1. Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

2. Copyright © 2004 South-Western The Expanded Circular Flow Diagram

3. Copyright © 2004 South-Western Balance of Payments Accounting

4. Copyright © 2004 South-Western US Balance of Payments Accounting

5. Copyright © 2004 South-Western Up close on Expanded Circular Flow

6. Copyright © 2004 South-Western Terms to Know Balance of Payments —the overview of a country’s transactions w/all other countries Current Account —balance of payments between one country and all others on goods and services, net transfers, and factor income Trade Balance —short hand for current account balance, meaning NX Financial Account — balance of payments between one country and all others on assets, meaning things like currencies, securities, and factories

7. Copyright © 2004 South-Western Formula for Balance of Payments Equation: CA + FA = 0 So…All the payments to the U.S. from other countries for current account items, + all the payments from the U.S. for current account items from other countries AND All the payments to the U.S. from other countries for assets, + all the payments from the U.S. for assets from other countries = 0

8. Copyright © 2004 South-Western Balance of Payments Wksht and Answers

9. Copyright © 2004 South-Western Loanable Funds Market as Financial Market Flow Model

10. Copyright © 2004 South-Western 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 USA 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 Modeling the Financial Account

11. Copyright © 2004 South-Western The “Rule” for Capital Inflows/Outflows Capital flows will move from the countries where interest in the LF market is lower to the countries where interest in the LF market is higher Why do various countries LF markets have differing interest rates?? Differences in economic growth rates Differences in savings rates

12. Copyright © 2004 South-Western In reality, Capital moves in both directions. WHY?? Differences in individual investor's incentives Financial specialization Countries can be both creditors and debtors simultaneously Two-way Capital Flows