The document discusses balance of payments and factors affecting international flows of funds. It defines balance of payments as a summary of all transactions between a country and foreign residents over time. Transactions are recorded as credits or debits. The balance of payments includes a current account summarizing trade in goods/services/income, and a capital/financial account tracking financial/non-financial assets. Factors like inflation, income, exchange rates, and government policies can affect trade balances. A trade deficit may be corrected by a floating exchange rate that weakens the home currency.

1. Chapter - 2
International Flow of Funds

2. BALANCE OF PAYMENTS
• Summary of all transactions between domestic and
foreign residents over a specified period of time.
• Represents an accounting of a country’s international
transactions for a period, usually a quarter or a year.
• Transaction recorded as:
– Credit: Inflows of funds generate positive numbers.
– Debit: Outflows of funds generate negative numbers.
• The transactions are presented in to two groups–
– Current Account
– Capital Account and Financial Account

3. BALANCE OF PAYMENTS
CURRENT ACCOUNT
• Summarizes the flow of funds between one specified
country and all other countries due to:
– Payments for Merchandise and Services
– Factor Income Payments
– Transfer Payments
• A current account deficit suggests a greater outflow of
funds from the specified country for its current
transactions.
• Balance of Trade: Difference between merchandise
exports and merchandise imports.

4. BALANCE OF PAYMENTS
CAPITAL & FINANCIAL ACCOUNTS
• Includes the value of financial and non-produced
nonfinancial assets transferred across country borders.
• Key components of the accounts:
– Patent
– Direct Foreign Investment
– Portfolio Investment
– Other Capital Investment (money market securities)
ERRORS & OMISSIONS AND RESERVES

5. FACTORS AFFECTING INTERNATIONAL TRADE FLOWS
• Inflation: A relative increase in a country’s inflation rate will
decrease its current account, as imports increase and exports
decrease.
• National Income: A relative increase in a country’s income
level will decrease its current account, as imports increase.
• Government Policies:
– Subsidies for Exporters
– Restrictions on Imports
– Lack of Restrictions on Piracy
• Exchange Rates: If a country’s currency begins to rise in
value, its current account balance will decrease as imports
increase and exports decrease.

6. CORRECTING A BALANCE OF TRADE DEFICIT
• A floating exchange rate system.
• Weakening of Home Currency.

7. CORRECTING A BALANCE OF TRADE DEFICIT
• Why a Weak Home Currency Is Not a Perfect
Solution?
– Counter pricing by Competitors.
– Impact of Other Weak Currencies.
– Prearranged International Transactions. (J-curve
effect)
– Intra-company Trade.

8. J-Curve Effect
U.S.TradeBalance
0 Time
J Curve

9. FACTORS AFFECTING DFI
• Changes in Restrictions: New opportunities may arise
from the removal of government barriers.
• Privatization: DFI has also been stimulated by the selling
of government operations.
• Potential Economic Growth: Countries with higher
potential economic growth are more likely to attract DFI.
• Tax Rates: Countries that impose relatively low tax rates
on corporate earnings are more likely to attract DFI.
• Exchange Rates: Firms will typically prefer to invest
their funds in a country when that country’s currency is
expected to strengthen.

10. Factors Affecting International Portfolio Investment
• Tax Rates on Interest or Dividends: Investors will
normally prefer countries where the tax rates are
relatively low.
• Interest Rates: Money tends to flow to countries
with high interest rates.
• Exchange Rates: Foreign investors may be attracted
if the local currency is expected to strengthen.