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C H A P T E R 2

C H A P T E R 2. International Flow of Funds. Chapter Overview. A. Balance of Payments B. International Trade Flows C. International Trade Issues D. Factors Affecting International Trade Flows E. Correcting a Balance of Trade Deficit F. International Capital Flows

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C H A P T E R 2

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  1. C H A P T E R 2 International Flow of Funds

  2. Chapter Overview A. Balance of Payments B. International Trade Flows C. International Trade Issues D. Factors Affecting International Trade Flows E. Correcting a Balance of Trade Deficit F. International Capital Flows G. Agencies That Facilitate International Flows

  3. What’s Special about “International” Finance? • Foreign Exchange Risk • Political Risk • Market Imperfections • Expanded Opportunity Set

  4. Foreign Exchange Risk • The risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. • Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share (Initial investment:$1000 or ¥100,000) . • One year later the investment is worth ten percent more in yen and the yen has depreciated to $1 = ¥120 (Received: ¥110,000, or $ 916.67) • What is your profit from this investment in ¥ and in $ ?

  5. Political Risk • Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways.

  6. Market Imperfections • Legal restrictions on the movement of goods, people, and money • Transactions costs • Shipping costs • Tax arbitrage

  7. Expanded Opportunity Set • Assets are allocated more efficiently Example: • A & B each have 60 unit of input, each allocate 40 unit to produce food and 20 unit to produce textiles • With 1 unit of input, • Country A can produce either 5 pounds of food or 3 yard of textiles • Country B can produce either 15 pounds of food or 2 yard of textiles • Should A & B trade with each other? • In Class Exercise #1

  8. Evolution of the International Monetary System (FYI) • Bimetallism: Before 1875 • Classical Gold Standard: 1875-1914 • Interwar Period: 1915-1944 • Bretton Woods System: 1945-1972 • The Flexible Exchange Rate Regime: 1973-Present

  9. Classical Gold Standard: 1875-1914 (FYI) If the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold. What should be the exchange rate between U.S. $ and British £ ? What will happen if this exchange rate does not hold, such as £1 = $4?

  10. German mark British pound French franc Par Value Par Value Par Value Bretton Woods System: 1945-1972 (FYI) U.S. dollar Pegged at $35/oz. Gold

  11. The Flexible Exchange Rate Regime: 1973-Present (FYI) • Free Float • Managed Float • Pegged to another currency • No national currency 2-11

  12. A. Balance of Payments (BOP) BOP is a summary of transactions between domestic and foreign residents for a specific country over a specific period of time. Examples of BOP: • An American tourist purchases a small Lapponia necklace in Finland. • A Mexican lawyer purchases a US corporation bond via a broker in US. BOP can be tracked by three major subaccounts: current account, capital account and financial account.

  13. A. Balance of Payments 1. Current Account: a. Payments for merchandise and services, or net exports / imports of goods (balance of trade) and net exports / imports of services. b. Factor income payments c. Transfer payments (funds transferred) 2. Capital and Financial Accounts a. Direct foreign investment (DFI) b. Portfolio investment (long term securities) c. Other (short term securities) d. Errors and Omissions and Reserves Statistical Supplement to the Federal Reserve Bulletin, December 2008 http://www.federalreserve.gov/Pubs/supplement/2008/12/table3_10.htm

  14. A. Balance of Payments BOP is a cash flow statement. It tracks the continuing flows of purchases and payments between a country and all other countries. BOP must balance. If it does not, something has not been counted or has been countered improperly. The item Errors and Omissions and Reserves catches the discrepancy.

  15. B. International Trade Flows 2006 Distribution of U.S. Exports and Imports Insert Exhibit 2.4 from page 28 • Discussion: • Should the U.S. be concerned about a Huge BOT Deficit? • 2. Can US depreciate the dollar to reduce BOT deficit? • 3. Should Trade Restrictions be Used to Influence Human Rights Issues?

  16. E. Correcting a Balance of Trade Deficit 1. Why a Weak Home Currency is Not a Perfect Solution a. Counterpricing by Competitors b. Impact of Other Weak Currencies c. Intercompany Trade

  17. C. International Trade Issues 1. Events that Increased International Trade a. Removal of the Berlin Wall b. Single European Act c. NAFTA d. Inception of the Euro e. European Union Expansion

  18. C. International Trade Issues 2. Trade Friction: Causes a. Using the exchange rate as policy b. Outsourcing c. Using trade and foreign ownership policies for security d. Using trade policies for political reasons

  19. D. Factors Affecting International Trade Flows 1. Three Factors Affecting International Portfolio Investment a. Tax Rates on Interest or Dividends b. Interest Rates c. Exchange Rates

  20. F. International Capital Flows Factors Affecting DFI a. Changes in Restrictions b. Privatization c. Potential Economic Growth d. Tax Rates e. Exchange Rates

  21. International Capital Flows (quarterly numbers, annualized; in billions of $) Insert exhibit 2.7 page 39

  22. Graph - International Capital Flow

  23. Graph - International Capital Flow

  24. F. International Capital Flows 4. Impact of International Capital Flows Impact of the international Flow of Funds on U.S. Interest Rates and Business Investment in the United States

  25. G. Agencies that Facilitate International Flows 1. International Monetary Funds 2. World Bank 3. World Trade Organization

  26. G. Agencies that Facilitate International Flows 4. International Financial Corporation 5. International Development Association 6. Bank for International Settlements 7. Organization for Economic Cooperation and Development 8. Regional Development Agencies

  27. Homework 1. If the dollar is pegged to gold at U.S. $30 = 1 ounce of gold, and the British pound is pegged to gold at £6 = 1 ounce of gold. What should be the exchange rate between U.S. $ and British £ ? How much can you make without any risk, if this exchange rate is £1 = $6? Assume that your initial investment is $1,200. 2. Internet exercises (not required, for interested students only) • IMF, world bank and UN are only a few of the major organizations that track, report and aid international economic and financial development. Using these website, you can summarize the economic outlook for each country. IMF: www.imf.org/external/index.htm UN: www.un.org/databases/index.htm World bank: www.worldbank.org’ Bank of international settlement: www.bis.org/index.htm • St. Louis Federal Reserve provides a large amount of recent open economy macroeconomic data online. You can track down BOP and GDP data for the major industrial countries. Recent international economic data: research.stlouisfed.org/publicaitons/iet Balance of Payments statistics: research.stlouisfed.org/fred2/categories/125

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