CHAPTER 4:

The International Flow of

Funds and Exchange Rates
GONZALES & MICOLOB
Learning Objectives
After studying this chapter, you should be able to:

LO-1 Explain the balance of payments for a country.

LO-2 Describe the foreign exchange market and its components.
LO-3 Discuss the development of international monetary systems.
LO-4 Explain exchange rate changes over time.
LO-5 Forecast exchange rates using different methodologies.
The Balance of International Payments
- refers to a statement of account that summarizes all transactions between the residents of one
country and the rest of the world for a given period of time, usually one year. A country's balance of
payments is an objective standard that shows how well the country's economy and government
policies are performing.
- is based on a system of credits and debits, the balance of payments must always balance.

2 Major Components
(1) the current account
(2) the financial account.

Factors Affecting International Trade Flow of Funds

● INFLATION
● NATIONAL INCOME ● NATURAL FACTORS
● EXCHANGE RATES ● POLITICAL FACTORS
● GOVERNMENT POLICIES
 CURRENT
IsACCOUNT
the activities of consumers and businesses in the
economy with respect to the trade balance, services
balance, income balance, and net transfers
FOUR SUB-ACCOUNTS OF CURRENT ACCOUNT:

1. Trade Balance
- is the difference between the value of exports of goods and services and the value
of imports of goods and services. A trade deficit means that the country is importing
more goods and services than it is exporting; a trade surplus means the opposite.
- The net of merchandise exports and merchandise imports in which the trade
balance is the net of merchandise exports ( + sign as incoming dollars when
merchandise, such as a Dell computer, is exported) and merchandise imports ( - sign
as dollars leave the country to pay for imports, such as Toyota brand cars).
 FOUR SUB-ACCOUNTS OF CURRENT ACCOUNT:

2. Service Balance
Is the balance of goods and services is the account that details the value of exported goods and services and
the value of imported goods and services which cater the the net of exports of services and imports of
services. The services balance (shipping, airlines, consulting, insurance, banking, tourism, software
development, etc.) is the net of exports of services (+ sign when they are sold overseas) and imports of
services (- sign when they purchased from overseas).

3. Income Balance
Is the net of investment income from abroad and investment payments to foreigners. Which is the third
subaccount in the current account of BOP is income balance, which is the net of investment income from
abroad (+ sign reflects earnings from overseas investment) and investment income paid to foreigners (- sign
indicates payments are sent overseas).

4. Balance of Transfer (Net Transfer)

Is the net of transfer payments going overseas and inflows from abroad. The balance of
transfers is the net of transfer payments between countries based on outflows (- sign means
that a payment is going abroad as foreign aid, retirement benefits, etc.) and inflows (+ sign
reflects repayment of foreign aid loans, etc.).
 FINANCIAL ACCOUNT
Is the consists of domestic-country- owned assets abroad, foreign- owned assets
in the domestic country, and net financial derivatives. So the financial account
describes the second half of a country's balance of payments, which shows how
the country's current account balance is financed.

SUB-ACCOUNTS OF FINANCIAL ACCOUNT:

1. Foreign Direct Investment (FDI)

- Is encompasses the purchases of fixed assets (such as factories and equipment) abroad
used in the manufacture and sales of goods and services for local consumption or exports.
Acquisitions of a foreign company (including those being privatized), creation of new
manufacturing or research facilities abroad, and expansion of an existing plant in a foreign
country are all examples of foreign direct investments.
SUB-ACCOUNTS OF FINANCIAL ACCOUNT:

2. Security Investments

Security investments also have a significant impact o the BOP's financial

account. Financial capital flows between countries in search of higher rates of
return on foreign stocks and bonds. Often, individuals and firms hold foreign
financial assets in order to diversify their investments beyond domestic
stocks and bonds only.

3. Statistical Discrepancy
Lastly, there is a statistical discrepancy line item in BOP statistics. While
the financial account balance is intended to offset the imbalance in the
current account, the offset is not complete. The statistical discrepancy line
reconciles any remaining imbalance to ensure that all debit and credit
entries in the BOP statement sum to zero.
 The Foreign Exchange Market
Foreign exchange market (forex, or FX, market), institution for the exchange of one
country's currency with that of another country. Foreign exchange markets are actually
made up of many different markets, because the trade between individual currencies
sample say, the euro and the U.S. dollar each constitutes a market.

The Exchange Rate - An exchange rate is nothing more than a price at which one
currency can be converted to another currency.

MAJOR ● INDEPENDENT FLOATING

CURRENCY ● EXCHANGE
MANAGED RATEFLOATING SYSTEM
EXCHANGE
VALUES: Components of the RATE
Foreign Exchange SYSTEM
Market

● SPOT ● FUTURES
● MARKE
FORWARD MARKET
 International Monetary System
Over time, various international monetary systems have developed to
facilitate international trade. In this regard, governments around the world
have worked together to promote stable exchange rates and world trade.

● Money and Inflation - Many governments have used money to meet political goals of stimulating economic growth
and providing employment for citizens. Printing more money could increase economic activity. With more money
on hand, people can purchase more goods and services and the economy can benefit, at least for a while.Many
governments have used money to meet political goals of stimulating economic growth and providing employment
for citizens. Printing more money could increase economic activity. With more money on hand, people can
purchase more goods and services and the economy can benefit, at least for a while. This political use of money
is not without its pitfalls, however; excess supplies of money could

The Bretton Woods System

Is the 1944 decision to establish a global currency system with the U.S. dollar pegged
at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to
the dollar
 MONETARY SYSTEM AGREEMENTS:
International Monetary Fund (IMF) financial authority established under the Bretton Woods
Agreement in 1944 to help ensure the stability of the international monetary and financial system

● SMITHSONIAN AGREEMENT ● JAMAICA AGREEMENT

the 1971 decision allowing the United States the 1976 international monetary order that
to devalue the dollar against other countries' allowed countries to adopt different
currencies exchange rate systems including floating
their currencies in world markets

The Flexible Exchange Rate System - the flexible exchange rate system began to emerge with market
forces of supply and demand determining the prices of different currencies. Currency values can be affected by a variety of
forces, including current account balance, economic conditions, inflation and interest rates, and other factors.

TYPES OF FLEXIBLE EXCHANGE RATE SYSTEM::

● CLEAN FLOAT CURRENCY ● DIRTY FLOAT CURRENCY
Thank you for
Listening!