International Flow of

Funds
Chapter 2

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Chapter Objectives
This chapter will:
A. Explain the key components of the balance of
payment
B. Explain how international trade flows are
influenced by economic factors and other factors
C. Explain how international capital flows are
influenced by country characteristics

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Balance of Payments
 Is a summary of transactions between
domestic and foreign residents for a specific
country over a specified period of time
 It represents an accounting of a country’s

international transactions for s period

(quarter, semester, year)
 It accounts for transactions by businesses,

individuals, and government

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Balance of Payments: Components
 the two main components of the BoP are: the
current account and the capital account
 Current account + capital account +

balancing items=0
a. Current Account: summary of flow of funds due to
purchases of goods or services or the provision of
income on financial assets
b. Capital Account: summary of flow of funds resulting from
the sale of assets between one specified country and all
other countries over a specified period of time

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Current Account: Components
 Payments for Merchandise and Services
 Factor Income Payments
 Transfer Payments

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Current Account: Components
 The main components of the current
accounts are:
 Payments for merchandise and services
(e.g., exports and imports of tangible
products, services: import & export tourism;
education; legal , insurance, and consulting
services). Exports result in an inflow of
funds and imports result is an outflow of
funds

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Current Account: Components
 Balance of trade: is the difference between
total exports and total imports. In other
words, it represents net exports
 A deficit in the BT means that total exports is

less than total imports

 A surplus in the BT means that total imports

is less than total exports

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UAE Balance of Trade

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U.S. Balance of Trade

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China Balance of Trade

10
Canada’s Balance of Trade

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Current Account: Components
 Factor Income Payments: represents income
(interest and dividend payments) received by
investors on foreign investments in financial
assets (inflows). Payments to foreign
investors represent outflows
 Transfer payments: represent aid, grants, and

gifts from one country to another one

 Refer to Exhibit 2.1 p. 33

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Capital and Financial Accounts:
Components
 Direct Foreign Investment (DFI aka FDI)
 Portfolio Investment
 Other Capital Investment
 Errors and Omissions and Reserves

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Capital and Financial Accounts:
Components
 Capital Account: includes the value of
financial assets transferred across country
borders by people who move to different
country. It also includes the value of
nonproduced nonfinancial assets that are
transferred across countries (e.g., patents)
 Capital account items are minor compared to

financial account items

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Capital and Financial Accounts:
Components
 Financial account items:
1. DFI
2. Portfolio Investment
3. Other Capital Investment
4. Errors and omissions and reserves

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Capital and Financial Accounts:
Components
 Direct Foreign Investment: represents the
investment in fixed assets in foreign countries
(e.g., acquisition of a foreign entity, expansion in
a foreign country, …)
 Portfolio investment: represents investment in
stocks and bonds (long-term securities) between
countries that do not affect the transfer of control
 refer to p. 33-34
 Other capital investment: involves transactions in
short-term financial securities (e.g., money
market securities)

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Capital and Financial Accounts:
Components
 Errors and omissions and reserves: the
balance of the current account should be
offset by the balance of the capital and
financial account. There is not a perfect offset
and therefore the BoP includes this
component

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U.S. Balance of Trade
1. U.S. Balance-of-Trade Trend: value has
grown substantially over time
2. Impact of Huge Balance-of-Trade Deficit:
could lead to higher U.S. unemployment
but increases competition leading to more
efficient production. Refer to p. 39-40

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Events That Increased International
Trade
1. Removal of the Berlin Wall (Reunification of the
two countries)
2. Single European Act of 1987 (removal of taxes on
goods traded between industrialized European
countries)
3. North American Free Trade Agreement (NAFTA)
4. General Agreement on Tariffs and Trade (GATT):
reduction or elimination of trade restrictions
5. Inception of the Euro
6. Expansion of the European Union
7. Other Trade Agreements

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Trade Frictions
1. Environmental restrictions
2. Labor laws
3. Bribes
4. Government subsidies: dumping
5. Tax breaks
 Refer to p. 42-43

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Trade Policies
 Using the exchange rate as a policy (e.g., Chinese
Yuan)
 Outsourcing
 Managerial decisions about outsourcing (shareholders
pressure to engage in outsourcing to save costs)
 Using trade policies for security reasons (Dubai world
and U.S. ports)
 http://www.nytimes.com/2006/03/10/politics/10por
ts.html

 Using trade policies for political reasons: protesters

against MNcs

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Factors Affecting International Trade
Flows
1. Inflation: current account decreases if inflation
increases relative to trade partners.
2. National Income: current account decreases if
national income increases relative to other
countries.
3. Government Policies
a. Subsidies for exporters
b. Restrictions on imports ( e.g. tariff, quota)
c. Lack of restrictions on piracy
4. Exchange Rates: current account decreases if
currency appreciates relative to other currencies
5. Interaction of Factors

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Limitations of a Weak Home Currency
Solution
1. Counterpricing by competitors:
competitors should adjust their prices
2. Impact of other weak currencies:
3. Prearranged international transactions: it
takes time to adjust trade transactions as
they are prearranged
4. Intracompany trade: intracompany trade
will continue regardless of the change in
the exchange rate

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Factors Affecting DFI
1. Changes in Restrictions: e.g., removal of
government barriers
2. Privatization
3. Potential Economic Growth
4. Tax Rates: e.g., low tax rates
5. Exchange Rates: when investors expect
that the foreign currency in which they
invest will strengthen against their own
currency

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Distribution of Global DFI across Regions in
2007-2008

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Factors Affecting International
Portfolio Investment
1. Tax rates on Interest or Dividends
2. Interest Rates
3. Exchange Rates

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Impact of the International Flow of Funds on U.S.
Interest Rates and Business Investment in the United
States

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Agencies that Facilitate International
Flows
1. International Monetary Fund (IMF)
2. World Bank
3. World Trade Organization (WTO)
4. International Financial Corporation (IFC)
5. International Development Association (IDA)
6. Bank for International Settlements (BIS)
7. Organization for Economic Cooperation and
Development (OECD)
8. Regional development agencies

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