Chapter One1
CHAPTER 1
Keeping Up with a Changing World —
Trade Flows, Capital Flows,
and the Balance of Payments
CHAPTER OVERVIEW
This chapter begins by discussing the importance of international economic integration, and citing recent current events that demonstrate the widely varying opinions of the advantages and disadvantages of international trade and finance. The chapter sets the stage to logically examine these opinions and stresses the need to begin by understanding how international transactions are measured. Historical data are also presented to give a sense of the drastically different degree of world trade before and after World War I.
The chapter defines the broad concept of globalization which includes increased market integration, the expansion of world governance, and the increased mobility of people and information; and the narrow focus of economic integration, which refers to the strengthening of existing and creation of new international linkages. The chapter then proceeds to distinguish the real and financial sectors that link the world’s economies and provides compelling data to illustrate the concepts.
Next, international balance of payments accounting is described in terms of a double entry bookkeeping system. The components of each of the three major accounts, (1) the current account, (2) the private capital account, and (3) the official settlements balance, are discussed in detail. The popular usage of the terms “balance of payments deficit” and “balance of payments surplus” are equated to a positive official settlements balance and a negative official settlements balance respectively, as distinct from the term “overall balance of payments” which must be zero by construction. The chapter provides a series of concrete examples of international transactions and the ways that these impact the balance of payments accounts. The examples used are:
(1) The importation of an automobile, which registers as a debit under current account merchandise and a credit under capital flows in the category of foreign assets in the U.S.
(2) The services consumed by a student who travels abroad, which registers as a debit under current account services, and a credit under capital flows in the category of foreign assets in the U.S.
(3) The purchase of a domestic treasury bill by a foreign resident, which registers as a credit under capital flows as a foreign asset in the U.S., and as a debit under capital flows as a U.S. asset abroad.
(4) The payment of interest by the U.S. on a foreign-held asset, which registers as debit under current account income and a credit under capital inflows in the foreign assets in the U.S. category.
(5) The provision of humanitarian aid abroad by a U.S. charitable organization in the form of a donation of wheat, which registers as a credit in the current account merchandise category, and a debit in the unilateral transfers category.
The section ends with a discussion of what it means for a country to be a net creditor or net debtor in terms of capital account balances.
The chapter applies the material to an examination of debt relief for heavily indebted poor countries (a hot political topic which may provide a good opportunity for class discussion).
Finally, the chapter relates current account balances to capital flows. It examines this issue based solely on accounting identities provided earlier. Domestic savings less domestic investment determine the current account balance as well as net capital flows. Thus, the current account balance is directly related to net capital flows.
OUTLINE
I . The International Economy
A. Globalization vs. International Economic Integration
B. Real and Financial Sectors
1. Definitions
2. Magnitudes of Trade
II. Balance of Payments
A. Double Entry Bookkeeping
1. Credit Entries
2. Debit Entries
B. Accounts in BOP
1. Current Account
2. Capital Account
3. Official Settlements Balance
4. Statistical Discrepancy
III. Examples using the Balance of Payments
A. Import of Auto
B. College Student Travels Abroad
C. Foreign Resident Purchase of Domestic Treasury Bill
D. U.S. Interest Payment on Foreign Held Asset
E. Charitable Organization in U.S. Provides Humanitarian Aid Abroad
IV. Capital Account and International Flow of Assets
A. Capital Account Surplus
B. Capital Account Deficit
C. U.S. Position as a Net Debtor
V. Relate Current Account Balance and Capital Flows
A. Domestic Saving – Domestic Investment = Current Account Balance
B. Domestic Saving – Domestic Investment = Net Capital Flows
C. Current Account Balance = Net Capital Flows
VI. Summary
FUNDAMENTAL ISSUES
1. How important is the global market for goods and services?
2. How important are the international monetary and financial markets.
3. What is a country’s balance of payments, and what does this measure?
4. What does it mean for a country to be a net debtor or net creditor?
5. What is the relationship between a nation’s current account balance and its capital flows?
CHAPTER FEATURES
1. Management Notebook: “Are Trade and Foreign Direct Investment Substitutes or Complements?”
Traditional thought has considered trade and foreign direct investment (FDI) as alternative means of serving a foreign market. Consequently, trade and FDI have been viewed as substitutes. More recent research has shown that the relationship between trade and FDI may likely be considerable more complex; suggesting that trade and FDI may be either substitutes or complements. FDI may serve as a means by which a firm can improve its competitiveness and increase trade as opposed to substitute for trade.
For critical analysis: The fact that evidence suggests that bilateral FDI between the U.S. and Japan has led to increased trade while bilateral FDI between Canada and the U.K. has led to decreased trade can be examined by the role that FDI plays between these respective countries. In the case of the U.S. and Japan, FDI may have served as a means by which to jump non-tariff barriers to gain access to the local markets. Thus, FDI and trade would complement each other. On the other hand, FDI and trade may well be substitutes between the U.K. and Canada; thereby resulting in less trade between the two countries as FDI between the counties increases.
2. Policy Notebook: “Is There Evidence of Unfair Interplanetary Trade?”
Theoretically, since one nation’s exports are another nation’s imports, global debits should equal global credits when tracking international transactions. In reality, the summation is not equal to zero. In the early 2000s, the current account deficit actually reached $250 billion.
Possible explanations suggest that transactions are becoming increasingly difficult to track and that exporters have incentives to underreport the actual value of their transactions.
For Critical Analysis: Trade figures ignore the multinational nature of many firms and exclude sales in other countries by subsidiaries of U.S. firms. Further, the use of two different national currencies could cause a collective current account deficit based on exchange rate changes that occur between the export of a good and the import of the good, as the good is in transit.
ANSWERS TO END OF CHAPTER QUESTIONS
1. a. Services: –$100
Foreign assets in Home Country: +$100
b. Merchandise: –$20,000
Foreign Assets in Home Country: +$20,000
c. Unilateral Transfer: –$100,000
Merchandise: +$100,000
d. Income: +$100
Foreign Assets in Home Country: –$100
2. Exports of Merchandise106
Imports of Merchandise –119
______
Balance on Merchandise (deficit)–13
Export of Services34
Imports of Services–28
______
Balance on Goods, Services and Income (deficit) –7
Unilateral Transfers8
______
Current Account (Surplus)1
3. The Capital Account balance is capital inflows, 6, less capital outflows 29. Therefore, there is a capital account deficit in the amount of 23.
4. Because the official settlements balance is –22 and the statistical discrepancy is zero, there is a balance of payments surplus in the amount of 22.
5. Positive aspects of being a net debtor include the possibility of financing domestic investment that is not possible through domestic savings; thereby allowing for domestic capital stock growth which may allow job, productivity, and income growth. Negative aspects include the fact that foreign savings may be used to finance domestic consumption rather than domestic savings; which will compromise the growth suggested above.
Positive aspects of being a net creditor include the ownership of foreign assets which can represent an income flows to the crediting country. Further, the net creditor position also implies a net exporting position. A negative aspect of being a net creditor includes the fact that foreign investment may substitute for domestic investment.
6. A nation may desire to receive both portfolio and direct investment due to the type of investment each represents. Portfolio investment is a financial investment while direct investment is dominated by the purchase of actual, real, productive assets. To the extent that a country can benefit by each type of investment, it will desire both types of investment. Further, portfolio investment tends to be short-run in nature, while FDI tends to be long-run in nature.
7. Domestic Savings – Domestic Investment = Current Account Balance
Domestic Savings – Domestic Investment = Net Capital Flows
Therefore, Current Account Balance = Net Capital Flows
8. Since the sum of private investment and the government deficit is greater than domestic savings, the current account is in deficit and the capital account is in surplus. The imbalance can be corrected by lower levels of domestic consumption leading to higher levels of domestic savings, and lower government deficits (or higher government surpluses).
9. The answer may depend upon what the current account surplus is used to finance. If it finances productive domestic investment, the aforementioned increases in domestic economic growth may allow the current account deficit to be sustained. On the other hand, if it is used to finance domestic consumption, the required productivity growth needed to repay the principal and interest on loans will not be able to be repaid. Hence, the current account deficit will not be able to be sustained.
MULTIPLE CHOICE EXAM QUESTIONS
1. Globalization refers to
A. only increasing market integration, while international economic integration refers to the strengthening
of existing international linkages of commerce and the addition of new international linkages.
B. only the expansion of world governance and global society, while international economic integration
refers to the strengthening of existing international linkages of commerce and the addition of new
international linkages.
C. only the increased mobility of peoples and information, while international economic integration refers
to the strengthening of existing international linkages of commerce and the addition of new
international linkages.
D. the increasing market integration, the expansion of world governance and global society, and the
increased mobility of peoples and information, while international economic integration refers
to the strengthening of existing international linkages of commerce and the addition of new
international linkages.
Answer: D
2. International economic integration refers to the
A. expansion of world governance and society.
B. increased mobility of peoples and information.
C. strengthening of existing international linkages of commerce and the addition of new linkages.
D. strengthening of existing international linkages of commerce but not the addition of new linkages.
Answer: C
3. Globalization refers to ______, and international economic integration refers to ______.
A. a broader scope of the internationalization process; a narrower focus of the internationalization process.
B. a narrower scope of the internationalization process; a broader focus of the internationalization process.
C. the same thing as international economic integration; the strengthening of international linkages of
commerce.
D. none of the above
Answer: A
4. Open trade in goods, services, and financial assets by leading economies of the world at levels close to those observed today
A. have never been experienced.
B. had been experienced before World War I.
C. had been experienced between World War I and World War II.
D. had been experienced only immediately before the Korean conflict.
Answer: B
5. Real sector transactions deal with transactions in
A. goods and services.
B. financial assets.
C. both goods and services and financial assets.
D. neither goods and services nor in financial assets.
Answer: A
6. Financial sector linkages deal with transactions in
A. goods and services.
B. financial assets.
C. both goods and services and financial assets.
D. neither goods and services nor in financial assets.
Answer: A
7. In terms of real sector activity, world trade in goods and services is important
A. only to developed economies.
B. only to developing economies.
C. to both developed and developing economies.
D. to neither developed nor developing economies.
Answer: C
8. In the last 35 years, the nearly 6 percent per annum growth in world trade has led to a ______-fold cumulative increase in world trade.
A. two B. three C. four D. five
Answer: D
9. When measured as a multiple of world exports of goods and services, foreign exchange turnover in 1998 was
A. 12. B. 38. C. 61. D. 69.
Answer: D
10. Over the last 35 years, the data on trade and financial flows show ______real flows and ______financial flows.
A. decreased; decreased
B. increased; decreased
C. decreased; increased
D. increased; increased
Answer: D
11. If domestic investment is greater than domestic saving, expenditures
A. equal domestic income and net exports equal zero.
B. are greater than domestic income and net exports are negative.
C. are less than domestic income and net exports are positive.
D. are greater than domestic income and net exports are positive zero.
Answer: B
12. If domestic investment is less than domestic saving, expenditures
A. equal domestic income and net exports equal zero.
B. are greater than domestic income and net exports are negative.
C. are less than domestic income and net exports are positive.
D. are greater than domestic income and net exports are positive zero.
Answer: C
13.If domestic savings equals 10 and domestic investment equals 6, then the current account balance equals
A. –16. B. –4. C. +4. D. +16.
Answer: C
14. If a nation’s domestic savings equals 6 and a nation’s domestic investment equals 10, then the nation is experiencing
A. a net capital outflow.
B a net capital inflow.
C. no net capital inflow or outflow.
D. a current account surplus.
Answer: B
15. If a nation’s domestic saving is 25 and the nation’s domestic investment is 30, then the nation is experiencing
A. a current account surplus.
B. a current account deficit.
C. a net capital inflow.
D. both B and C
Answer: D
16. A current account deficit in the U.S. is
A. necessarily bad because it represents a lack of domestic saving.
B. necessarily good because it represents foreign savings in the U.S.
C. necessarily bad because it undermines the U.S.’s ability to experience economic growth.
D. neither good nor bad.
Answer: D
17. The balance of payments system
A. is another method for calculating GDP.
B. insures that the net exports are always equal to zero.
C. measures the total value of a domestic economy’s transactions with the rest of the world.
D. attempts to limit the fluctuation in international exchange rates.
Answer: C
18. The balance on merchandise trade is a component of
A. the current account.
B. the capital account.
C. foreign direct investment.
D. portfolio investment.
Answer: A
19. A debit entry in the balance of payments accounts represents
A. a transaction that includes a payment from abroad a domestic resident.
B. a transaction that includes a payment abroad by a domestic resident.
C. a decrease in the current account deficit.
D. an increase in the capital account surplus.
Answer: B
20. Which of the following transactions are not included in the current account?
A. exports of manufactured goods
B. imports of manufactured goods
C. payments of interest and dividends on foreign assets held by a domestic U.S. resident
D. the purchase of foreign assets by a domestic U.S. resident
Answer: D
21. When a country faces a current account deficit, it also faces a
A. services trade deficit.
B. capital account deficit.
C. capital account surplus.
D. merchandise trade deficit.
Answer: C
22. In terms of balance of payments accounting, which of the following would be recorded as a debit entry?
A. exports of merchandise
B. exports of services
C. a foreigner’s purchase of a U.S. Treasury bond
D. an increase in a U.S. citizen’s account at a foreign bank
Answer: D
23. Given the following data, what is the country’s current account balance? Merchandise trade balance =
–120; Services trade balance = +45; Unilateral transfers made in excess of those received = 15.
A. –60 B. –90 C. –100 D. –150
Answer: D
24. Suppose an American tourist travels to Mexico, and uses U.S. dollars to purchase a hotel room in
Mexico City. This transaction is recorded as a
A. credit in the current account and debit in the capital account.
B. debit in the capital account and a credit in the current account.
C. credit in the capital account and debit in the current account.
D. credit in the capital account and debit in the capital account.
Answer: C
25. Foreign direct investment is a component of
A. portfolio investment.
B. the current account.
C. total trade in services.
D. the capital account.
Answer: D
26. In order for the purchase of stocks to be categorized as foreign direct investment, it must represent at
least ______percent of the foreign entity’s outstanding stock
A. 1 B. 10 C. 25 D. 40
Answer: B
27.Purchases of stock that are too small too be considered foreign direct investment are classified as
A. depreciation.
B. investment spending.
C. portfolio investment.
D. capital investment.
Answer: C
28. After accounting for statistical discrepancies, a capital account
A. surplus will always imply a current account surplus.
B. surplus will always imply a current account deficit.
C. surplus will always exceed the associated current account surplus.
D. deficit will always exceed the associated current account surplus.
Answer: B
29. The United States is currently a net debtor nation. This necessarily implies that the
A. federal government owes money to foreign investors.
B. value of U.S. held assets abroad is lower than the value of foreign held assets in the U.S.
C. value of the U.S. dollar is less than the average value of foreign currencies.
D. U.S. is running a deficit in manufactured goods trade.
Answer: B
30. A balance of payments deficit is defined as a situation in which
A. the value of payments made to foreigners exceeds the value of payments received from foreigners in a
given period of time.
B. the federal government must borrow in order to meet its budget obligations.
C. the value of manufactured good exports is less than the value of imported manufactured goods.
D. balance of payments credits exceed balance of payments debits.
Answer: A
31. In recent years, the U.S. has generally had a capital account
A. surplus and a current account surplus.
B. surplus and a current account deficit.
C. deficit and a current account surplus.
D. deficit and a current account deficit.
Answer: B