International Flow of Funds C H A P T E R 2 International Flow of Funds

Foreign Exchange Risk The risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share (Initial investment:$1000 or ¥100,000) . One year later the investment is worth ten percent more in yen and the yen has depreciated to $1 = ¥120 (Received: ¥110,000, or $ 916.67) What is your profit from this investment in ¥ and in $ ?

Evolution of the International Monetary System Bimetallism: Before 1875 Classical Gold Standard: 1875-1914 Interwar Period: 1915-1944 Bretton Woods System: 1945-1972 The Flexible Exchange Rate Regime: 1973-Present

Classical Gold Standard: 1875-1914 If the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold. What should be the exchange rate between U.S. $ and British £ ? What will happen if this exchange rate does not hold, such as £1 = $4?

Bretton Woods System: 1945-1972 German mark British pound French franc Par Value Par Value Par Value U.S. dollar Pegged at $35/oz. Gold

The Flexible Exchange Rate Regime: 1973-Present Free Float Managed Float Pegged to another currency No national currency 2-6

A. Balance of Payments (BOP) BOP is a summary of transactions between domestic and foreign residents for a specific country over a specific period of time. Examples of BOP: An American tourist purchases a small Lapponia necklace in Finland. A Mexican lawyer purchases a US corporation bond via a broker in US. BOP can be tracked by three major subaccounts: current account, capital account and financial account.

A. Balance of Payments 1. Current Account: a. Payments for merchandise and services, or net exports / imports of goods (balance of trade) and net exports / imports of services. b. Factor income payments c. Transfer payments (funds transferred) 2. Capital and Financial Accounts a. Direct foreign investment (DFI) b. Portfolio investment (long term securities) c. Other (short term securities) d. Errors and Omissions and Reserves Statistical Supplement to the Federal Reserve Bulletin, December 2008 http://www.federalreserve.gov/Pubs/supplement/2008/12/table3_10.htm

A. Balance of Payments BOP is a cash flow statement. It tracks the continuing flows of purchases and payments between a country and all other countries. BOP must balance. If it does not, something has not been counted or has been countered improperly. The item Errors and Omissions and Reserves catches the discrepancy.

B. International Trade Flows 2006 Distribution of U.S. Exports and Imports Insert Exhibit 2.4 from page 28 Discussion: Should the U.S. be concerned about a Huge BOT Deficit? 2. Can US depreciate the dollar to reduce BOT deficit? 3. Should Trade Restrictions be Used to Influence Human Rights Issues?

C. Correcting a Balance of Trade Deficit 1. Why a Weak Home Currency is Not a Perfect Solution a. Counterpricing by Competitors b. Impact of Other Weak Currencies c. Intercompany Trade

D. International Trade Issues 1. Events that Increased International Trade a. Removal of the Berlin Wall b. Single European Act c. NAFTA d. Inception of the Euro e. European Union Expansion