International Trade and Finance: Capital Flows and Balance of Payments

1. International Tradeand Finance:Capital Flows and Balance of Payments AP Economics Mr. Bordelon

2. Balance of Payments Accounts • Balance of payments accounts. Summary of the country’s transactions with other countries.

3. Row 1. Payments that arise from sales of g/s. • Row 2. Factor income. Payments for use of factors of production owned by residents of other countries. Examples: interest on overseas loans, profits of foreign-owned corporations. • Row 3. International transfers. Funds sent by residents of one country to residents of another. Example: remittances sent by immigrants.

4. Rows 1-3 are known as the current account. The current account is a country’s balance of payments on g/s plus net international transfer payments and income. They do not create liabilities. • Row 4. Transactions that involve govt’s or govt agencies, particularly central banks. Example: accumulation of foreign exchange reserves by central banks. • Row 5. Private sales of assets. Example: sales of foreign stocks and corporations.

5. Rows 4-5 are known as the finance account. The finance account is the difference between a country’s sales of assets to foreigners and its purchases of assets from foreigners during a given period. • Trade balance. Difference between a country’s exports and imports of goods.

6. Current and Financial Accounts • Balance of payments accounting requires that the current and financial accounts equal zero. • CA + FA = 0 • Sources of cash must equal the uses of cash.

7. Financial Accounting • To model financial accounting, we use the loanable funds model. • The financial account is a measure of capital inflows, of foreign savings that are available to finance domestic investment spending.

8. Financial Accounting In these loanable funds models, we see the loanable funds markets of the U.S. and U.K. In Panel (a), the U.S. has an equilibrium interest rate at 6%, and panel (b) shows an equilibrium interest rate at 2%. The interest rates of 6% and 2% respectively will not remain at those rates. Looking at the interest rates, British investors, attracted by the higher rates in the U.S., will make their funds available to the U.S. This is capital inflow, and increases the QLF available to U.S. borrowers. This decreases the interest rate as supply increases. In turn, this reduces the amount of funds available in the U.K., which increases the interest rate as supply decreases. This is a capital outflow. The international capital flows serve to eliminate the gap in interest rates.

9. Financial Accounting • Why does the interest rate equalize? • U.K. lenders see a loan to the U.S. as good as a local loan. • U.S. borrowers see no difference in a loan from the U.K. compared locally. • Flow of funds from U.K. to U.S. will continue until gap between interest rates is eliminated. • International capital flows will equalize interest rates in the two countries.

10. Financial Accounting Comparing the loanable funds markets of the U.S. and U.K. together once more, knowing that international capital flows eliminate the gap between interest rates in different countries, we end up with a new equilibrium interest rate at 4%. At this rate, the quantity of loanable funds demanded by U.S. borrowers exceeds the quantity of loanable funds supplied by U.S. lenders. To eliminate this shortage, the U.S. loanable funds market “imports” U.K. funds—capital inflow. On the U.K. end, the quantity of loanable funds supplied by U.K. lenders exceeds that demanded by U.K. borrowers. The excess is “exported” to eliminate the surplus in the form of a capital outflow to the U.S.

11. Financial Accounting The result is that the two loanable funds markets end up at equilibrium at 4%. At that interest rate, the total quantity of loans demanded by borrowers across both markets equals the total quantity of loans supplied by lenders across both markets. Think of international flows of capital like those of g/s. Capital moves from places where it would be cheap in the absence of international capital flows to places where it would be expensive in the absence of those flows.

12. Determinants ofInternational Capital Flows • International differences in the demand for funds reflect underlying differences in investment opportunities. • A country with a rapidly growing economy, other things equal, tends to offer more investment opportunities than a country with a slowly growing economy.

13. Determinants ofInternational Capital Flows • International differences in the demand for funds reflect underlying differences in investment opportunities. • A rapidly growing economy typically has a higher demand for capital and offers higher returns to investors than a slowly growing economy in the absence of capital flows. As a result, capital tends to flow from slowly growing to rapidly growing economies.

14. Determinants ofInternational Capital Flows • International differences in the demand for funds reflect underlying differences in investment opportunities. • International differences in the supply of funds reflect differences in savings across countries. These may be the result of differences in private savings rates, which vary widely among countries. (Think MPS and MPC). • They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows.

15. Two-Way Capital Flows • Flow of financial capital is a two-way street. • Financial investors in the U.S. are sending money to Japan because interest rates might be higher, but Japanese investors are sending money to the U.S. stock market because they believe the U.S. economy has a brighter future. • Corporations diversify financial risk by both selling shares of their own stock to foreign investors, but also by purchasing foreign shares of stocks or foreign bonds.

16. Question 1 • How would the following transactions be categorized in the U.S. balance of payments accounts? How will the balance of payments on the current and financial accounts change? • An American college student decides to spend a year studying (and paying tuition) at a university in Australia. • A German telecommunications firm purchases microprocessors from an American firm. • An American bank purchases shares of stock in Japanese firms traded on the Tokyo stock exchange.

17. Question 2 Suppose Northlandia and Southlandia are the only two trading countries in the world, that each nation runs a balance of payments on both current and financial accounts equal to zero, and that each nation sees the other’s assets as identical to its own. Using these graphs, explain how the demand and supply of loanable funds, the interest rate, and the balance of payments on the current and financial accounts will change in each country if international capital flows are possible.