Chapter 2: International Flow of Funds

What is the Balance of Payments (BOP)?

A measurement of all transactions between domestic and foreign residents for a specific country over a specific period of time.

What is the balance of payments composed of?

1. The current account

2. The capital account

3. The financial account

Briefly explain what the current account measures in the BOP

It measures the flow of funds between a specific country and all other countries due to purchases of goods or services or income generated by assets. It includes:

• Payment for goods (Balance of Trade): Exports & Imports

• Balance of Services: Legal, Insurance, and Consulting

• Primary income (factor income): income earned on DFI

• Secondary income (transfer payments): aids, grants, and gifts from one country to another

What is the balance of trade?

Exports - Imports

Exporting vs Importing

Exporting: Selling your products to foreign countries

• Inflow of funds

Importing: Buying products from foreign countries

• Outflow of funds

Briefly explain what the financial account measures in the BOP

Measures the flow of funds produced through:

1. Direct Foreign Investment: MNC’s pay to acquire, construct or expand an existing plant into a foreign country

2. Portfolio Investment: Investments in financial assets such as stocks or bonds over a given period

3. Other Capital Investment: Transactions involving short-term financial assets between countries

Briefly explain what the capital account measures in the BOP

Measures the flow of funds due to financial assets being transferred to foreign countries or due to sales of patents or trademarks (very large cashflows).

How has the US Benefited from International Trade?

It has created job opportunities, prompts a shift of production to countries that can produce products more efficiently, and ensures global competition amongst producers.

Briefly explain some of the events that increased international trade

1. The fall of the Berlin wall: Encouraged development of free enterprises and improved relations between Eastern and Western Europe

2. The European Act: Removed taxes on goods through uniform regulations

3. NAFTA (CUSMA now): Eliminated trade barriers and allowed access to more markets

4. General Agreements on Tariffs & Trade (GATT): Taxes on foreign goods.

How does outsourcing affect trade?

Through outsourcing, MNC’s purchase products or services from another country which increases international trade.

Briefly explain the factors that affect international trade flows

1. Inflation: If the inflation rate increases, this could cause exports to decrease and imports to rise.

2. National Income: If national income increases relative to other countries, the current account will decrease

3. Government Policies: These policies include restrictions on imports through tariffs, subsidies for exporters, lack of restrictions on piracy

4. Exchange rates: Current account decreases if currency appreciates relative to other currencies

Why do firms pursue direct foreign investment?

DFI allows firms to reach additional customers or utilize low cost of labour

The factors affecting direct foreign investment include….

1. Changes in restrictions: Trade barriers being removed

2. Privatization: Selling some operations to corporations or other investors

3. Potential economic growth: Capitalizing on growth opportunities by establishing more business there

4. Tax rates: Countries with lower taxes will attract more DFI

5. Exchange rates: Firms pursue DFI where the currency is expected to appreciate against theirs

Briefly explain the factors that affect international portfolio investment

1. Tax rates on interest or dividends: Investors prefer to invest where taxes on interest or dividend income is lower.

2. Interest rates: Higher interests rates are preferred

3. Exchange rates: If a country’s home currency is expected to strengthen foreign investors will invest in securities

What agencies facilitate international flows?

1. IMF

2. World Bank

3. World Trade Organization (WTO)

4. International Financial Corporation (IFC)

5. International Development Association (IDA)

6. Bank of International Settlement (BIS)

7. The Organization for Economic Co-operation & Development (OECD)

What is the International Monetary Fund (IMF)

The major objectives of the IMF is to:

• Promote cooperation among countries on international money issues

• Promote stability in exchange rates

• Provide temporary funds to help with imbalances

• Promote free mobility of capital funds across countries

• Promote free trade

What is the purpose of the World Bank?

Provide loans to countries to reduce poverty and enhance economic development.

What is another name for the world bank?

The International Bank of Reconstruction & Development

What is the purpose of the World Trade Organization (WTO)

To provide a forum for multilateral trade negotiations and settle disputes.

Why was the International Financial Corporation established?

To promote private enterprises within countries for catalysts or development projects

What does the International Development Association (IDA) do?

They extend loans at lower interest rates to poor nations

What does the Bank of International Settlements do?

It serves central banks of countries in their pursuit of financial stability, also known as the “central banks, central bank”

What are examples of trade frictions?

1. Dumping (price below cost)

2. Copyright piracy (copy right violation of imported goods)

3. Environmental restrictions

4. Labour Laws

5. Bribes

6. Government Subsidies

7. Tax Breaks

Explain the purpose of net errors & omissions & reserves

The net errors & omissions account ensures that the BOP actually balances, and the reserves account is the total reserves held by official monetary authorities.

What are the different exchange rates within the BOP

1. Fixed exchange rates

2. Floating exchange rates

3. Managed floats

What is a fixed exchange rate?

One country is fixing the exchange rate with another. The government does this to ensure that the BOP is near zero.

Briefly explain what a floating exchange rate is

Under a floating exchange rate system, the government has no responsibility to peg it’s foreign exchange rate. Forces of supply and demand will stabilize the currency rate.

What are managed floats?

Countries operating with managed floats take action to maintain their desired exchange rate values.

List the trade policies

1. Using the exchange rate as a policy

2. Outsourcing

3. Managerial decisions about outsourcing

4. Using trade policies for security reasons

5. Using trade policies for political reasons

What does the OECD do?

They facilitate governance in governments and corporations of countries with market economies.

What is the J-curve effect?

The effect of a weaker dollar on the U.S trade balance in which the trade balance initially deteriorates.

What is intracompany trade?

The process that companies adopt to purchase products that are produced by their subsidies.