Module 41 Section 8 Lecture Notes
THE OPEN ECONOMY- INTERNATIONA TRADE AND FINANCE
Module 41: CAPITAL FLOWS AND THE BALANCE OF PAYMENTS
Key Concepts:
 A country’s balance of payments accounts are a summary of the country’s transactions with other countries.
 Balance of Payment has two accounts – the financial and current accounts
 Transactions that don’t create future liabilities are recorded in the current account.
 Transactions that do create future liabilities are recorded in the financial account.
 The balance on the current account plus the balance on the financial account must sum to zero.
 Why? In total the sources of cash must equal the uses of cash.
 CA= -FA
 If one nation has a higher real interest rate than another nation, it will attract an inflow of financial capital. The
nation with the lower interest rate will experience an outflow of financial capital.
 When we talk about the balance of payments on the financial account, we count financial capital such as stocks,
bonds, or CD’s not physical capital like hammers, tractors, etc…
 Goods and Services, factor income (interest and dividends on foreign financial assets) and transfers (foreign aid
and private cash transfers) are counted in the current account.
 If imports are greater than exports, a trade deficit occurs in the current account. If exports are greater than
imports, then the nation has a trade surplus in the current account.
What is financial capital?
Financial capital is the money, credit and other forms of funding that companies use to invest in their businesses.
** Real interest rates drive the flow of financial capital not physical capital.
*******************************************************************************************
I: Capital Flows and Balance of Payments:
Every year Americans buy trillions of dollars of “stuff” from firms and foreign countries. Consumers in foreign countries
buy nearly the same amount of “stuff” from America.
Economists keep track of international transactions using the balance of payments accounts.
A: Balance of Payments Accounts: are a summary of a country’s transactions with other countries.
Example:
 The Santa Cruz 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 the bills, the family took the remaining cash and deposited it into the bank.
The Table below shows the net inflow of cash for the Santa Cruz family business.
1
Purchases or sales of
goods and services
2
Interest income and
payments
Sources of Cash
Auto repair sales:
$450,000
Interest received
from investments:
$5000
Uses of Cash
Shop operations and
living expenses:
$400,000
Interest paid on
mortgage: $25,000
Net
+$50,000
-$20,000
3
Loans and Deposits
Total
Funds received from
new loans: $0
$455,000
Funds deposited in
bank: $30,000
$455,000
-$30,000
$0
Row 1: Summarizes the sale of goods and services to customers, and the payments made to outside firms for the
purchase of goods and services.
Row 2: Summarizes interest income received from past savings and interest paid for past borrowing.
Row 3: Summarizes money received from new borrowing and money used for new saving.
*** Student Alert: The sum of cash coming in from all sources and the sum of cash used are equal. Thus- every dollar
has a source, and every dollar received gets used somewhere.
Refer to Table 41.2 in the textbook.
Row 1: Shows payments that arise from sales and purchases of goods and services.
 The US exports cars to be sold in Canada. This is a payment from foreigners for goods and services.
 The US imports oil from Venezuela. This is a payment to foreigners for goods and services.
Row 2: Shows factor income- payment 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.
Row 3: Shows international transfers- funds sent by residents of one country to residents of another. The main element
here is the remittances (money) that immigrants, such as the millions of Mexicans-born workers employed in the US,
send to their families in their country of origin. Notice that it is an estimate- Why? The US govt. only provides an
estimate of the net, not a breakdown between payments to foreigners and payments from foreigners.
Rows 4 and 5 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 US Treasury bill, cash flows from China to the US.
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.
Notice the rows 1, 2,and 3 are separated from rows 4, and 5. This reflects the important difference between the two
groups of transactions and how these transactions affect the future.
Note: The table separates balance of payment accounts that don’t create liabilities ( like when an American buys a jacket
produced in Taiwan) and those that do ( like when a Honduran banker buys a US treasury bill)
 Transactions that don’t create liabilities are considered part of the balance of payments on current account,
often referred to simply as the current account: the balance of payments on goods and services plus factor
income and net international transfer payments.
 The most important part of the current account: the balance on goods and services, the difference between
the value of exports and the value of imports during a given period.
 The merchandise trade balance or simply the trade balance is the difference between a country’s exports and
imports of goods alone-not including services.
The current account consists of international transactions that don’t create liabilities. Transactions that involve the sale
or purchase of assets, and therefore do create future liabilities are considered part of the balance payment on
financial account or financial account.
Student Alert: On some AP exams you may find the term capital account. It is the same as financial account. Economists
used to refer to financial accounts as the capital account so you may see both terms.
The total on Table 41.2 is not zero but $44 billion. This is a statistical error. Remember the basic rule of balance of
payments accounting says that the current account and the financial account must sum to zero.
CA + FA =0 or CA=- FA Why must this be true? Because the sources of cash must equal the uses of cash.
Remember the circular flow? Another way to say it: Positive entries on current account+ Positive entries on financial
accounts = Negative entries on current account+ Negative entries on financial accounts.
Or Positive entries on current account- Negative entries on current account= Positive entries on financial accounts –
Negative entries on financial account = 0
II: Modeling the Financial Account: What determines whether money flows into a nation’s financial account?
The financial account is a measure of capital inflows, of foreign savings that are available to finance domestic
investment spending.
We use the model of loanable funds market to model the flow of financial capital from one nation to another.
 Economists simplify the reality of international capital flows by assuming that all flows are in the form of loans.
In reality they take many forms, including purchases of share of stock in foreign companies, and foreign real
estate as well as direct foreign investment, in which companies build factories or acquire productive assets
abroad.

Economist ignore the effects of expected changes in exchange rates, they analyze the determination of
exchange rates later.

See Figures 41.3 and 41. 4 to illustrate this model.
When 2 nations have differing real interest rates, in their domestic loanable funds markets, savers in the US begin to
look for countries where the return on a financial asset is higher. Individuals and firms in the US begin to purchase
financial assets in the country with the higher interest rate, sending dollars as payment to that country.
So you have the US exporting dollars and importing financial assets. The other country is exporting the financial asset
and importing dollars.
****Student Alert: The recent AP exams have been very strict on this point. It is important to remember that US
investors are seeking financial assets not physical asset (like factories) in the foreign country.*********
The dollars serve as capital inflow to the foreign country and as capital outflow from the US. The flow of dollars ends
when the disparity between interest rates closes or come together.
III: Underlying Determinants of International Capital Flows: 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. Rapidly growing economies have a higher demand for capital
and offer higher returns to investors (but not always).
 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. Government budget deficits which reduce overall
national savings can lead to capital inflows.
IV: Two-way Capital Inflows: The flow of financial capital is a two-way street.
 Financial investors in the US are sending money to Japan because interest rates might be higher, but Japanese
investors are sending money to the US Stock Market because they believe the US economy has a brighter future.
 Corporations diversify financial risk by both selling shares of their own stock to foreign investors, but also by
purchasing foreign shares of stocks of foreign bonds.
AP EXAM TIP: Remember that the current account includes goods and services and cash transfers such as foreign aid
and gifts, and grants. You may be asked to identify these transactions on the AP exam.
AP EXAM TIP: Financial accounts track assets such as real estate, stocks, and bonds. Dividends and interest paid are
not assets. They are counted in the current account. You may be asked to identify these transactions on the AP exam.
Test your Knowledge:
1. The current account includes which of the following?
I: payments for goods and services
II: transfer payments
III: factor income
a. I only
b. II only
c. III only
d. I and II only
e. I, II, III only
2. Which of the following will increase the demand for loanable funds in a country?
a. Economic growth
b. Decreased investment opportunities
c. A recession
d. Decreased private savings rates
e. Government budget surpluses
3. Which of the balance of payment accounts do the following events affect?
a. Boeing, a US based company sells a newly built plane to China.
b. Chinese investors buy stock in Boeing from Americans.
c. A Chinese company buys a used airplane from American Airlines and ships it to China.
d. A Chinese investor who owns property in the US buys a corporate jet, which he will keep in the US so he can
travel around America.