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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