is greater than exports.
Following from this, the impact of any policy on the balance of trade can be identified and assessed by considering its effect in the country's savings and investment. Logically, any policy which causes savings and investment to increase supports a trade surplus while one which causes decline in savings and investment will lead to a trade deficit.
In order to ...
There are two type of exchange rates: nominal which is the relative price of currency of two countries while real is the relative price of goods of two countries. These two are related in the sense that the real exchange rate is equal to the nominal exchange rate multiplied by the ratio of price levels in the two countries. Thus, if the real exchange rate is high, foreign goods are relatively cheap, and domestic goods are relatively expensive. On the other hand, if the real exchange rate is low, foreign goods are relatively expensive, and domestic goods are relatively cheap.
The real exchange rate is directly related to net exports in the sense that when real exchange rate is high and domestic goods are less expensive, it is expected that net exports will be greater as domestic goods will appeal more to other countries and exports are higher. Another determinant of real exchange rate is net capital outflow. It should be noted that the equilibrium real exchange rate is the rate at which the quantity of net exports demanded equals to the net capital outflow.
On the other hand, since the nominal exchange rate is determined by the prices of commodities in one country compared to the other, the price level is its most significant determinant. Empirical evidence shows that the high level of inflation which makes domestic goods priced higher will tend to cause a depreciating currency.
The Mundell-Fleming model has been recognized as a dominant policy paradigm for the study of open-economy monetary and fiscal policy. It is the same as the IS-LM Model in the sense that both emphasize the interaction between the goods and money market. Also, these models assume that price is fixed while showing what affects short-run