INTERNATIONAL MONETARY

AND
Chapter 1
FINANCIAL ECONOMICS

Third Edition Keeping Up with

a Changing World

Trade Flows, Capital Flows, and

the Balance of Payments
Joseph P. Daniels
David D. VanHoose

Copyright © South-Western, a division of Thomson Learning. All rights reserved.

International Economic Integration
• International economic integration refers to the extent
and strength of real-sector and financial-sector
linkages among national economies.
• Real Sector: The sector of the economy engaged in
the production and sale of goods and services.
• Financial Sector: The sector of the economy where
individuals trade in financial assets.
• Though economists tend to measure activity in these
two sectors separately, an important point of this
chapter is to show that they are linked.

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 Importance of the Global Market
for Goods and Services
• Over the last 35 years, the volume of world trade in
goods and services has grown by almost 6 percent
annually.
• The cumulative effect of this growth is more than a
five-fold increase in world trade.
• As measured by the share of overall real-sector
activity, world trade in goods and services has
become more important to advanced and developing
economies alike.

3
 Growth of World Exports
During the past thirty
years, world trade in
goods and services has
exhibited positive
growth rates for all but
two years.

SOURCE: International Monetary Fund, Economic Outlook, and authors’

estimates.
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 Selected Nation’s Trade
The global market for goods
and services has become more
important for individual
nations. The percentage
shown reflects each nation’s
trade as a share of its overall
economic activity.

SOURCE: International Monetary Fund, International Financial

Statistics, various issues, and authors’ estimates.

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 Growth of Trade
and Foreign Exchange Transactions

FOREIGN EXCHANGE TURNOVER AND WORLD EXPORTS

Foreign Exchange World Exports of Goods Ratio
Turnover ($ trillion)
($ trillion)
1979 $17.5 $1.5 12:1
1986 75.0 2.0 38:1
1989 190.0 3.1 61:1
1992 252.0 4.7 54:1
1995 297.5 5.0 60:1
1998 372.5 5.4 69:1
2001 300.0 6.6 45:1
2004 367.2 7.0 52:5
SOURCES: Held, David, Anthony McGrew, David Goldblatt and Jonathan Perraton, Global
Transformations, p. 209; Bank for International Settlements, Central Bank Survey of Foreign Exchange
and Derivatives Market Activity, 1998, p. 5; International Monetary Fund, World Economic Outlook, 1998,
p. 200, and authors’ estimates.
6
 Cross-Border Transaction in Bonds
and Equities
In Germany, the United
States, and the United
Kingdom, international
transactions in bonds
and equities have grown
by more than 3,000
percent, 1000 percent,
and 700 percent
respectively.

SOURCE: Bank for International Settlements, International Financial Statistics,

and authors’ estimates.

7
 Top Twenty Globalized Nations
1. Ireland 11. Norway
2. Switzerland 12. United States
3. Singapore 13. France
4. Netherlands 14. Germany
5. Sweden 15. Portugal
6. Finland 16. Czech Republic
7. Canada 17. Spain
8. Denmark 18. Israel
9. Austria 19. New Zealand
10. United Kingdom 20. Malaysia
Source: Foreign Policy
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 The Top Global Companies
Ranked by Foreign Assets
Rank Company Home Country Industry

1 Vodaphone United Kingdom Telecommunication

2 General Electric United States Electrical
3 ExxonMobile United States Petroleum
4 Vivendi Universal France Diversified
5 General Motors United States Motor Vehicles
6 Royal Dutch/Shell United Petroleum
Kingdom /
Netherlands
7 BP United Kingdom Petroleum
8 Toyota Motor Japan Motor Vehicles
9 Telefónica Spain Telecommunications
10 Fiat Italy Motor Vehicles 9
 Transnationality
• Are the activities of the world’s largest firms
really spread out globally?
• A transnationality index measures this.
• It is calculated by averaging the ratios of
– Foreign assets to total assets
– Foreign sales to total sales
– Foreign employees to total empolyees.

10
 An Example
• General Electric, a U.S. TNC, ranks second on
the list of the world’s largest non-financial
TCS based on foreign assets.
• Foreign assets are 159,188, total assets
437,006, foreign sales 49,528, total sales
129,853, foreign employment 145,000 and
total employment 313,000.
• Its TNI is only 40.3 and it does not appear on
the list of the top ten TNCs by TNI.
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 Calculation

 159,188 49,528 145,000 

   
 437,006 129,853 313,000   40.3%
3

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 The Top Global Companies
Based on Transnationality
Ranking Company Home Country Industry
1 Rio Tinto U.K. / Australia Mining
2 Thomson Canada Media
3 ABB Switzerland Machinery and
Equipment
4 Nestlé Switzerland Food and Beverages
5 British American United Kingdom Tobacco
Tobacco
6 Electrolux Sweden Electronic Equipment
7 Interbrew Belgium Food and Beverage
8 Anglo American United Kingdom Mining
9 Astrazeneca United Kingdom Pharmaceuticals
10 Phillips Netherlands Electronic Equipment
Electronics 13
 Balance of Payments Accounting
• To understand how economists measure international
transactions in the real and financial sectors of an
economy, and how these sectors are linked, we turn
to the balance of payments (BOP) accounting system.
• A system of accounts which is a subset of the
National Income and Production Accounts.
• A double-entry system.
• Debit Entries: Transactions that generate a payment
outflow (e.g., import).
• Credit Entries: Transactions that generate a payment
inflow (e.g., export).

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 Balance of Payments
• The current account is the broadest measure of a
nation’s real sector trade.
• Includes:
– Goods
– Services
– Income Receipts and Payments
– Unilateral Transfers

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 Current Account
• Goods: Exports and imports of tangible items.
• Services: Exports and imports of services, for
example:
– Typical business services such as banking and financial
services, insurance, and consulting.
– Tourism

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 Current Account

• Income Receipts: Includes items such as

– Investment income on US-owned assets abroad.
– Receipts of income on US direct investment abroad.
– Government income receipts
• Income Payments: Includes items such as
– Investment income on foreign-owned assets in the
United States.
– Payments of income on foreign direct investment in the
United States
– US Government income payments

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 Current Account
• Unilateral Transfers: Includes items such as:
– Government grants abroad
– Private remittances
– Private grants abroad
• The current account balance is the sum of the debit
and credit entries in the accounts just described.
• A current account deficit occurs when the sum of the
debit entries exceeds the sum of the credit entries. A
current account surplus occurs when the sum of the
credit entries exceeds the sum of the debit entries.

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 US Current Account (2003)
Exports Millions 1,314,888
Goods 713,122
Services 307,381
Income Receipts 266,799
Imports -1,778,117
Goods -1,260,674
Services -256,337
Income Payments -261,106
Unilateral Transfers -67,439
Current Account Balance -530,668
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 Balance of Payments
The Financial Sector
• The Capital and Financial Account tabulates the
flows of financial assets between domestic residents
and foreign residents and governments.
• The private capital account tabulates flows among
private domestic residents and foreign private
residents.

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 The Capital Account
• The Capital Account:
– Divided into private capital account and official settlement
balance
– Records international transactions in the financial sector.
– Includes portfolio and foreign direct investment.
• The main accounts are:
– US-Owned Assets Abroad: Increase (dt) or decrease (ct) in
US ownership of foreign financial assets.
– Foreign-Owned Assets in the US: Increase (ct) or decrease
(dt) in foreign ownership of domestic assets.
– Reserve Assets: Primarily the assets of central banks.

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 Portfolio and Foreign Direct
Investment
• Portfolio Investment: Individual or business
purchase of stocks, bond, or other financial assets or
deposits. (An income strategy)
• Foreign Direct Investment (FDI): Purchase of
financial assets that results in a 10 percent or greater
ownership share. (A financial control strategy)

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 The Balance of Payments
The Statistical Discrepancy
• The sum of the debit and
credit entries in all of the
BOP should total zero. Balance on Current Account -530,668
• Of course there are errors
and omissions resulting in a Capital Account, net -3,0790
non-zero balance.
Net Financial Flows 545,759
• An offsetting entry to this
non-zero balance is made in Statistical Discrepancy -12,012
the statistical discrepancy
account.
• In this way, the total of the
debit and credit entries
equals zero.

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 BOP Examples
U.S. company imports an automobile valued at $50,000

Income
Goods Services Payments UT Capital
and
Receipts

Debits
-50,000
(imports)

Credits
50,000
(exports)

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 BOP Examples
U.S. government sends $1 million in humanitarian supplies to Afghanistan

Goods Services Income UT Capital

Payments
and
Receipts

Debits
-1 million
(imports)

Credits
1 million
(exports)

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 BOP Examples
U.S. resident buys a UK Tbill equivalent in value to $1,000

Goods Services Income UT Capital

Payments
and
Receipts

Debits
-1,000
(imports)

Credits
1,000
(exports)

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 BOP Examples
U.S. resident receives $100 in interest on a foreign asset they own

Goods Services Income UT Capital

Payments
and
Receipts

Debits
-100
(imports)

Credits
100
(exports)

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 BOP Examples
A Marquette University student goes to Mexico on break and spends $500

Goods Services Income UT Capital

Payments
and
Receipts

Debits
-500
(imports)

Credits
500
(exports)

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 BOP Examples
Total

Goods Services Income UT Capital

Payments and
Receipts

Debits -50,000 -1,000

-500 -1 mil
(imports) -100

1,000
Credits
1 mill 100 50,000
(exports)
500

Current Capital
-50,400 50,400
Account Account

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What is BOP deficit/surplus?
• In theory, the overall balance of payment must equal to
zero.
• So, what does the BOP surplus or deficit mean?
• Ignoring statistical discrepancy, BOP deficit refers to a
situation in which the official settlement balance is
positive (the sum of credits and debits in current and
private capital account is negative).
• This implies that private payments made to foreigner
exceed private payment received from foreigners.

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Net Creditor and Net Debtor Status
• Capital account surplus – sum of credits> sum of debits (capital
inflows > capital outflows)
• Capital account deficit - sum of debits > sum of credits (capital
inflows > capital outflows)
• Flows of capital are lending and borrowing which may add to or
reduce stock of assets held by domestic resident and foreigners.
• net creditor - foreign financial assets> foreign-owned domestic
financial assets.
• net debtor - foreign financial assets< foreign-owned domestic
financial assets.

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 The Relationship Between the Current Account
and the Capital Account
• Expenditures Approach to National Income
– National income is the sum of expenditures in the
following categories; consumer expenditures, private
investment expenditures, government expenditures, and net
export expenditures,
y= c + ip + g + (x-m)
• Let the current account, ca equal
ca = (x – m)
• Then
y=c + ip + g + ca

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The Relationship Between the Current Account
and the Capital Account
• Income Approach
– Income has three possible uses; it can be spent on current
consumption, it can be saved (private saving), and we pay
taxes to the government
y= c + sp + t
• Because both approaches equal national
income, we can set the two identities equal:
c + sp + t = c +ip + g + ca
• or, sp – ip – (g - t) = ca
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 The Relationship Between the Current Account
and the Capital Account
• Private Saving
– Private saving can be used to purchase three types of
assets, domestic private investment, government debt (g –
t) or to accumulate foreign assets (fa),
sp = ip + (g – t) + fa
• where fa is the (net) accumulation of foreign assets
(domestic residents’ purchases of foreign assets in
excess of foreign residents’ purchases of domestic
assets).
• Then, by rearrangement
sp – ip – (g – t) = fa

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 The Relationship Between the Current Account
and the Capital Account
• Putting the two together:
ca = sp – ip – (g – t) = fa
• In words, private domestic saving less private
domestic investment less the fiscal balance
(government saving) equals the current account
balance, which also equals the (net) accumulation of
foreign assets.

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 An Example of the Relationship Between the
Current Account and the Capital Account
• Using the equality we derived,
ca = sp – ip – (g – t) = fa
• Suppose a nation’s private saving rate is 5.2 percent of
its total output, its private investment rate is 7.3
percent, and its fiscal budget deficit is 3.3 percent
ca = fa = 5.2 – 7.3 – 3.3 = -5.4.
• In words, this nation’s residents must borrow from
abroad (fa = -5.4) to finance their investment
expenditures, resulting in a current account deficit in
the amount of 5.4 percent of total output.
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