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Unformatted text preview: 12/08/2020 Capital Flows | Boundless Economics Boundless Economics Open Economy Macroeconomics Capital Flows -flows/ 1/19 12/08/2020 Capital Flows | Boundless Economics The Balance of Payments The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world. LEARNING OBJECTIVES Explain the components and importance of the balance of payments KEY TAKEAWAYS Key Points Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Whenever a country has an out ow of funds, it is recorded as a debit on the balance of payments. When all components of the BOP accounts are included they must sum to zero with no overall surplus or de cit. BOP=Current Account+Financial Account+ Capital Account+Balancing Item. The current account records the ow of income from one country to another. The nancial account records the ow of assets from one country to another. -flows/ 2/19 12/08/2020 Capital Flows | Boundless Economics The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not a ect national income. Key Terms balance of payments: A record of all monetary transac- tions between a country and the rest of the world The balance of payments (BOP) is a record of all monetary transactions between a country and the rest of the world. This includes payments for the country’s exports and imports, the sale and purchase of assets, and nancial transfers. The BOP is given for a speci c period of time (usually a year) and in terms of the domestic currency. Whenever a country receives funds from a foreign source, a credit is recorded on the balance of payments. Sources of funds include exports, the receipt of loans or investment, and income from foreign assets. Whenever a country has an out ow of funds, such as when the country imports goods and services or when it invests in foreign assets, it is recorded as a debit on the balance of payments. When all components of the BOP accounts are included they must sum to zero with no overall surplus or de cit. For example, if a country is importing more than it exports, its trade balance will be in de cit, but the shortfall will have to be counterbalanced in other ways – such as by funds earned from its foreign investments, by running down central bank reserves, or by receiving loans from other countries. -flows/ 3/19 12/08/2020 Capital Flows | Boundless Economics U.S. Current Account: The chart shows the current account de cit of the U.S., both in dollars and as a percent of GDP. De cits in the current account must be o set by surpluses in the nancial and capital accounts. Components of the Balance of Payments The BOP can be expressed as: BOP = CurrentAccount + F inancialAccount + CapitalAccount + Ba The current account records the ow of income from one country to another. It includes the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers. The nancial account records the ow of assets from one country to another. It is composed of foreign direct investment, portfolio investment, other investment, and reserve account ows. The capital account is typically much smaller than the other two and includes miscellaneous transfers that do not a ect national income. Debt forgiveness would a ect the capital account, as would the purchase of -flows/ 4/19 12/08/2020 Capital Flows | Boundless Economics non- nancial and non-produced assets such as the rights to natural resources or patents. The balancing item is simply an amount that accounts for any statistical errors and ensures that the total balance of payments is zero. The Current Account The current account represents the sum of net exports, factor income, and cash transfers. LEARNING OBJECTIVES Calculate the current account KEY TAKEAWAYS Key Points The balance of trade is the di erence between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade de cit if its imports exceeds its exports. The net factor income records a country’s in ow of income and out ow of payments. Income refers not only to the money received from investments made abroad but also to remittances. Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. A country’s current account can by calculated by the following formula: CA = (X − M ) + N Y + N CT . -flows/ 5/19 12/08/2020 Capital Flows | Boundless Economics Key Terms credit: An addition to certain accounts. balance of trade: The di erence between the monetary value of exports and imports in an economy over a certain period of time. debit: A sum of money taken out of an account. The current account represents the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors), and cash transfers. It is called the current account as it covers transactions in the “here and now” – those that don’t give rise to future claims. The balance of trade is the di erence between a nation’s exports of goods and services and its imports of goods and services. A nation has a trade de cit if its imports exceed its exports. Because the trade balance is typically the largest component of the current account, a current account surplus is usually associated with positive net exports. This, however, is not always the case. Secluded economies like Australia are more likely to feature income de cits larger than their trade surplus. The net factor income records a country’s in ow of income and out ow of payments. Income refers not only to the money received from investments made abroad (note: the investments themselves are recorded in the capital account but income from investments is recorded in the current account) but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc. Cash transfers take place when a certain foreign country simply provides currency to another country with nothing received as a return. Typically, such transfers are done in the form of donations, aids, or o cial assistance. -flows/ 6/19 12/08/2020 Capital Flows | Boundless Economics Calculating the Current Account Normally, the current account is calculated by adding up the 4 components of current account: goods, services, income and cash transfers. Goods are traded by countries all over the world. When ownership of a good is transferred from a local country to a foreign country, this is called an export. When a good’s ownership is transferred from a foreign country to a local country, this is called an import. In calculating the current account, exports are marked as a credit (in ow of money) and imports are marked as a debit (out ow of money). Services can also be traded by countries. This happens frequently in the case of tourism. When a tourist from a local country visits a foreign country, the local country is consuming the foreign services and this is counted as an import. Likewise, when a foreign tourist comes and enjoys the services of a local country, this is counted as an export. Other services can also be transferred between countries, such as when a nancial adviser in one country assists clients in another. A credit of income happens when a domestic individual or company receives money from a foreign individual or company. This would typically take place when a domestic investor receives dividends from an investment made in a foreign country, or when a worker abroad sends remittances back to the local country. Likewise, a debit in the income account takes place when a foreign entity receives money from an investment in the local economy. Finally, a credit in the cash transfers column would be a gift of aid from a foreign country to the domestic country. Similarly, a debit in the cash transfers column might be the provision of o cial assistance by the local economy to a foreign economy. Thus, a country’s current account can by calculated by the following formula: CA = (X − M ) + N Y + N CT -flows/ 7/19 12/08/2020 Capital Flows | Boundless Economics Where CA is the current account, X and M and the export and import of goods and services respectively, N Y is net income from abroad, and N CT is the net current transfers. When the sum of these four components is positive, the current account has a surplus. Global Current Accounts: The map shows the per capita current accounts surpluses and de cits of countries around the world from 1980 to 2008. Deeper red implies a higher per capita de cit, while deeper green implies a higher per capita surplus. The Financial Account The nancial account measures the net change in ownership of national assets. LEARNING OBJECTIVES Calculate the nancial account KEY TAKEAWAYS Key Points -flows/ 8/19 12/08/2020 Capital Flows | Boundless Economics A nancial account surplus means that buyers in the rest of the world are purchasing more of a country’s assets than buyers in the domestic economy are spending on rest-of-world assets. The nancial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account ows. Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants. Portfolio investment refers to the purchase of shares and bonds. Other investment includes capital ows into bank accounts or provided as loans. The reserve account is operated by a nation’s central bank to buy and sell foreign currencies. Key Terms central bank: The principal monetary authority of a country or monetary union; it normally regulates the supply of money, issues currency and controls interest rates. interest rate: The percentage of an amount of money charged for its use per some period of time (often a year). The nancial account (also known as the capital account under some balance of payments systems) measures the net change in ownership of national assets. When nancial account has a positive balance, we say that there is a nancial account surplus. A nancial account surplus means that the net ownership of a country’s assets is owing out of a country – that is, foreign buyers are purchasing more domestic assets than domestic buyers are purchasing of assets from the rest of the world. Likewise, we say that there is a nancial account de cit when the nancial account has a negative balance. This occurs when domestic -flows/ 9/19 12/08/2020 Capital Flows | Boundless Economics buyers are purchasing more foreign assets than foreign buyers are purchasing of domestic assets. For example, a nancial accounts de cit would exist when Country A’s citizens buy $200 million worth of real estate overseas, while overseas investors purchase only $100 million worth of real estate within Country A. Calculating the Financial Account The nancial account has four components: foreign direct investment, portfolio investment, other investment, and reserve account ows. Foreign direct investment (FDI) refers to long term capital investment such as the purchase or construction of machinery, buildings, or even whole manufacturing plants. If foreigners are investing in a country, that is an inbound ow and counts as a surplus item on the nancial account. If a nation’s citizens are investing in foreign countries, there is an outbound ow that will count as a de cit. After the initial investment, any yearly pro ts not re-invested will ow in the opposite direction, but will be recorded in the current account rather than the nancial account. -flows/ 10/19 12/08/2020 Capital Flows | Boundless Economics FDI in Austria: Austria has experienced a surplus of foreign direct investment: more foreign investors invest in Austria than Austrian investors do in the rest of the world. This contributes to a nancial account surplus. Portfolio investment refers to the purchase of shares and bonds. It is sometimes grouped together with “other” as short term investment. As with FDI, the income derived from these assets is recorded in the current account; the nancial account entry will just be for any buying or selling of the portfolio assets in the international nancial markets. Other investment includes capital ows into bank accounts or provided as loans. Large short term ows between accounts in di erent nations are commonly seen when the market is able to take advantage of uctuations in interest rates and/or the exchange rate between currencies. Sometimes this category can include the reserve account. The reserve account is operated by a nation’s central bank to buy and sell foreign currencies; it can be a source of large capital ows to counteract those originating from the market. Inbound capital ows (from -flows/ 11/19 12/08/2020 Capital Flows | Boundless Economics sales of the account’s foreign currency), especially when combined with a current account surplus, can cause a rise in value (appreciation) of a nation’s currency, while outbound ows can cause a fall in value (depreciation). If a government (or, if authorized to operate independently in this area, the central bank itself) does not consider the market-driven change to its currency value to be in the nation’s best interests, it can intervene. Such intervention a ects the nancial account. Purchases of foreign currencies, for example, will increase the de cit and vis versa. To calculate the total surplus or de cit in the nancial account, sum the net change in FDI, portfolio investment, other investment, and the reserve account. Interest Rates and the Financial Account The out ow or in ow of assets in the nancial account depends in large part on the domestic interest rate and how it compares to interest rates in other countries. A higher central bank interest rate will tend to increase the interest rate on all domestic nancial assets, such as bonds, loans, and government securities. In general, if interest rates are higher in one country than another, an investor would prefer to purchase nancial assets in the country with the higher interest rate. An increase in the domestic interest rate will therefore cause foreign investors to purchase more domestic assets, creating a nancial account surplus. Likewise, a fall in the domestic interest rate will cause domestic investors to purchase foreign assets in place of domestic assets, and will cause a nancial account de cit. The Capital Account The capital account acts as a sort of miscellaneous account, measuring non-produced and non- nancial assets, as well as capital transfers. LEARNING OBJECTIVES -flows/ 12/19 12/08/2020 Capital Flows | Boundless Economics Calculate the Capital Account KEY TAKEAWAYS Key Points A de cit in the capital account means that money is owing out of a country and the country is accumulating foreign assets. The capital account can be split into two categories: non-produced and non- nancial assets, and capital transfers. Non-produced and non- nancial assets include things like drilling rights, patents, and trademarks. Capital transfers include debt forgiveness, the transfer of goods and nancial assets by migrants leaving or entering a country, and the transfer of ownership on xed assets. Key Terms debt forgiveness: The partial or total writing down of debt owed by individuals, corporations, or nations. There are two common de nitions of the capital account in economics. The rst is a broad interpretation that re ects the net change in ownership of national assets. Under the International Monetary Fund (IMF) de nition, however, most of these asset ows are captured in the nancial account. Instead, the capital account acts as a sort of miscellaneous account, measuring non-produced and non- nancial assets, as well as capital transfers. The capital account is normally much smaller than the nancial and current accounts. Like the nancial account, a de cit in the capital account means that money is owing out of a country and the country is accumulating -flows/ 13/19 12/08/2020 Capital Flows | Boundless Economics foreign assets. Likewise, a surplus in the capital account means that a money is owing into a country and the country is selling (or otherwise disposing of) non-produced, non- nancial assets. Calculating the Capital Account The capital account can be split into two categories: non-produced and non- nancial assets, and capital transfers. Non-produced and nonnancial assets include things like drilling rights, patents, and trademarks. For example, if a domestic company acquires the rights to mineral resources in a foreign country, there is an out ow of money and the domestic country acquires an asset, creating a capital account de cit. Natural Gas Rights: If a U.S. company sold its rights to drill for natural gas o the southern coast of the U.S., it would be recorded as a credit in the capital account. Capital transfers include debt forgiveness, the transfer of goods and nancial assets by migrants leaving or entering a country, the transfer of ownership on xed assets, the transfer of funds received to the sale or acquisition of xed assets, gift and inheritance taxes, death levies, and uninsured damage to xed asset. For example, if the domestic country -flows/ 14/19 12/08/2020 Capital Flows | Boundless Economics forgives a loan made to a foreign country, this transfer creates a de cit in the capital account. Thus, the balance of the capital account is calculated as the sum of the surpluses or de cits of net non-produced, non- nancial assets, and net capital transfers. Reason for a Zero Balance Equilibrium in the market for a country’s currency implies that the balance of payments is equal to zero. LEARNING OBJECTIVES Discuss the long term equilibrium of a country’s balance of payments KEY TAKEAWAYS Key Points Equilibrium in the foreign exchange market implies that the quantity of currency demanded = quantity of currency supplied. The quantity of a currency demanded is from two sources: exports and rest-of-world purchases of domestic assets. The quantity supplied of a currency is also from two sources: imports and domestic purchases of rest-of-world assets. Therefore, exports + (rest-of-world purchases of domestic assets) = imports + (domestic purchases or rest-ofworld assets). -flows/ 15/19 12/08/2020 Capital Flows | Boundless Economics Finally, this means that exports – imports = (domestic purchases of rest-of-world assets) – (rest-of-world purchases of domestic assets). In other words, the current account balances out the nancial account and the balance of payments is zero. Key Terms net exports: The di erence between the monetary val- ue of exports and imports. foreign exchange: The changing of currency from one country for currency from another country. Capital Flows Trade within a country di ers in one important way from trade between countries: unless the two nations share a common currency, any trade requires that countries go through the foreign exchange market to trade currency, in addition to trading goods and services. For example, imagine that buyers in France purchase oranges produced in Chile. The French buyers use the euro in order to make the purchase but the Chilean orange producers must be paid with the Chilean peso. This exchange between France and Chile requires that the rms exchange euros for pesos. In general, there are two reasons for demanding a country’s currency: to purchase assets within the country and to purchase a country’s exports – that is, the goods and services produced within that country. The country’s currency is supplied when it is used to purchase foreign currencies. This also happens for two reasons: to purchase assets in other countries and to import goods o...
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