AP Macroeconomics Section 8 International Trade & Finance Modules 41-44

AP Macroeconomics Section 8 International Trade & FinanceModules 41-44 Nancy K. Ware Instructor Gainesville High School

Module 41Capital Flows & theBalance of Payments

Module 41 Essential Questions • What is meaning of the balance of payments accounts? • What are the determinants of international capital flows?

Balance of Payments Accounts • Current Account • Net Exports • Trade Balance • Factor Income • Transfers • Financial Account • Current/Financial Relationship

Balance of Payments Accounts explained 2. Examples: Examples: 3. Examples: These 3 rows are called ____________ ____________ These 2 rows are called ____________ ____________ AKA: __________ account 4. Examples: 5. Examples:

Balance of Payments Accounts explained 3. Examples: Mainly shows remittances that immigrants employed in the United States, send to their families in their country of origin 2. Examples: profits of foreign-owned corporations or labor income from native-born workers who work overseasWal-Mart earns profit from stores in Europe. Honda produces and sells cars in Indiana & other U.S. states Examples: U.S. exports cars to be sold in Canada & U.S. imports oil from Venezuela These 3 rows are called Current Account These 2 rows are called Financial Account 4. Example: When the central bank of China purchases a U.S. Treasury, cash flows from China to the U.S. & vice versa 5. Example: When Coca-Cola buys a factory in Mexico, this is an asset purchase and payment to foreigners. If a Brazilian company buys an apartment building in Boston, this is an asset sale, and payment to foreigners.

Current & Financial Accounts • Transactions that don’t create liabilities: balance of payments on c___________account (usually just simply referred to as c___________account) • CA: the balance of payments on g__________& s__________ + plus f_________ income + net international t____________payments. • **Most important part of the current account: the balance of payments on g________ & s________, which ia the difference between the v__________ofexports and the v_________ofimports (value of X-M trade) during a given period. • The merchandise trade balance, (or simply trade balance) is the difference between a country’s exports and imports of goods alone—not including s____________. • The current account consists of international transactions that _________create liabilities. • Transactions that involve the sale or purchase of assets, and therefore DO create future liabilities, are considered part of the balance of payments on f_____________ account, or just simply known as the f______________ account (also known as the capital account back in the day)for short.

Current & Financial Accounts Cont’d • Transactions that don’t create liabilities :balance of payments on current account (usually just referred to as current account) • CA: the balance of payments on goods and services + plus factor income + net international transfer payments. • **Most important part of the current account: the balance of payments on goods and services, the difference between the value of exports and the value of imports (value of X-M trade) during a given period. • The merchandise trade balance, (or simply trade balance) is the difference between a country’s exports and imports of goods alone—not including services. • The current account consists of international transactions that don’t create liabilities. • Transactions that involve the sale or purchase of assets, and therefore DO create future liabilities, are considered part of the balance of payments on financial account, or the financial account(also known as the capital account back in the day)for short.

Current & Financial Accounts Cont’d The current account and the financial account must sum to z______: Current account (CA) + Financial account (FA) = _____ or CA = -FA Why must the current account and financial account sum to zero? Hint: Happiness runs in a circular motion! Can you Draw it?

Modeling the Financial Account People, businesses & governments will save and invest where their money yields the highest returns (interest rates, low inflation & low expected inflation). SLF 1 USA SLF China r% r% SLF USA SLF 1 China DLF China DLF USA QLF USA QLF China What is happening in this graph? What is happening in this graph?

Modeling the Financial Account People, businesses & governments will save and invest where their money yields the highest returns (interest rates, low inflation & low expected inflation). SLF 1 USA SLF China r% r% SLF USA SLF 1 China DLF China DLF USA QLF USA QLF China MS in US is decreasing; Debit to the US Financial Account or Capital Outflow MS in China is increasing, Credit to the Chinese Financial Account or Capital Inflow

Modeling the Financial Account What determines whether money flows into a nation’s financial account? 1. 2. 3. The loanable funds market model is used to model the flow of f_________ c________fromone nation to another. 2 assumptions: • All flows are loans. • Ignore effects of expected changes in exchange rates Suppose that the real interest rate in the US is 3% and the real interest rate in Australia is 7%. Draw two side-by-side markets and show how the real interest rate in Australia is significantly higher. Show on your graphs the increase and the decrease in LF in both markets.

Modeling the Financial Account What determines whether money flows into a nation’s financial account? • More investment opportunities • High demand for capital • High return for investors The loanable funds market model is used to model the flow of financial capital from one nation to another. 2 assumptions: 1. All flows are loans. (In reality, capital flows take many forms: purchases of shares of stock in foreign companies, foreign real estate, direct foreign investment, in which companies build factories or acquire other productive assets abroad) 2. Ignore effects of expected changes in exchange rates (the values of different national currencies) Suppose that the real interest rate in the US is 3% and the real interest rate in Australia is 7%. Draw two side-by-side markets and show how the real interest rate in Australia is significantly higher.

Modeling the Financial Account • Since the real interest rate is higher in Australia, what will savers in the United States do with their money? • Individuals and firms in the U.S. begin to purchase financial assets in Australia, sending ______as payment to Australia. • The US is exporting US dollars and importing f________ a______. • Australia is exporting f______________ a___________andimporting US d__________. • These dollars serve as capital inflow in Australia, and capital outflow from the U.S. When does the flow of US dollars to Australia end?

Modeling the Financial Account • Since the real interest rate is higher in Australia, what will savers in the United States do with their money? Savers in the U.S. begin to look for countries like Australia where the return on a financial asset is higher! • Individuals and firms in the U.S. begin to purchase financial assets in Japan, sending dollars as payment to Australia. • The US is exporting dollars and importing financial assets. • Australia is exporting financial assets and importing US dollars. • These dollars serve as capital inflow in Australia, and capital outflow from the U.S. When does the flow of US dollars to Australia end? when the interest rate evens out, maybe 5%.

What are the causes of the differences across countries in the supply and demand for funds? • Differences in economic growth rates: • Fast growing economy = ________ investment opportunities • Slowly growing economy = ________ investment opportunities • Higher demand for capital offers higher r__________ to investors than a slowly growing economy • Result: capital tends to flow from s_________ growing to f__________ growing economies (ex. China) • 2. Differences in savings rates: • International differences in the supply of funds reflect differences in s___________ across countries • Result: this influences private s__________ rates, which vary widely among countries • Private savings rates may also reflect differences in savings by g______________. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows

What are the causes of the differences across countries in the supply and demand for funds? • Differences in economic growth rates: • Fast growing economy = more investment opportunities • Slowly growing economy = less investment opportunities • Higher demand for capital offers higher returns to investors than a slowly growing economy • Result: capital tends to flow from slowly growing to rapidly growing economies (ex. China) • 2. Differences in savings rates: • International differences in the supply of funds reflect differences in savings across countries • Result: differences in private savings rates, which vary widely among countries • Savings rates may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows

Two-way Capital Flows • Capital moves in both directions! • Differences in individual investor's incentives: Financial investors in the US are sending $$$ to China because interest rates might be higher, but China investors are sending $$$ to the US stock market because they believe the US economy has a brighter future (NYSE is over 15,000) • Financial specialization: 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 • Countries can be both creditors and debtors simultaneously USAA China & Joined at the HIP

Module 41 Review Questions p. 419 – 420 • Read Module 42 p. 421 - 429

AP Macroeconomics Section 8 International Trade & Finance Modules 41-44