Capital Flows and Balance of Payments - Section 8, Module 41

  • economists keep track of domestic economy using the national income and product accounts

  • to keep track of international transactions - balanace of payment accoutns

  • balance of payment accoutns - summary of the country’s transactions with other countries

  • balance of payments on the current account/current account - BOP of g/s, factor income, and net international transfer payments

    • balance of payments on goods and services - most important part of current account, and is the difference between the value of exports and the value of imports

      • merchandise trade balance (trade balance) - difference between a country’s exports and imports, NOT INCLUDING SERVICES

    • factor income = payments for the use of factors of production owned by residents other countries

      • mainly investment income - interest paid on loans from oversees, profits of foreign corps in the US, etc.

      • but also, labor income - ex if an american is working abroad

    • international transfers - funds set by residents of one country to residents of another

      • mainly immigrant residents of one country sending money back home

  • balance of payments on the financial account (financial account) (called capital account in the past) - transactions that involve the sale/purchase of assets and create future liabilities

  • BOP includes currenta account and financial account

  • CA AND FA = ZERO ALWAYS

    • sources of case must equal uses of cash:

  • financial assets are exhcnaged for financial capital - funds from savings that are available for investment spending

  • FA = measure of capital inflows in the form of foreign savings that become available to finance domestic investment spenidng

  • motivations fo rcapital flows that are causd by prviate decisions = can be found throug loanable funds

    • simplifications are made: internaltioncapital flows are simplified by the assumption that all flows are in the form of loans (but IRL, they take many forms [such as stocks, foreign real estate, foreign direct investment - companies build factories/get other productive assests abroad]); and the effects of expected changes in exchange rates are ignored

    • basically, country w the higher interest rate attracts investors to send some of their loanable funds to the foreign country - the capital inflow incr loanable funds supply in tht country = brings interest rate down

      • at the same time, quantity of loanable funds supplied to country a’s borrowers decr = incr in IR

      • narrows the gap unitl eliminated

      • example:

    • capital flows from countries w low IR to countries w high ir

  • international differences in demand for funds is bc some countries have more investment opportunities (are more rapidly growing) → they ahve a higher D for capital and offer higher returns to investors

  • internat differences in supply for funds is bc of the diff in savings → private or national

    • govt budget deficits (reduce overall national spending) can lead to capital inflows

  • loanable funds market shows the direction of NET capital flows

  • gross capital flows takes place in both dreictsion, bc IRL, there are other motives for capital flows other than a higher IR

    • investors want to diversify against risk by buying foreign/domestic stocks

    • business stratgey

    • some countries may be intl banking centers - ppl from all over the world put their money into tht country’s financial institutions, which then uses those funds to invets abroad

  • these lead to 2 way capital flows: economies are both debtors AND creditors