MAN 441: International Finance

1. MAN 441: International Finance The Balance of Payments and International Linkages

2. CHAPTER OVERVIEW • I. BALANCE-OF-PAYMENT CATEGORIES • II. THE INTERNATIONAL FLOW OF GOODS, SERVICES,AND CAPITAL • III. COPING WITH CURRENT ACCOUNT DEFICITS

3. PART I.BALANCE-OF-PAYMENTCATEGORIES • A. THE BALANCE OF PAYMENTS (B-O-P) • 1. PURPOSE: • Measures all financial and economic transactions over a specified period of time.

4. BALANCE-OF-PAYMENTCATEGORIES • 2. Double-entry bookkeeping • a. Currency inflows = credits • earn foreign exchange • b. Currency outflows = debits • expend foreign exchange

5. BALANCE-OF-PAYMENTCATEGORIES • 3. Three Major Accounts: • a. Current • b. Capital • c. Official Reserves • 4. Current Account • records net flow of goods, services, and unilateral transfers.

6. BALANCE-OF-PAYMENTCATEGORIES • 5. Capital Account • a. Function: records public and private investment and lending. • b. Inflows = credits • c. Outflows = debits

7. BALANCE-OF-PAYMENTCATEGORIES • 5. Capital Account (con’t) • d. Transactions classified as • 1.) Portfolio • 2.) Direct • 3.) Short term

8. BALANCE-OF-PAYMENTCATEGORIES • 6. Official Reserves Account • a. Function: • 1.) Measures changes in international reserves owned by central banks. • 2.) Reflects surplus/deficit of • a.) Current account • b.) Capital account • b. Reserves consist of • 1.) Gold • 2.) Convertible securities

9. BALANCE-OF-PAYMENTCATEGORIES • 7. Net Effects: • a. Sum of all transactions must be zero: • 1.) Current account • 2.) Capital account • 3.) Official reserves

10. BALANCE-OF-PAYMENTCATEGORIES • 8. The Balance-of-payment measures • a. Some Definitions: • 1.) Basic Balance • a.) Consists of current account and long-term capital flows. • b.) Emphasizes long-term trends. • c.) Excludes short-term capital flows that heavily depend on temporary factors.

11. BALANCE-OF-PAYMENT CATEGORIES • 2.) Net Liquidity Balance: • Measures the change in private domestic borrowing or lending require to keep payments equal without adjusting official reserves. • 3.) Official Reserve Transactions Balance • Measures adjustments needed by official reserves.

12. PART II. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL • II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWS • A. Global Linkages • set of basic macroeconomic identities which link: • -Domestic spending and production to current and capital accounts. • B.Domestic Savings and Investmentand the Capital Account • 1. National Income Accounting • a. National Income (NI) is either spent (C) or saved (S) • NI = C + S (5.1)

13. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL • b. National spending (NS) is • divided into personal spending (C)and investment (I) • NS = C + I (5.2) • c. Subtracting (5.2) - (5.1) • NI - NS = S - I (5.3) • If NI >NS, S > I which implies that surplus capital spent overseas.

14. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL • d. In a freely-floating system, • excess saving = the capital account balance • e. Implications: • 1.A nation which produces more than it spends will save more than it invests domestically with a net capital outflow producing a capital account deficit.

15. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL 2. A nation which spends more than it produces has a net capital inflow producing a capital account surplus. 3. A healthy economy will tend to run a current account deficit.

16. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL • C. THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS • 1. Beginning identity • NI - NS = X - M (5.4) • where X = exports, M = imports • X-M=current account balance (CA) • 2. Combining (5.3) + (5.4) • S - I = X - M (5.5) • 3. If S - I = Net Foreign Investment (NFI) • NFI = X - M (5.6)

17. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL • 4. Implications: • a. If CA is in surplus, the nation must be a net exporter of capital. • b. If CA is a deficit, the nation is a major capital importer. • c. When NS > NI, the excess must be acquired through foreign trade. • d. Solutions for Improving CA deficits: • 1.)Raise national income (output)relative to national spending . • 2.)Increase (S) relative to domestic investment (I).

18. PART III. COPING WITH THE CURRENT ACCOUNT DEFICIT • I. POSSIBLE SOLUTIONS UNLIKELY TO WORK: • A. Currency Depreciation • B. Protectionism

19. COPING WITH THE CURRENT ACCOUNT DEFICIT • II.CURRENCY DEPRECIATION • A. U.S. Experience: • Does not improve the trade deficit.

20. COPING WITH THE CURRENT ACCOUNT DEFICIT • B. Depreciations are ineffective because • 1. It takes time to affect trade. • 2. J-Curve Effect • States that a decline in currency value will initially worsen the deficit before improvement.

21. THE J - CURVE Tradebalance improves Net change in trade balance Currency depreciation TIME 0 Trade balance initially deteriorates

22. COPING WITH THE CURRENT ACCOUNT DEFICIT • III. PROTECTIONISM • A. Trade Barriers used: • 1. Tariffs • 2. Quotas • B. Results: • Most likely will reduce both X and M.

23. COPING WITH THE CURRENT ACCOUNT DEFICIT • III. SUMMARY: CURRENT-ACCOUNT • DEFICITS • - neither bad nor good inherently • 1. Since one country’s exports are another’s imports, it is not possible for all to run a surplus

24. COPING WITH THE CURRENT ACCOUNT DEFICIT • 2. Deficits may be a solution to the problem of different national propensities to save and invest.