Lecture 7 Capital Flows Flashcards
What is the balance of payments and its categories
summarizes all of a country’s’ international transactions during a specified period
determined by a countries exports, imports, services bought and sold, income payments, transfers, and asset purchases and sales.
Current, Capital, Finance
The current account
Covers all current transactions with foreigners in the normal business of residents of a country.
dominated by the merchandise trade balance, the balance of all exports and imports
Trade balance (exports – imports of goods)
+ services balance (exports – imports of services)
+ net factor income from abroad (interest/dividends)
+ net transfers from abroad (remittances)
= Current account balance.
The capital account (CAPAC)
records unilateral transfers
such as foreign donations, debt forgiveness, or transfers of military bases
Small for developed, large for EM
Financial account (FANCB)
Financial account non-central bank
records capital flows — purchases and sales
of financial assets with foreigners. It includes:
— Direct investments made by companies (called FDI or
foreign direct investment)
— Portfolio investments in equity, bonds, and other securities
— Other investments and liabilities (such as deposits or borrowing
from foreign banks).
— An errors and omissions or “statistical discrepancy” balancing
item (sometimes reported as a separate item).
Describe the balance of payments for country with floating exchange rate
The balance of payments is always in equilibrium.
The exchange rate adjusts to make the balance
of payments = 0.
The external accounts balance exactly without affecting the central bank’s reserves, because exchange rate adjusts
Describe the balance of payments for country with fixed exchange rate
The balance of payments (change in reserves) can be in surplus or deficit
Current account + capital account + financial account = change in central bank reserves
If a country wishes to invest more than is available from
domestic savings, I - S > 0, it can get the resources from
only two ways:
1) It can run a government budget surplus (which is government saving) so T – G > 0
2) It can run a current account deficit, M – X > 0, financed with capital inflows. The savings come from abroad.
What are the consequences of capital inflows?
can drive up prices and exchange rates
- as a result make country’s exports uncompetitive.
inflows can complicate monetary policy enormously (they are difficult to sterilize)
always the concern that a “sudden stop” may occur
Does the composition of a country’s capital inflows matter
Conventional wisdom: Foreign Direct Investment (FDI) is a more stable source of funds than portfolio investment, especially short-term instruments
heavy reliance on short-term sources of funding is widely believed to have been instrumental in Mexico’s 1994 devaluation and the Asian financial crisis of 1998
Recent research found found that long-term flows are as unpredictable as short-term flows. Monetize investment in PPE.
