1

The International Trade and Capital Flows

Chapter 23

2

Intro

Individuals, businesses and governments in a country may interact with individuals, businesses and governments in another country. In this sense, we say residents of different countries interact.

As you know, in the US the money we carry around and use in our day to day transactions is called the dollar. But, other countries may call their money something else. For example, there is the British Pound, the Japanese Yen, the Canadian Dollar and the Chinese Yuan.

Note that typically one US dollar does not equal 1 unit of the other country’s money (not even the Canadian Dollar).

3

Here I want you to see that when we engage in economic activity with other countries we typically give up something and get something back.

US of ARest

Of

World

Give up

Get

With all trade

4

Balance of Payments

A nation’s balance of payments, BOP, is a system to keep track of the international transactions of the residents for a particular period of time. The focus is on the money flows, or financial side of the transactions.

Any transaction that causes money to flow into a country is a credit to its BOP account and will have a plus sign attached to it.

Any transaction that causes money to flow out of a country is a debit to its BOP account and will have a minus sign attached to it.

The BOP is made up of the CURRENT ACCOUNT and the CAPITAL AND FINANCIAL ACCOUNT.

5

US export

Say some folks in Nebraska want to sell beef in Columbia. This would be a US export.

Ultimately the Nebraska sellers want dollars. If the Columbians do not have dollars they can get them in the foreign exchange market. The Nebraska export of beef will mean money flows into US (either in US dollars Columbians already have, or by giving up their currency in the exchange market to get dollars).

This is an example of a good being exported, but a similar result holds if we export a service (like engineering knowledge of building a bridge), or if we make a financial investment in a foreign country and we are going to get paid interest or dividends.

6

US import

Say in Nebraska someone wants to roast coffee beans to sell to the public in the form of coffee. The Nebraskan would import the coffee beans from Columbia.

Ultimately the Columbian sellers want their own currency. If the Nebraskans do not have the Columbian currency they can get them in the foreign exchange market. The Nebraska import of coffee beans will mean money flows out of US (either in Columbian currency we already have, or by giving up dollars in the exchange market to get their currency).

This is an example of a good being imported, but a similar result holds if we import a service (like insurance from a foreign company), or if foreigners make a financial investment in the US and we are going to pay them interest or dividends.

7

The Current AccountThe current account is one part of the BOP. The types of transactions kept track of in the current account include

a) export of goods,

b) import of goods,

c) export of services,

d) import of services,

e) net investment income or income payments, and

f) net transfers or unilateral transfers.

8

More Current Account

Remember a credit is a money inflow and will have a plus sign and a debit is a money outflow and will have a minus sign. For the items in the current account we have

a) export of goods +

b) import of goods -

c) export of services +

d) import of services -

e) net investment income or income payments +

f) net transfers or unilateral transfers -

Recall exports bring money in and imports have money go out. The signs we see here for imports and exports will always be the case. But the signs on net investment income and net transfers will not always be as shown. Let’s explore this and other ideas next.

9

Even more Current Account infoFolks talk about balance on goods (or what is called the merchandise trade balance), balance on services, and balance on goods and services. The point here is the combining of exports and imports. Note in a recent year the balance on goods was negative, the balance on services was positive and the balance on goods and services (the trade balance) was negative meaning the goods negative was bigger than the services positive.

When the balance on goods and services is negative we talk of a trade deficit, and when positive we talk of a trade surplus.

Net investment income or income payments is made up of i) interest and dividends paid by foreigners to us (an inflow, a credit or plus sign) and ii) interest and dividend paid by us to foreigners (an outflow, a debit or minus sign). It just so happens in a recent year this was a net positive.

10

Still more current account info

Net or unilateral transfers are made up of i) foreigners making payments to us for things like aid after a disaster (hurricane Katrina, an inflow, a credit or plus sign), and ii) US making similar payments abroad (an outflow, a debit or minus sign). In the US this term has been a net minus for many years.

A current account deficit means when looking at the whole set of accounts the debits are larger than the credits. This also means the outflow is larger than the inflow.

11

1975

Year

Some notion of current account

0

In this graph for the United States (not the exact real world picture, but the correct flavor of the historical record), when we consider the merchandise trade balance or current account balance in either dollar terms or as a percent of GDP,the value was small and positive up until about 1975, and then becomes negative and larger after 1975.

In a given year can all countries have a trade deficit in goods and services? No, some have positive ones and some have negative ones – the US has been on a negative streak for many years! So, this means two things. More money flows out of the country than flows in, but more goods and services flow in than out!

12

Capital and Financial AccountThe capital and financial account is the second part of the BOP. The types of transactions kept track of here are

a) The balance on the capital account,

b) Foreign purchases of assets in the US, and

c) US purchases of assets abroad.

13

The Capital AccountThe balance on the capital account is a net amount measuring debt forgiveness.

Analogy: say I (a foreign entity to you) owe you (the homey) 10 bucks. When you forgive the debt it is like you give me 10 bucks. Did you give me 10 bucks? NO, but it feels like it because you had it coming to you and then cancelled it. From your perspective you had an outflow of 10 bucks – a debit!

So, when a debt owed to the US is forgiven there is an outflow or debit. When foreigners forgive debt we owe there is a credit.

Note in a recent year this balance is a debit – we forgave more than they.

14

The Financial Account

The foreign purchase of assets in the US (like US exporting assets such as real estate or US government securities) will always be a credit or inflow

and

the US purchase of assets abroad (like US importing assets such as common stock in a foreign firm or buying a foreign hotel chain) will always be a debit or outflow.

The balance on these two accounts is called the balance on financial account and in the US has been positive lately.

15

BOP = 0

The BOP then really is made up of the combination of the current account and the capital and financial account.

If you are like me, then it is not obvious that the balance on all these accounts must add up to 0. But, these accounts add up to zero during a period of time. No kidding!

Note I am not saying the current account balance must be zero, or the capital account must be zero, or the financial account must be zero. Any one of these may be in deficit or surplus, but in total the accounts must add to zero.

This means a current account deficit must be accompanied by a capital and financial account surplus, and vice versa.

16

A Story

In this story we want to think in the perspective of the foreigners want to pay for stuff using their currency (what we call foreign exchange) and wanting to be paid in their currency (have I mentioned we call their currency foreign exchange?).

On the next slide you see a big table and foreign exchange will be put on the table and taken off the table.

For example, when we export goods and services foreigners bring foreign exchange to the table.

When we import we take foreign exchange off the table and give to the foreigners.

17

The big foreign exchange table in the US

+ Exports

Net Investment income

Foreign purchase of assets in US

-Imports

Net transfers

Capital Account

US purchase of assets abroad

18

More of the story

Now you see in the slide with the table a dashed line. All the accounts above that line make up the current account. What is below is called the capital and financial account. (Remember what is above and what is below must balance out to zero.)

People make decisions to buy stuff like cars out of personal preference. This has implications for exports/imports. We also make investment decisions based on preference (how much return we get being a factor). US citizens might invest in foreign countries and foreigners might invest here. This impacts the financial accounts. In fact, when we invest abroad we take more off the big table and when they invest here they put more foreign currency on the big table.

19

The rest of the storyThe is no rhyme or reason as to why the current account and the parts of the capital and financial accounts I have mentioned should exactly balance. In many years recently in the US on the current account we have a deficit – this means less foreign exchange is coming to the table than going out.

How can we do this? We will have to give up other assets!! Some of the assets will be from private citizens (buildings and land) and some will be from the government (gold, maybe or other things we see later).

At the end of the day (really, at the end of the year), current account deficits are balanced by capital and financial account surpluses and the overall balance of payments = 0.