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CHAPTER 5

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International Flow of Funds

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Balance of Payments
 The 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 a period, usually a quarter or a year.
 It accounts for transactions by businesses, individuals, and
the government

– Current account
– Capital account

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Balance of Payments

 Transactions that reflect inflows of funds

generate positive numbers (credits) for the
country’s balance
 Transactions that reflect outflows of funds
generate negative numbers (debits) for the
country’s balance.

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Balance of Payments
• Current Account (Purchase Summary)

– Balance of Trade (Imports & Exports)

 Merchandise export and import

 Service export and import

– Factor Income (income on financial assets): which

represents income (interest and dividend payments)
received by investors on foreign investments in
financial assets (securities)
– Transfer Payments (Aid, Gift, Grants)

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Balance of Payments

• Capital Account (Flow of funds; one country to other)

– Direct Foreign Investment: represents the investment in fixed assets in
foreign countries that can be used to conduct business operations. Examples
of direct foreign investment include a firm’s acquisition of a foreign
company, its construction of a new manufacturing plant, or its expansion of
an existing plant in a foreign country.
– Portfolio Investment: Portfolio investment represents transactions involving
long-term financial assets (such as stocks and bonds) between countries that
do not affect the transfer of control.
– Capital Investment: represents transactions involving short-term financial
assets (such as money market securities) between countries

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Factors Affecting
International Trade Flows

 Impact of Inflation

 If a country’s rate of inflation increases from the

country with which it trades so it will decrease its
current account,

 Imports increase and exports decrease in this

case

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Factors Affecting
International Trade Flows
 Impact of National Income

 A relative increase in a country’s income level will

decrease its current account,
 Demand for foreign goods will increase

 Consumption of imports will increase

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Factors Affecting
International Trade Flows
 Impact of Government Restrictions
 A government may reduce its country’s imports by
imposing a tariff on imported goods, or by
enforcing a quota.
 Some trade restrictions may be imposed on certain
products for health and safety reasons.
 Tariffs by Government increase the prices of
foreign goods
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Factors Affecting
International Trade Flows

 Impact of Exchange Rates

 If a country’s currency begins to rise in value,
its current account balance will decrease as
imports increase and exports decrease.
 When currency appreciates exports will be
expensive for the other countries
 Demand for such products will decrease
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Factors Affecting DFI

 Changes in Restrictions
 Opportunities may arise from the removal of
government barriers.
 Privatization
 DFI has also been stimulated by the selling of
government operations to corporations and other
investors.
 Privatization allows for greater international business
as foreign firms can acquire operations sold by national
government.
 Potential Economic Growth
 Countries that have higher potential for economic
growth are more attractive.

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Factors Affecting DFI

 Tax Rates

 Countries that impose relatively low tax rates on

corporate earnings are more likely to attract DFI.
 Exchange Rates

 Firms typically prefer to invest in countries where

the local currency is expected to strengthen
against their own.
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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.

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