Capital Flows and the Balance of Payments Module 41 May 2015

Balance of Payment Accounts Balance of payment accounts – a summary of the country’s transactions with other countries In the upcoming table: 1. shows payments that arise from sales and purchases of goods and services (wheat exports in first column of numbers, oil imports in the 2nd) 2. factor income – payments for the use of factors of production owned by residents of other countries – mostly this is investment income – interest paid on loans from overseas, profits earned by Disneyland Paris. In the 2nd column are profits earned by the U.S. operations of Japanese auto co. - includes labor income, for ex. American engineer working in Dubai

Balance of Payment Accounts 3. international transfers – funds sent by residents of one country to residents of another – remittances that immigrants, such as the millions of Mexican-born workers employed in the U.S. send to their families in their countries of origin – this table shows the NET not a breakdown between payments to foreigners and payments from foreigners 4. the next two rows show payments resulting from sales and purchases of assets, broken down by who is doing the buying and selling 4. shows transactions that involve governments or government agencies, mainly central banks 5. shows private sales and purchases of assets like the purchase of Budweiser by a Belgian corporation.

Table 41.2 The U.S. Balance of Payments in 2008 (billions of dollars) Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Balance of Payment Accounts When a U.S. resident sells a good, such as wheat, to a foreigner, that’s the end of the transaction. But a financial asset, such as a bond, is different. A bond is a promise to pay interest and principal in the future. So its sale is a liability, the U.S. will have to pay interest and repay principal in the future The balance of payments accounts distinguish between transactions that don’t create liabilities and those that do.

Balance of Payment Accounts Balance of payments on the current account or just current account – is the balance of payments on goods and services plus net international transfer payments and factor income Balance of payments on goods and services – the difference between its exports and its import during a given period Merchandise trade balance, or trade balance – the difference between a country’s exports and imports of goods

Balance of Payment Accounts Balance of payments on the financial account or simply the financial account – the difference between its sales of assets to foreigners and its purchases of assets from foreigners during a given period. Current account (CA) + Financial account (FA) = 0

Figure 41.1 The Balance of Payments Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

The blue arrows represent payments that are counted in the current account. The red arrows represent payments that are counted in the financial account. Because the total flow into the U.S. must equal the total flow out of the U.S., the sum of the current account plus the financial account is zero

Financial Account Financial capital – funds from sawings that are available for investment spending Capital inflows – foreign savings that have become available to finance domestic investment spending

The Loanable Funds Model Revisited According to the loanable funds model of the interest rate, the equilibrium interest rate is determined by the intersection of the supply of loanable funds curse, S, and the demand for loanable funds, D. At point E, the equilibrium interest rate is 4%.

Figure 41.2 The Loanable Funds Model Revisited Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Loanable Funds Market in 2 Countries The U.S. and Britain, each with its own loanable funds market. The equilibrium interest rate is 6% in the U.S. market but only 2% in the British market. This creates an incentive for capital to flow from Britain to the U.S.

Figure 41.3 Loanable Funds Markets in Two Countries Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

British lenders lend to borrowers in the U. S British lenders lend to borrowers in the U.S. leading to equalization of interest rates at 4% in both countries. At that rate, American borrowing exceeds American lending; the difference is made up by capital inflows to the U.S. Meanwhile, British lending exceeds British borrowing; the excess is a capital outflow from Britain.

Figure 41.4 International Capital Flows Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers