Why is it important to understand how capital flows affect imports and exports in an economy?

1 Answer
May 14, 2015

We can understand capital flows in terms of exchange rate. Here, let's use the "British concept", i.e., the amount of local currency that a foreign currency can buy.

For example, currently, #US$1 = R$3#, one American dollar equals to (aproximately) three Brazilian reais.

Next, let's think of currencies as "expensive" or "cheap" in comparison to their own price during time. I mean: If today #US$1 = R$3#, then it means you need three reais to get one dollar. In 2014, let's suppose the average exchange was #US$1 = R$2#, so we needed only two reais to get a dollar.

Now, final conceptual consideration: in worldwide transactions, dollar is the most accepted currency so everything traded and negotiated worldwide is almost always priced in dollars. Ok.

Now, think of this: from 2014 to 2015, it became more expensive for Brazilians to import goods , as in 2014 they got 2 reais to change for a dollar and in 2015 they are adding one more: now they have to get 3 reais to get a dollar.

On the other hand, it became cheaper for Americans (or other users of dollars, if we consider the hypothesis of all other currencies being stable from 2014 to 2015) to import Brazilian goods, as in 2014 they needed #US$0,50# to correspond to one real and in 2015 this amount fell to mere #US$0,33#.

In a nutshell: if Real depreciates in relation to Dollar, it stimulates Brazilian exports (that will be cheaper for the world to buy, as they are priced in reais), and it discourages Brazilian imports (as the world goods are priced in dollars).

The final thing we need to clarify: one important way to depreciate or valuate the exchange rate is via Foreign Reserves. So, if a Brazilian company exports something, it will receive in dollars - as it is the international currency - and change those dollars with the Central Bank in Brazil for reais, as dollars have no use in the Brazilian economy. That way Brazilian reserves of dollars will rise, and, having more dollars in Reserve, the tendency is that Real ends up appreciating, and vice-versa.

The "beauty" in exchange rate is this: theoretically, it will oscilate up and down in proportion to imports and exports.