Exchange Rate, International Trade, and Capital Flows

• Capital Account is an account in Balance of Payments that is used to record all transactions made between entities in one country with the rest of the world. Any transaction that involves two currencies is recorded in Capital Account. E.g. Import, Export, Remittance, etc.
• If the incoming foreign currency is more than outgo of the domestic currency, it is termed as a capital account surplus and when the incoming foreign currency is less than the outgo of the domestic currency, it is termed as a capital account deficit.
• To balance the capital account, all surplus should be settled by a simultaneous deficit and a deficit should be settled by simultaneous surplus. Let us see the following illustration:

Illustration 1: Jai is a trader in India who wants to import goods worth USD 10 million, Jai converts his INR to USD through a bank and purchases the goods, below is a summary of activity that will happen in capital account in India:

1. The bank purchases USD 10 million and give it to Jai, this marks an incoming of USD 10 million in Capital Account.
2. Jai paid USD 10 million as a price of imported goods; this marks an outgoing of USD 10 million in Capital Account.

In this scenario, the capital account is balanced by incoming as well as outgoing transaction.

• However, the capital account is not balanced in several situations. Suppose citizens of India start selling USD, the outflow of the USD will be high as there is no corresponding purchase of USD. In such situations, as the supply of USD in the market increase rapidly as compared to its demand, the exchange rate falls which leads to reduced cost of imports as the rate of USD has reduced, this leads to high imports that balance the Capital Account.
• Hence, Exchange Rate, International Trade, and Capital Account are interrelated to each other. Any variation in any of the elements is balanced by the other two.

The Elasticities Approach to Trade Balance and Exchange Rates

• Devaluation of currency impacts the relative prices; the imports become costly and the exports become profitable that influence the Capital Flows of the country. If the Exports are high the capital flow is positive and if Imports are high the capital flow is negative.
• The Elasticities Approach on based on the Marshal-Lerner condition which states that the sum of elasticities of demand for a country’s exports and its demand for imports should exceed 1 for devaluation to have a positive impact on the trade of the country. If the sum is less than 1 then the country needs to revaluate its currency.
• The value can only be greater than 1 if the exports are more than the imports. This depends on the types of goods that the country imports and exports. For example, if the country imports raw materials then the imports will have more effect than the exports whereas, on the other side of the country exports raw materials, its export will have more effect than its imports.

The Absorption Approach to Trade Balance and Exchange Rates

• The elasticity theory fails to consider the changes in income levels of the population which may have a significant impact on the Capital Account. As per the Absorption theory, a devaluation is considered to have a positive impact on the economy if an Increase in Income exceeds the Domestic Expenditure.
• If Domestic Expenditure exceeds Income, then it will have a negative impact on Capital Account and if Income exceeds Domestic Expenditure then it will have a positive impact on Capital Account.