Module Capital Flows and the Balance of Payments KRUGMAN'S MACROECONOMICS for AP* 41 Margaret Ray and David Anderson

What you will learn in this Module : The meaning of the balance of payments accounts The determinants of international capital flows

Balance of Payments Accounts Every year Americans buy trillions of $$ of ‘stuff’ from firms in foreign countries. Consumers in foreign countries buy nearly the same amount of ‘stuff’ from the US. Economists keep track of international transactions using the Balance of Payments Accounts

The Santa Cruz family runs an auto repair and body shop. Over the course of the year, the shop earned $450,000 in sales.

Balance of Payments Accounts The family SPENT $450,000 for 1.Living expenses 2.Running the shop 1.Purchasing equipment 2.Supplies 3.materials 4.utilities The family EARNED $5000 in 1.Interest on savings 2.Interest on investments The family PAID $20,000 in interest on the mortgage For the building. The family DEPOSITED the remaining cash in the bank.

Balance of Payments Accounts Let’s decide which transactions goes where. The sum of cash coming in = some of cash used Every $ has a source AND Every $ received is used somewhere.

Balance of Payments Accounts Balance of Payments Accounts Row 1 – US Imports and Exports Row 2 – payments for the use of F of P owned by residents of other countries. Interest on overseas loans Profits of foreign-owned corps. Labor income from US workers working overseas. Row 3 – international transfers – funds sent by residents of one country to residents of another. Current Account = transactions that do not create liabilities. Row 1 is most important,

Balance of Payments Accounts Balance of Payments Accounts Row 4 – transactions with Central Banks. Row 5 – private sales and asset Purchases. Financial Account (Capital Account) = transactions that do create liabilities. Current Account + Financial Account (Capital Account) = 0.

Modeling the Financial Account Modeling the Financial Account r% Q LF USA S USA D Japan r% Q LF Japan D US S Japan Loanable Funds Mkt., USLoanable Funds Mkt., Japan 5% 3% 7% Capital outflow From US Capital inflow To Japan US is looking for a higher interest rate to make more $$$. US investors are seeking Financial Assets in Japan

Modeling the Financial Account Modeling the Financial Account Savings will flow toward higher returns r% Q LF USA S LF USA D LF Japan r% Q LF Japan S LF Japan D LF China S LF 1 USA S LF 1 Japan Debit to the US Financial Account or Capital Outflow Credit to the Japanese Financial Account or Capital Inflow

Underlying Determinants of International Capital Flows Underlying Determinants of International Capital Flows Differences in economic growth rates A country with a rapidly growing economy Offers more investment opportunities Higher demand for capital Offers higher returns on investments Differences in savings rates International private and/or government savings rates (required reserves)

Two-way Capital Flows Two-way Capital Flows Capital moves in both directions Differences in individual investor's incentives Financial specialization Countries can be both creditors and debtors simultaneously