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

The Expanded Circular Flow Diagram

Page 3: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

Balance of Payments Accounting

Page 4: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

US Balance of Payments Accounting

Page 5: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

Up close on Expanded Circular Flow

Page 6: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

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

Page 7: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

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

Page 8: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

Balance of Payments Wksht and Answers

Page 9: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

Loanable Funds Market as Financial Market Flow Model

Page 10: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

QLF USA

SLF USA

DLF Japan

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

Page 11: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

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

Page 12: Copyright © 2004 South-Western Mod 41 The Open Economy: Capital Flows and Balance of Payments

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

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