1. CAPITAL FLOWS AND THEBALANCE OF PAYMENTS MODULE 41

2. BALANCE OF PAYMENTS ACCOUNTS In the same way economists keep track of thedomestic economy using the national income andproduct accounts, economists keep track of theinternational transactions using the balance ofpayments accounts. A countrys balance of payments accounts are asummary of the countrys transactions with othercountries. These accounts show payments from foreigners andpayments to foreigners. 3. THE CURRENT ACCOUNTThe first row shows payments that arise from sales and purchases of goods and services.The second row shows factor income (payments for the use of factors of production owned by residents of other countries). This mostly means interest paid on loans from overseas, the profits of foreign-owned corporations, etc. This factor income also includes labor income (wages). 4. THE CURRENT ACCOUNTThe third row shows international transfers (funds sent by residents of one country to residents of another), such as the remittances sent by Guatemalans working in the United States to their family in Guatemala.These first three rows of the balance of payments accounts are made up of international transactions that dont create liabilities. 5. BALANCE OF PAYMENTS ON THECURRENT ACCOUNT These first three rows make up the balance ofpayments on the current account (or just the currentaccount): the balance of payments on goods andservices plus factor income and net internationaltransfer payments. The first row corresponds to the most importantpart of the current account: the balance of paymentson goods and services, which is the differencebetween the value of exports and the value ofimports during a given period. 6. THE MERCHANDISE TRADE BALANCE The merchandise trade balance (or just tradebalance) is often referred to in news reports. This is made up of the difference between acountrys exports and imports of goods alone, notincluding services. Economists sometimes focus only on themerchandise trade balance, even though its anincomplete measure, because data on internationaltrade in services are not as accurate as data trade inphysical goods. 7. THE FINANCIAL ACCOUNTThe fourth and fifth row 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.Row 5 shows private sales and purchases of assets. 8. THE FINANCIAL ACCOUNTThese last two rows of the balance of payments make up the balance of payments on the financial account (or just financial account). *In the past, this as known as the capital account*These are the transactions that involve the sale or purchase of assets, and do create future liabilities.An example of such an asset is when a bond is sold. 9. BASIC RULE OF BALANCE OF PAYMENTSACCOUNTING It is a basic rule of balance of payments accountingthat the current account and the financial accountsum to zero: Current account (CA)+Financial Account (FA)=0 When the current account and the financial accountdo not add up to zero, this is considered a statisticalerror. In other words, the flows of money into a countrymust equal the flows of money out of a country. 10. CIRCULAR FLOW DIAGRAM OF AN OPENECONOMY This shows the flow of money between nationaleconomies:a) Money flows into a country from the rest of the world as:1. payments for exports of goods and services2. payments for the factors of production3. as transfer payments (1, 2, and 3 are the positive components of the current account).4. money also flows into the country from foreigners who purchase the countrys assets. (the positive component of the financial account). 11. CIRCULAR FLOW DIAGRAM OF AN OPENECONOMYb) Money flows out of a country to the rest of the world as:1. payments for imports of goods and services2. payments for the use of foreign-owned factors of production3. as transfer payments (1, 2, and 3 are the negative components of the current account).4. money also flows out of the country to purchase foreign assets. (the negative component of the financial account). 12. CIRCULAR FLOW DIAGRAM OF AN OPENECONOMY The flow into a box and the flow out of the box are equal.In other words:Positive entries on the current account + Positive entries on thefinancial account = Negative entries on the current account + Negativeentries on the financial account This equation can be rearranged as follows:Positive entries on the current account - Negative entries on thecurrent account = Positive entries on the financial account - Negativeentries on the financial account The current account plus the financial account, both equal topositive entries minus negative entries, is equal to zero. 13. MODELING THE FINANCIAL ACCOUNT A countrys financial account measures its net sales of assetsto foreigners. Those assets are exchanged for a type of capital calledfinancial capital, which is funds from savings that areavailable for investment spending. Therefore, we can think of financial account as a measure ofcapital inflows in the form of foreign savings that becomeavailable to finance domestic investment spending. 14. WHAT DETERMINES THESE CAPITAL INFLOWS? We can use the loanable funds model to gain insight into themotivations for capital inflows. Two important simplifications we must make are:1. Assume that all flows are in the form of loans (in reality, capital flows take many forms, including purchases of shares of stock in foreign companies and foreign real estate, as well as foreign direct investment in which companies build factories or acquire other productive assets abroad).2. Ignore the effects of expected changes in exchange rates (the relative values of different national currencies) 15. WHAT DETERMINES THESE CAPITAL INFLOWS? International flows of capital are like international flows ofgoods and services. Capital moves from places where it would be cheap in theabsence of international capital flows to places where itwould be expensive in the absence of such flows. 16. DETERMINANTS OF INTERNATIONAL CAPITAL FLOWS International differences in the demand for funds reflectunderlying differences in investment opportunities. So acountry with a growing economy tends to offer moreinvestment opportunities than a country with a slowlygrowing economy. So a rapidly growing economy may have a higher demand forcapital and offer higher returns to investors than a slowlygrowing economy, in the absence of capital flows. As a result, capital tends to flow from slowly growing torapidly growing economies. 17. DETERMINANTS OF INTERNATIONAL CAPITAL FLOWS International differences in the supply of funds reflectdifferences in savings across countries. This may be the result of private savings rates, which varywidely among countries. This may also reflect differences in savings by governments.In particular, government budget deficits, which reduceoverall national savings, can lead to capital inflows. 18. TWO-WAY CAPITAL FLOWS The loanable funds model helps understand the direction ofnet capital flows (the excess of inflows into a country overoutflows, or vice versa). However, gross flows take place in both directions. A countrymay both sell assets to foreigners and buy assets fromforeigners. The reason why capital moves in both directions is becausethere are other motives for international capital flows besidesseeking a higher rate of interest. 19. TWO-WAY CAPITAL FLOWS1. Investors may seek to diversify against risk by buying stocks in a number of countries.2. Corporations often engage in international investment as part of their business strategy.3. Some countries are international banking centers, which means that people from all over the world put money into their financial institutions, which then invest many of these funds overseas. The result of these two-way flows is that modern economiesare typically both debtors (countries that owe money to therest of the world) and creditors (countries to which the rest ofthe world owes money).