1. The Open Economy: International Trade and Finance
Section 8

2. INTERNATIONAL TRADE & FINANCE
Module 41
INTERNATIONAL TRADE & FINANCE 2

3. Videos Macro 5.1- Balance of Payments

4. Capital Flows and the Balance of Payments
M41: INTERNATIONAL TRADE & FINANCE
Capital Flows and the Balance of Payments
A. Balance of Payments Accounts
B. Modeling the Financial Account
C. Underlying Determinants of International Capital Flows
D. Two-way Capital Flows
What we will cover

5. Capital Flows and the Balance of Payments
A country’s balance of payments accounts are a summary of the country’s transactions with other countries.

6. Example
The Patel family runs an auto repair and body shop. Over the course of the year, the shop earned $450,000 in sales.
The family spent $400,000 for living expenses and to run the shop, including purchasing equipment, supplies, materials and utilities.
The family earned $5000 in interest on savings and other investments.
The family paid $20,000 in interest on the mortgage for the building.
After paying all of the bills, the family took the remaining cash and deposited it into the bank.
Every dollar has a source, and every dollar received gets used somewhere.

7. Statistical error
Row 1 of Table 41-2 shows payments that arise from sales and purchases of goods and services.
The U.S. exports cars to be sold in Canada. This is a payment from foreigners for goods and
services.
The U.S. imports oil from Venezuela. This is a payment to foreigners for goods and services.
Row 2 shows factor income—payments for the use of factors of production owned by residents of other countries. This can be interest on loans from overseas, profits of foreign-owned corporations or labor income from native-born workers who work overseas.
Wal-mart, an American company, earns profit from stores in Europe. This is a factor income payment from foreigners.
Honda, a Japanese company, produces and sells cars in Indiana and other U.S. states. This is a factory income payment to foreigners.
Row 3 shows international transfers—funds sent by residents of one country to residents of another. The main element here is the remittances that immigrants, such as the millions of Mexican - born workers employed in the United States, send to their families in their country of origin. Notice that Table 41-2 only shows the net value of transfers. That’s because the U.S. government only provides an estimate of the net, not a breakdown between payments to foreigners and payments from foreigners.
The next two rows of Table 41-2 show payments resulting from sales and purchases of assets, broken down by who is doing the buying and selling.
Row 4 shows transactions that involve governments or government agencies, mainly central banks.
• When the central bank of China purchases a U.S. Treasury debt instrument such as a bond, cash
flows from China to the U.S.
Row 5 shows private sales and purchases of assets. • When Coca-Cola buys a factory in Mexico, this is an asset purchase and payment to foreigners. • If a Brazilian company buys an apartment building in Boston, this is an asset sale, and payment to
foreigners.
Row 1: payments that arise from sales and purchases of goods and services.
Row 2: factor income—payments for the use of factors of production owned by residents of other countries.
interest on loans from overseas, profits of foreign-owned corporations or labor income from native-born workers who work overseas.
Row 3: international transfers—funds sent by residents of one country to residents of another.
Row 4:transactions that involve governments or government agencies, mainly central banks.
Row 5 shows private sales and purchases of assets.

8. Definitions
A country’s balance of payments on the current account, or the current account, is its balance of payments on goods and services plus net international transfer payments and factor income.
A country’s balance of payments on goods and services is the difference between its exports and its imports during a given period.
The merchandise trade balance, or trade balance, is the difference between a country’s exports and imports of goods.
A country’s balance of payments on the financial account, or simply the financial account, is the difference between its sales of assets to foreigners and its purchases of assets from foreigners during a given period.
financial account also known as the capital account.

9. The financial account must sum to zero:
Current account (CA) + Financial account (FA) = 0 or
CA = −FA
Why must this be true? In total, the sources of cash must equal the uses of cash.

10. Current account (CA) + Financial account (FA) = 0
is its balance of payments on goods and services plus net international transfer payments and factor income.
is the difference between its sales of assets to foreigners and its purchases of assets from foreigners during a given period.

11. FINANCIAL ASSETS ≠ PHYSICAL ASSETS
Modeling the Financial Account The financial account is a measure of capital inflows
assuming that all flows are in the form of loans & ignore the effects of expected changes in exchange rates,
Suppose that the real interest rate in the U.S. is 3% and the real interest rate in Japan is 7%.
FINANCIAL ASSETS ≠ PHYSICAL ASSETS
International differences in the demand for funds reflect underlying differences in investment opportunities.
A country with a rapidly growing economy, other things equal, tends to offer more investment opportunities than a country with a slowly growing economy. So a rapidly growing economy typically—though not always—has a higher demand for capital and offers higher returns to investors than a slowly growing economy in the absence of capital flows. As a result, capital tends to flow from slowly growing to rapidly growing economies.
International differences in the supply of funds reflect differences in savings across countries. These may be the result of differences in private savings rates, which vary widely among countries. They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows.
savers in the U.S. begin to look for countries like Japan where the return on a financial asset is higher
U.S. exporting dollars and importing financial assets & Japan is exporting the financial assets and importing dollars.

12. Two-way Capital Flows Capital moves in both directions
Differences in individual investor's incentives
interest rates might be higher
brighter future.
Financial specialization
Countries can be both creditors and debtors simultaneously 12

13. AP TIPS

14. Balance of Payments (BOP)
Balance of trade includes only goods and service but balance of payments considers ALL international transactions.
The BOP summary is done for a given year &
Prepared in the domestic country’s currency
Ex. If accounting the BOP of the U.S. it would be in the Dollar.
The balance of payments is made up of two accounts. The current account and the capital account.

15. The Current Account is made up of three parts:
Trades in Goods and Services (Net Exports)- Difference between a nation’s exports of goods and services and its imports
Ex: Toys imported from China, US cars exported to Mexico
Investment Income- $ from factors of production including payments made to foreign investors.
Ex: Money earned by Japanese car producers in the US
Net Transfers- $ flows from the private & public sectors
Ex: donations, aids and grants, official assistance

16. Capital or (Financial) Account
The Capital Account measures the purchase and sale of financial assets abroad.
(Purchases of things that stay in the foreign country).
Examples:
US company buys a hotel in Russia
A Korean company sells a factory in Ohio
Australian company owns local Mall

17. Current or Capital Account?
Identify if examples are counted in the current or capital account and determine if it is a credit or debit for the US.
Bill, an American, invests $20 million in a ski resort in Canada
A Korean company sells vests to the US Military
A US company, Boeing, sells twenty 747s to France
A Chinese company buys a shopping mall in San Diego
An illegal immigrant sends a portion of his earning to his family
An German investor buys $50,000 US Treasury Bonds
Italian tourists spend 5 million in the US while American tourists spend 8 million in Italy.

18. Current or Capital Account Answers
Capital Account (financial asset), Debit
Current Account (trade of goods/services), Debit
Current Account (trade of goods/services), Credit
Capital Account (financial asset), Credit
Current Account (net transfer), Debit

19. Practice Questions & Answers
1. U.S. income increases relative to other countries. Does the BOP move toward a deficit or a surplus?
U.S. citizens have more disposable income
Americans import more
Net exports (Xn) decrease
The current account balance decreases and moves toward a deficit.
2. If the U.S. dollar depreciates relative to other countries does the BOP move to a deficit or a surplus?
US exports are desirable
America exports more
Net exports (Xn) increase
The current account balance decreases and moves toward a surplus.

20. THE FOREIGN EXCHANGE MARKET
Module 42
THE FOREIGN EXCHANGE MARKET 20

21. Videos Forex Market Basics
Foreign Exchange (FOREX)-Macro 5.2**
Foreign Exchange Practice- Macro Practice- Macro 5.3*
Macro 5.3- Foreign Exchange Practice* (Diff from above)
Imports, Exports, and Exchange Rates: Crash Course Economics #15**
MACROeconomics 15 Minute Review

22. The Role of the Exchange Rate
M42: THE FOREIGN EXCHANGE MARKET
The Role of the Exchange Rate
A. Understanding Exchange Rates
B. The Equilibrium Exchange Rate
C. Inflation and Real Exchange Rates
D. Purchasing Power Parity
What we will cover
In the previous module we saw that the market for loanable funds shows us how financial capital flows
into or out of a nation’s financial account.
Goods and services also flow, but this flow is tracked as balance of payments into and out of the current
account.
So given that the financial account reflects the movement of capital and the current account reflects the
movement of goods and services, what ensures that the balance of payments really does balance? That is,
what ensures that the two accounts actually offset each other?
The answer lies in the role of the exchange rate, which is determined in the foreign exchange market.

23. The Forex & Chuck-e-Cheese?
The Foreign Exchange Market is where currencies are traded. The price of said currencies are known as exchange rates.
CHUCK-E-CHEESE
In order to play you must have the right TOKENS.
Dollars and Coins do not work in the machines.
so, you MUST exchange dollars for tokens to play.
THE FOREX
Countries also have “tokens”: yens, pounds, euros
To buy foreing goods and services you MUST exchange for foreign currency.

24. The current exchange rate is $1 = 4 tokens
What if it changed to $1 = 10 tokens – Would the demand for games increase?
YES!
The dollar has APPRECIATED in value.
More “foreign” games will be purchased. =
IMPORTS ⬆︎ and NET EXPORTS ⬇︎
*if the token machine changed - $1 = 2 tokens. Fewer dollars would be converted (supplied) and the demand for games would decrease. When the dollar depreciates. Imports fall, and net exports rise.

25. Exports and Imports
US sells cars to Mexico
Mexico buys tractors from Canada
Canada sells syrup to the U.S.
For all these transactions, there are different national currencies.
Each country must be paid in their own currency.
The buyer (importer) must exchange their currency for that of the sellers (exporter).

26. Depreciation
The loss of value of a country's currency with respect to a foreign currency
If the dollar losses value compared to another country’s currency
More units of dollars are needed to buy a single unit of the other currency.
The dollar is said to be “Weaker”

27. Appreciation
The increase of value of a country's currency with respect to a foreign currency
If the dollar gains value compared to another country’s currency
Less units of dollars are needed to buy a single unit of the other currency.
The dollar is said to be “Stronger”

28. Video: Down and Out Dollar

29. Mexico buys tractors from Canada Canada sells syrup to the U.S.
Exports and Imports
US sells cars to Mexico
Mexico buys tractors from Canada
Canada sells syrup to the U.S.
Japan buys Fireworks from Mexico
For all these transactions, there are different national currencies.
Each country must be paid in their own currency
The buyer (importer) must exchange their currency for that of the sellers (exporter).

30. The turnover in FOREX markets is almost $4 trillion (USD) a day
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31. Exchange Rates
In the FOREX market we only look at two countries/currencies at a time
Ex: US Dollars and Euros
We examine the price of one currency in terms of the other currency. Ex: $3 = €2
The Exchange Rate depends on which currency you are converting:
The price of one US Dollar in terms of Euros is
1 Dollar = €2/$3 = €.66
The price of one Euro in terms of Dollars is
1 Euro = $3/€2= $1.5
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32. The dollar is said to be “Weaker”
What happens if you need more dollars to buy one euro (the price for a euro increases)?
Ex: From $3=€2 to $6=€2
The U.S. Dollar DEPRECIATES relative to the Euro.
Depreciation- The loss of value of a country's currency with respect to a foreign currency
More units of dollars are needed to buy a single unit of the other currency.
The dollar is said to be “Weaker”
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33. The dollar is said to be “Stronger”
What happens if you need less dollar to buy one euro (the price for a euro decreases)?
Ex: From $3= €2 to $1= €2
The U.S. Dollar APPRECIATES relative to the euro.
Appreciation- The increase of value of a country's currency with respect to a foreign currency
Less units of dollars are needed to buy a single unit of the other currency.
The dollar is said to be “Stronger”
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34. FOREX Supply and Demand Simplified
Imagine a huge table with all the different currencies from every country
This is the Foreign Exchange Market!
Just like at a product market, you can’t take things without paying.
If you demand one currency, you must supply your currency.
Ex: If Canadians what Russian Rubles. The demand for Rubles in the FOREX market will increase and the supply of Canadian Dollars will increase.
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36. What happens if Europeans prefer vacationing in the United States?
Exchange
Rate:
Exchange
Rate: €
Dollars $
Euros $ $ € S
er1 S S1
ere
ere D1
er1 D D
Quantity of Dollars
Quantity of Euros
The Dollar APPRECIATES
The Euro DEPRECIATES
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37. Let’s use the example of the US Dollar and the British Pound
FOREX Shifters
Let’s use the example of the US Dollar and the British Pound
T.R.Y.P.S

38. 1. Tastes and Preferences for imports and exports -
Ex: British tourists flock to the U.S…
Demand for U.S. dollars increases (shifts right)
Supply of British pounds increases (shifts right)
Pound-depreciates
Dollar-appreciates
2. Relative Interest Rates (high rate attracts financial investment)-
Ex: US has a higher interest rate than Britain.
British people want to put money in US banks
Capital Flow increase towards the US
British demand for U.S. dollars increases…
British supply more pounds
Dollar- appreciates

39. 3. Relative Incomes, GDP, Econ Growth (high levels boost imports)-
Ex: US growth increase US incomes….
U.S. buys more imports…
U.S. Demand for pounds increases
Supply of U.S. dollars increases
Pound- appreciates
Dollar- depreciates
4. Relative Price Level (low level attracts foreign consumers / imports )-
Ex: US prices increase relative to Britain….
U.S. demand for cheaper imports increases…
U.S. demand for pounds increases
5. Speculations (Buy low and sell high)

40. What will happen to the international value of the Mexican peso if there is high inflation in Mexico?
The demand for pesos will decrease since Mexico's trading partners will not want to purchase higher priced Mexican products.
The supply will increase as Mexicans look to buy lower priced imports.
Pesos
The peso DEPRECIATES

41. Practice Shifter Value of Dollar ($) Value of Yen (¥ ) 1 2 3 4 5 6 7
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42. How do these scenarios affect exports and imports?
Practice
For each of the following examples, identify what will happen to the value of US Dollars and Japanese Yen.
American tourists increase visits to Japan.
The US government significantly decreases personal income tax.
Inflation in the Japan rises significantly faster than in the US.
Japan has a large budget deficit that increases Japanese interest rates.
Japan places high tariffs on all US imports.
The US suffers a larger recession.
The US Federal Reserve sells bonds at high interest rates.
1. USD depreciates and Yen appreciates
2. USD depreciates and Yen appreciates
3. USD appreciates and Yen depreciates
4. USD depreciates and Yen appreciates
5. USD depreciates (Demand Falls) and Yen appreciates (Supply Falls)
6. USD appreciates (Supply Falls) and Yen depreciates (Demand Falls)
7. USD appreciates and Yen depreciates
How do these scenarios affect exports and imports?

43. Practice
Shifter
Value of Dollar ($)
Value of Yen (¥ ) 1
Tastes
(S↑) Depreciates
(D↑) Appreciates 2
Income 3
Price Level 4
Interest Rate 5
Regulation
(D↓) Depreciates
(S↓) Appreciates 6
(S↓)Appreciates 7
Scenarios 1, 2, and 4 will increase US exports because US products are now relatively “cheaper”
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44. 2008 Audit Exam A

45. High interest rates attract foreign currency
2008 Audit Exam
Answer- B
High interest rates attract foreign currency

46. Exchange Rate Regimes
Fixed Exchange Rate- The government activity manages the country’s currency
Floating Exchange Rate- The market determines the value of the country’s currency
Some governments attempt to depreciate their country’s currency in order to promote exports
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47. 2010 FRQ #3

48. 2010 FRQ #3

49. Module 43 Exchange Rate Policy
Governments have more power to influence nominal exchange rates than other prices
Exchange rates are important to countries where exports and imports are a large fraction of GDP

50. Fixed Exchange Rate: When the government keeps the exchange rate against another currency at or near a particular target rate. (provides certainty but must keep large quantities of foreign currency on hand and thus low-return investment)
Floating Exchange Rate: Country lets exchange rate go where ever the market takes it. (helps to insulate nation from recessions in other nations)
"Managed" & "Target Zone"
An exchange rate regime is a rule governing policy toward the exchange rate.
There are two main kinds of exchange rate regimes.
A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target. For example, Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1.
A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it. This is the policy followed by Britain, Canada, and the United States.
But if the exchange rate is determined by market forces of supply and demand, how can it be held fixed?

51. If using a fixed exchange rate then country must be prepared to “step into the market” to adjust currency rates.

52. Hypothetical country of Genovia lowers interest rates and thus attracts less foreign investors reducing demand for Genos

54. Module 44: Exchange Rates and Policy
Devaluation: A reduction in the value of a nation’s currency
Revaluation: An increase in a nation’s currency value
General Rule: Recessions lead to a fall in imports and an expansion leads to a rise in imports