Download Capital Flows, Balance of Payments, and the Foreign Exchange

Balance of Payments Accounts
Payments from
foreigners
Payments to
foreigners
Net
S/P of goods &
services
$1,994 billion
$2,523 billion
-$529 billion
Factor income
$765 billion
$646 billion
$119 billion
Transfers
$372 billion
$500 billion
-$128 billion
Current accounts
-$538 billion
Official asset S/P
$487 billion
$530 billion
-$43 billion
Private asset S/P
$47 billion
-$534 billion
$581 billion
Financial accounts
Total
$538 billion
$0
Two Categories of Transactions
 Current account – Sales & purchases, factor income, and transfers
 Balance of payments on goods & services – Exports minus imports
of goods & services
 Trade balance – Exports minus imports of goods only (more
accurate & accessible)
 Financial account – Sales & purchases of financial assets
The Rule of Balance of Payments
Current account (CA) + Financial account (FA) = 0
OR
Positive entries on CA + positive entries on FA = Negative entries on CA +
negative entries on FA
Modeling the Financial Account
 Financial account measures sales of assets to foreigners
 For simplification, these are all shown in the form of loans – and only
two countries are shown
 Money flows from lenders to the country with the higher interest rate
Let’s graph this…
Effects of Capital Flows in the
Loanable Funds Market
 Capital inflows pushing r down, capital outflows push r up
 This can continue until the interest rates in two countries equalize –
with a shortage of loanable funds in one country offset by a surplus of
loanable funds in the other
Underlying Determinants of
Capital Flows
1.
2.
Differences in investment opportunities – Countries with rapid
economic growth have higher demand for capital, so they offer
higher returns
International differences in savings rates, including budget balance
Two-Way Capital Flows
Loanable funds model explains net capital flows, but in reality flows take
place in both directions for a variety of reasons, such as:
1.
International investors’ desire to diversify
2. International transactions as part of business model
3. International banking centers
The Foreign Exchange Market
 Goods produced within a country must be paid for with that country’s




currency, so there is a market in which currencies are exchanged for
one another
This market determines exchange rates
When a currency becomes more valuable in terms of other currencies,
it appreciates
When a currency’s value falls, it depreciates
Exchange rates affect relative price, thus impacting trade
Modeling Foreign Exchange Rates
 FOREX is governed by supply and demand
Let’s graph this…
 Demand slopes downward because higher price means less money
demanded (i.e., higher priced American products would mean fewer
European purchasers)
 Supply slopes upward because higher price means greater willingness
to supply (i.e., relatively cheaper European goods will cause Americans
to put more dollars on the market to exchange)
 Rationale: Americans will
demand the less expensive
German goods. To purchase the
German goods, they need euros,
so the demand for euros
increases (shifts to the right).
To buy euros, the Americans will
supply U.S. dollars to the foreign
exchange market, so the supply
of U.S. dollars shifts to the right.
The U.S. dollar depreciates (the
exchange rate decreases). The
euro appreciates (the exchange
rate increases).
Equilibrium Exchange Rate
 Rate at which quantity demanded of a currency = quantity supplied
 Demand shifts can cause the exchange rate to appreciate or depreciate
 Any change in Financial account creates an equal and opposite reaction
in the current account, maintaining CA + FA = 0
 Movements in the exchange rate ensure that FA and CA offset one
another
Inflation & Real Exchange Rate
 Appreciation/depreciation can be exaggerated due to differences in
inflation rates
Real XR = XR (X per Y) ● Price LevelY/Price LevelX
(i.e., Mexican pesos per $1U.S. X PLUS/PLMex)
 Current account responds only to changes in Real XR, not nominal
Purchasing Power Parity
 PPP is the nominal exchange rate at
which a given basket of goods would
cost the same in two countries
 Comparing PPP to XR over time
reveals the impact of inflation
 The relationship between PPP and
exchange rate reveals the relative
cost of living in each country
Additional Terms to Know
 Statistical discrepancy
 Gross National Product (NOT GDP)
 Tariffs
 Import quotas