Net exports are the difference between exports and imports. They are equal to the difference between what we produce and what we demand for consumption, investment, and government purchases.
The net capital outflow is the excess of domestic saving over domestic investment. The trade balance is the amount received for our net exports of goods and services. The national income accounts identity shows that the net capital outflow always equals the trade balance.
The impact of any policy on the trade balance can be determined by examining its impact on saving and investment. Policies that raise saving or lower investment lead to a trade surplus, and policies that lower saving or raise investment lead to a trade deficit.
The nominal exchange rate is the rate at which people trade the currency of one country for the currency of another country. The real exchange rate is the rate at which people trade the goods produced by the two countries. The real exchange rate equals the nominal exchange rate multiplied by the ratio of the price levels in the two countries.
Because the real exchange rate is the price of domestic goods relative to foreign goods, an appreciation of the real exchange rate tends to reduce net exports. The equilibrium real exchange rate is the rate at which the quantity of net exports demanded equals the net capital outflow.
The nominal exchange rate is determined by the real exchange rate and the price levels in the two countries. Other things equal, a high rate of inflation leads to a depreciating currency.
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