Question

Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Explain why such a statement is economically impossible.

Short answer

In summary, it is economically impossible for a country to have both a trade surplus and a healthy inflow of capital from abroad simultaneously. A trade surplus attracts capital inflow, which increases the value of the country's currency, making its exports more expensive and reducing the trade surplus. Furthermore, having both a positive current account (trade surplus) and a positive capital account (healthy capital inflow) would violate the balance of payments equation, as it requires the sum of these accounts to equal zero.

Step-by-step solution

Understand the Terms

The key terms in this problem are trade surplus, capital inflow, current account, and capital account. A trade surplus occurs when a country exports more goods and services than it imports, receiving more money from other countries than it spends. It is a positive balance of trade. Capital inflow refers to the net flow of funds into a country due to investments, loans, or other financial transactions. It is a healthy inflow of capital when a country's economy is attracting foreign funds, driving up the value of its currency and increasing its purchasing power. The current account summarizes a country's trade balance, including goods, services, income, and current transfers. A positive current account balance indicates a trade surplus, while a negative balance indicates a trade deficit. The capital account records the net change in a country's financial assets and liabilities, including direct investments and securities transactions. A positive capital account balance indicates a net inflow of capital, while a negative balance indicates a net outflow. The balance of payments is the sum of the current account and the capital account.

Explain the Relationship between Trade Surplus and Capital Inflow

In a trade surplus, the country is exporting more goods and services than it is importing, meaning it is receiving more foreign currency than it is spending. This excess foreign currency is typically invested in the country with the trade surplus, leading to capital inflow. However, a healthy inflow of capital from abroad usually means that the country's currency is in high demand, leading to an increase in its value. This makes the country's exports more expensive and its imports cheaper, reducing the trade surplus over time.

Demonstrate why Both Trade Surplus and Capital Inflows cannot Coexist

For a country to have both a trade surplus and a healthy inflow of capital from abroad, its current account must be positive, and its capital account must also be positive. This would mean that the country is receiving more foreign currency than it is spending, both through trade and through financial transactions. According to the balance of payments equation, the sum of the current account and the capital account must equal zero. If both the current account and the capital account are positive, the balance of payments equation cannot hold true. This is economically impossible.

Conclusion

A trade surplus and a healthy inflow of capital from abroad cannot coexist because they require both the current account and the capital account to be positive, violating the balance of payments equation. Furthermore, a trade surplus can lead to capital inflow, but this inflow eventually reduces the trade surplus over time. Therefore, it is economically impossible for a country to have both a trade surplus and a healthy inflow of capital from abroad at the same time.