In the first macroeconomics SparkNote on measuring the economy, we learned the identity Y = C + I + G + NX to describe the output of an economy. In this equation, Y is the nominal output, C is money spent on consumption, I is money spent on investment, G is money spent by the government, and NX is net exports or exports less imports. The sum of these costs is the total amount of both income and output in a country.
To understand how capital and goods flow in and out of countries, we should keep the Y = C + I + G + NX identity in mind. NX is of particular interest. NX is defined as the total amount of exports less the total amount of imports. NX is positive if a country exports more than it imports, negative if a country imports more than it exports, and zero if exports and imports are equal.
Let's work through each of these examples in turn. First we'll examine the simplest case, in which exports and imports are equal. In this example, there are two countries, Country A and Country B. If Country A exports 1 million dollars worth of coconuts to Country B and imports 1 million dollars worth of bananas from Country B, then the NX for both countries is equal to zero since exports equal imports. In this case, goods are traded for goods and at the end of the term, the trade balance is equal.
When countries import less than they export or import more than they export, the situation becomes significantly more complicated. Now let's examine the case when a country imports more than it exports. If Country A exports 0.5 million dollars worth of coconuts to Country B and imports 1 million dollars worth of bananas from Country B, then Country A has a negative trade balance, called a trade deficit. In this case, Country A owes Country B money for the imported bananas beyond the 0.5 million dollars worth of exported coconuts. If this is a short-term debt, nothing of consequence would occur since Country A has the ability to export more coconuts quickly to make up for the difference.
If the debt is long term, however, Country A must somehow repay Country B for the imported bananas. The easiest way to think of this exchange is to imagine Country A giving Country B interest in the future coconuts produced by Country A. To repay the debt that Country A owes to Country B, Country B becomes invested in Country A. Any amount of exports that exceeds the total amount of imports results in foreign investment. The opposite occurs when exports exceed imports as the exporting country becomes a foreign investor in the importing country.
This leads us to another important international trade identity: NX = NFI where NX is net exports or exports less imports and NFI is net foreign investment. Simply put, the difference between what a country exports and imports is equal to the amount of foreign investment. The trade balance can remain fairly even if a country imports more than it exports--it must make up the difference through foreign investment.