Resources for Students

The link between trade, foreign investment and the trade balance is not well understood. We have several ways for trying to explain this relationship mathematically, but still students struggle to understand why the trade balance is driven by foreign investment and not trade. Here is the mathematical background and a few exercises that are designed to help you think about it.

The basic relationship between trade and investment is often given by:

Where X is exports; IM is imports; NFY is net foreign income received (e.g., remittances or income on ownership of capital abroad or foreign aid); S is domestic private savings; I is domestic investment; T is taxes or government revenue; G is government spending and NCI is net capital inflow (or foreign investment).

This relationship states that the trade balance X – IM (plus any net foreign income received NFY) is equal to the extent to which domestic private savings covers domestic investment and any government deficit (G – T) . If domestic savings cover domestic investment and any government deficit, then there will be a trade surplus. If domestic savings is not sufficient, then there will be a trade deficit and foreign investment (NCI) is required to fund the excess investment and government deficit that domestic savings cannot.

This relationship can be derived in several ways:

1. By recognizing that a country’s consumption should equal its income:

If Income = GDP + NFY = C + I + G + X - IM + NFY, and Consumption = C + S + T, then:

C + I + G + X - IM + NFY = C + S + T

X - IM + NFY = (S – I) + (T – G)

Where: GDP is gross domestic product; NFY is net foreign income inflows (e.g., remittances, foreign capital income, etc).

2. Using demand and supply for the currency or balance of payments:

In countries with floating exchange rates the balance of payments equals zero and hence Demand for currency = supply of currency. In the table below we see some examples of demand and supply of currency.

If demand = supply of a currency, then:

Note that net inflows include both net foreign income (NFY) (remittances, income and foreign aid) and Net capital flows (NCI including demand as a world reserve currency).

And from above we know that net capital inflows (NCI) fund the extra investment and government deficit that domestic savings cannot:

Hence:

Questions

1. The table above contains a number of examples. Assuming floating exchange rates, how will each of these examples impact the exchange rate and trade balance of the country listed in column 2.

Example	Country
Nigeria finds and export oil	Nigeria
Increased Foreign Direct Investment (FDI) in Thailand	Thailand
Increased demand for Euros as a world reserve currency by China	Europe
US lowers tax on foreign income earned abroad	USA
India suffers recession and remittances rise	India
Malawi suffers drought and foreign aid rises	Malawi

2. The Trump administration has negotiated approximately 15 trade deals since entering office in January 2025, including deals with Argentina, the EU, Japan, Malaysia, South Korea, and the United Kingdom. Many of the deals have involved limits being placed on tariff increases in return for increased investment in the USA.
• Explain how an increase in foreign investment, negotiated as part of these trade deals, could impact the US trade balance and hence the US exports?
• Explain how an increase in tariffs could impact the US trade balance? Use the table below to help guide you.

What could happen?	Change in demand/supply	Exchange Rate?	Trade balance?
Tariffs raise cost of imports	Impact on Trade?
Tariffs raise cost of imported intermediates and hence price of US goods	Impact on Trade?
Tariffs raise cost of imported capital goods and reduce US rate of return on investment	Impact on Investment?

In class we use a basic tariff diagram (Figure 1) to show the impact of raising or lowering tariffs on the importing country’s welfare.

Where: P_W is the free on board (fob) price and P_W(1+τ) is the tariff inclusive price paid by the home consumer.

These tariff diagrams are also used to show the potential for trade diversion resulting from free trade agreements (FTAs).

Trade diversion is when a country diverts trade from a low-cost producer to a high-cost producer because of the reduction of tariffs or other change in protection. For instance, when the USA charges lower tariffs on goods from Mexico, this reduces the price of Mexican goods to US consumers, compared to goods from other countries, e.g., Thailand. The result of the FTA is that US consumers will buy less from Thailand and more from Mexico.

Figure 2 illustrates this trade diversion. Notice that each country is assumed to have perfectly elastic supply curves and consumers switch between suppliers depending on relative prices. Where PTHA represents the fob price (or costs of production plus transportation) of goods from Thailand and P_THA(1+τ) is the tariff inclusive price paid by US consumers.

Initially, the USA applies a tariff to goods from both Thailand and Mexico. In the case drawn in Figure 2, US consumers would purchase the amount M_THA from Thailand, because the price of the Thai good inclusive of tariffs in lower than the Mexican good inclusive of tariffs (P_THA(1+τ) < P_MEX(1+τ)). However, if the US forms a FTA with Mexico in which the tariff on Mexican goods is removed, US consumers will switch from buying Thai goods to buying Mexican goods (P_THA(1+τ)> P_MEX). This is trade diversion because US consumers are purchasing goods from the high-cost supplier, Mexico (P_MEX > P_THA). We can then examine the impact on welfare:

Consumer surplus: + (a + b + c + d)

Producer surplus: - a

Govt revenue – (c + e)

Total welfare change: b + d - e

Area e represents the loss from trade diversion – US consumers buy from a higher-cost producer. The overall gain/loss depends on the whether the areas b + d outweigh the trade diversion effect e.

Questions

The Regional Comprehensive Economic Partnership (RCEP) agreement is the largest free trade agreement to be implemented to date, covering 30 percent of the world’s GDP. RCEP includes Australia, Brunei, Cambodia, China, Indonesia, Japan, South Korea, Laos, Malaysia, Myanmar, New Zealand, the Philippines, Singapore, Thailand, and Vietnam.

Most of the countries within RCEP (including Korea and Vietnam) are already linked to each other through a complex set of smaller overlapping trade agreements with zero tariffs and rules of origin clauses. In fact, only three of the 15 members are not in formal agreements with all the other RCEP members: Japan, South Korea and China. Japan does not have a free trade agreement with South Korea or China.

1. Assuming Korea is a small country importer, show using a graph how the RCEP agreement could lead to an expansion of Korean imports from Japan and a reduction in imports from Vietnam. What are the welfare implications of this for Korea?
2. Is this trade diversion?
3. Why would Vietnam enter RCEP in this case?

Link to answer