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International Finance Chapter 2 Lecture Notes This chapter is designed to give you an idea about the importance of international business transactions, individual transactions and government transactions. The overall level of transactions between one country and another are recorded as the Balance of Payments: The Balance of Payment is broken down into the Current Account and Financial Account. Balance of Payments Current Account Predominately Trade Flows: Goods and Services Financial Account Financial Flows: Foreign Business Acquisitions Stocks and Bonds Balance of Payments: A measure of all transactions between domestic and foreign residents over a specified period of time. Current Account: Flow of funds due to purchases of goods or services or the provision of income on financial assets Merchandise Exports and Imports Service Exports and Imports Factor income Trade Flow 2004 2005 2006 2007 2008 2009 2010 2011 2012 Goods Exports P*Q Exports 1159 (billion) 1281 (billion) 1451 (billion) 1643 (billion) 1827 (billion) 1575 (billion) 1844 (billion) 2113 (billion) 2211 (billion) and minus Services Imports Surplus/Deficit P*fxrate*Q Imports 1769 (billion) 1996 (billion) 2212 (billion) 2345 (billion) 2522 (billion) 1956 (billion) 2344 (billion) 2670 (billion) 2745 (billion) Deficit -610 (billion) -715 (billion) -761 (billion) -702 (billion) -695 (billion) -381 (billion) -499 (billion) -557 (billion) -535 (billion) Financial/Capital Account: Flow of funds resulting from the sale of assets (both real and financial). Inflows of funds are credits and outflows of funds are debits. Financial Account includes Direct Foreign Investment, Portfolio Investment (Stocks and Bonds), and Other Capital Investment Most people are familiar with the Balance of Trade Deficit the US faces. So how do we keep our Balance of Payment in balance if we have a huge trade deficit? See Article from Fed Reserve The answer is we must be able to attract capital (money to pay for the extra goods and services we purchased) by selling more financial securities than we buy. (I.E. we “borrow” the money by selling financial assets such as stocks or bonds). If we look at the financial flows data from the US Treasury Department for 2007, we can see that we have financial inflows (surplus) of $693 billion. In Summary for 2007, we had a trade deficit of about 700 billion and a capital inflow (surplus) of about 700 billion. See exhibit 2.5 for the US Balance of Trade over Time. Factors Affecting International Trade Flow: Exports P*Q Trade Flows minus Imports P*fxrate*Q =Surplus/Deficit Inflation: (___P______) National Income: (____Q____) Government Policies: (__Subsidies-P___Tariff/Quots-Q_____) Exchange Rate: Stronger Home Currency (___FX rate____) Weaker Home Currency (____FX rate____) Simultaneous interaction of factors produces a net effect Even a weaker home currency may not improve a balance of trade deficit. Why? Factors Affecting Direct Foreign Investment Changes in Gov. restrictions Privatization Economic growth potential Tax rates Exchange rates Factors Affecting International Portfolio Investments Taxes Interest rates Exchange rates