copyright © 2004 south-western mod 41 the open economy: capital flows and balance of payments

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Mod Mod 4141The Open Economy:

Capital Flows and Balance of Payments

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The Expanded Circular Flow Diagram

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Balance of Payments Accounting

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US Balance of Payments Accounting

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Up close on Expanded Circular Flow

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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

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Formula for Balance of Payments

Equation: CA + FA = 0So…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

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Balance of Payments Wksht and Answers

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Loanable Funds Market as Financial Market Flow Model

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r%

QLF USA

SLF USA

DLF Japan

r%

QLF Japan

SLF Japan

DLF USA

SLF 1 USA

SLF 1 Japan

Debit to the US Financial Account or Capital Outflow

Credit to the Japanese Financial Account or Capital Inflow

Modeling the Financial Account

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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

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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