Final answer:
Capital outflows increase the supply of a domestic currency and may decrease its demand in the foreign exchange market, causing depreciation of the domestic currency. This depreciation can decrease imports and increase exports due to changes in relative prices.
Step-by-step explanation:
Capital outflows from a small, open economy can significantly impact the value of its domestic currency. When there is an increase in capital outflows, domestic currency is sold in exchange for foreign currencies to invest or save abroad. Consequently, the supply of the domestic currency in the foreign exchange market increases while the demand for the same currency may decrease or remain unchanged.
This leads to a depreciation of the domestic currency, since an excess supply of the currency tends to lower its price in terms of foreign currencies. A depreciated domestic currency makes imports more expensive, hence potentially reducing the volume of imports. Conversely, it makes exports cheaper for foreign buyers, which could increase the volume of exports.
An example to illustrate this would be if U.S. investors start investing more heavily in European assets, they need euros to make these investments. This would increase the supply of dollars (capital outflows) and increase demand for euros, causing the dollar to depreciate relative to the euro. As a result, European products would become more expensive for American consumers (reducing imports), and American products would become cheaper for Europeans (increasing exports).
Experienced capital outflows in a small, open economy lead to the depreciation of the domestic currency, which could potentially decrease imports and increase exports.