Chapter 1:Keeping Up With a Changing World-Trade Flows, Capital Flows, and the Balance Of PaymentsI. Chapter OverviewThe chapter begins by discussing on the importance of international economic integration, 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.The second section of 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. Historical data are presented to give a sense of the growth of world trade and transactions in global financial markets during the past few decades.In the third section of the chapter, 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 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 next section 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 organizations 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 next section provides a discussion of what it means for a country to be a net creditor or net debtor in terms of capital account balances. The section 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).The final section of 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.II. OutlineA. Why It Is Important to Understand International Money and FinanceB. International Economic Integration: The Importance of Global Trade and FinancialMarkets1. The Real and Financial Sectors of an Economy2. World Trade in Goods and Services3. International Transactions in Financial Assets4. The Most Globalized NationsC. The Balance of Payments1. Balance of Payments as a Double-Entry Bookkeeping System2. Balance-of-Payments Accountsa. The Current Account1) Goods2) Services3) Incomeb. Capital Accountc. The Official Settlements Balance3. Deficits and Surpluses in the Balance of Payments4. Other Deficit and Surplus MeasuresD. Examples of International Transactions and How they Affect the Balance ofPayments1. Example 1: Import of an Automobile2. Example 2: A College Student Travels Abroad3. Example 3: A Foreign Resident Purchases a Domestic Treasury Bill4. Example 4: The United States Pays Interest on a Foreign-Held Asset5. Example 5: A Charitable Organization in the United States ProvidesHumanitarian Aid Abroad6. Example CombinedE. The Capital Account and the International Flow of Assets1. Example: A College Student2. A Capital Account Surplus3. The United States as a Net Debtor4. Debt Relief for the Heavily Indebted Poor CountriesF. Relating the Current Account Balance and Capital FlowsG. Chapter SummaryIII. Fundamental Issues1. 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 capitalflows?IV. Chapter Features1. Management Notebook: “What are the Most Globalized Firms?”This notebook first considers the largest multinational enterprises (MNEs) in the world and then considers the world’s most globalized firms. The measure ofglobalization that is used is the transnationality index of the United NationsConference on Trade and Development (UNCTAD). This measure averages the values of the ratios of foreign sales to total sales, foreign assets to total assets and employees abroad to total employees. Typically the most globalized firms are the MNEs of smaller advanced economies.For Critical Analysis: Being globalized should not be an objective in and of itself.A firm may want to globalize if there are gains that enhance its profitability. Forexample, a firm may want to globalize if there are economies of scale to be enjoyed in doing so.2. Management Notebook: "Are Trade and Foreign Direct Investment Substitutes orComplements?"Traditional thought has considered trade and foreign direct investment (FDI) asalternative 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 meansby which a firm can improve its competitiveness and increase trade as opposed to substitute for trade.For critical analysis: The service sector tends to be very localized and does nottypically trade in intermediate products. Hence, if a firm established a presence in a foreign market-to service a foreign market-it no longer needs to export to theforeign market.3. Online Notebook: “Are U.S. Exports Understated Because of the Internet?”This Notebook examines measurement problems in tracking international trade. One particular problem is that small value exports-transactions of less than $2,500-need not be reported. Because most internet transactions are small value transactions, U.S.exports may be understated. As a result, the U.S. trade deficit may not be as large as that reported by the U.S. Commerce Department.For Critical Analysis: The U.S. trade deficit may not be as large as reported. Hence, the large U.S. current account deficit may no be as large as reported.V. Answers to End of Chapter Questions2. Using the table provided above:a. The balance on goods and services is a deficit of $21,000.b. The current account balance is a deficit of $1,020,900.c. The capital account balance would be a surplus of $1,020,900.3. The balance on merchandise trade is the difference between exports of goods, 719and the imports of goods, 1,145, for a deficit of 426. The balance on goods, services and income is 719 + 279 +284 – 1145 - 210 – 269, for a deficit of 342. Addingunilateral transfers to this gives a current account deficit of 391, [-342 + (-49) = -391]. (Note that income receipts are credits and income payments are debits.)4. Because the current account balance is a deficit of 391, then without a statisticaldiscrepancy, the capital account is a surplus of 391. In this problem, however, the statistical discrepancy is recorded as a positive amount (credit) of 11. Hence, thesum of the debits in the balance of payments must exceed the credits by 11. So, the deficit of the current account must be greater than the surplus on the capital account by 11. The capital account, therefore, is a surplus of 391 – 11 = 380.5. A balance-of-payments equilibrium (see page 19) is when the debits and credits inthe current account and the private capital account sum to zero. In the problemabove we do not know the private capital account balance. We cannot say, therefore, whether this country is experiencing a balance-of-payments surplus or deficit or if it is in equilibrium.6. The current account is a deficit of $541,830 and the private capital account balanceis a surplus of $369,068. The U.S., therefore, has a balance of payments deficit.7. Positive aspects of being a net debtor include the possibility of financing domesticinvestment that is not possible through domestic savings; thereby allowing fordomestic capital stock growth which may allow job, productivity, and incomegrowth. Negative aspects include the fact that foreign savings may be used tofinance 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 creditorposition also implies a net exporting position. A negative aspect of being a netcreditor includes the fact that foreign investment may substitute for domesticinvestment.8. A nation may desire to receive both portfolio and direct investment due to the typeof 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. This is also addressed in much greaterdetail in Chapter 7.9. Domestic Savings - Domestic Investment = Current Account BalanceDomestic Savings - Domestic Investment = Net Capital FlowsTherefore, Current Account Balance = Net Capital Flows10. Using the equations above, private savings of 5 percent of income, governmentsavings of -1 percent, and investment expenditures of 10 percent would results in a current account deficit of 6 percent of income and a capital account surplus (netcapital inflows) of 6 percent of income. This could be corrected with a reduction in the government deficit (to a surplus) and/or an increase in private savings.11. The transnationality index for World Films is:(533/1233 + 227/615 + 322/1256)/3 = (0.432 + 0.369 + 0.256)/3 = 1.057/3 = 0.352.The transationality index for Music Publishers Worldwide is:(455/2456 + 246/809 + 900/2467)/3 = (0.185 + 0.304 + 0.365)/3 = 0.854/3 = 0.285.Based on this index, World films is the most globalized firm.VI. Multiple Choice Questions1. Globalization refers to:A. only increasing market integration, while international economic integrationrefers 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 internationaleconomic 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 internationaleconomic 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 globalsociety, 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: D2. International economic integration refers to:A. the expansion of world governance and society.B. the increased mobility of peoples and information.C. the strengthening of existing international linkages of commerce and the additionof new linkages.D. the strengthening of existing international linkages of commerce but not theaddition of new linkages.Answer: C3. Globalization refers to _________, and international economic integration refers to___________.A. a broader scope of the internationalization process, a narrower focus of theinternationalization process.B. a narrower scope of the internationalization process, a broader focus of theinternationalization process.C. the same thing as international economic integration, the strengthening ofinternational linkages of commerce.D. None of the above.Answer: A4. Open trade in goods, services, and financial assets by leading economies of theworld 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: B5. Real sector transactions deal with:A. transactions in goods and services.B. transactions in financial assets.C. transactions in both goods and services and financial assets.D. transactions in neither goods and services nor in financial assets.Answer: A6. Financial sector linkages deal with:A. transactions in goods and services.B. transactions in financial assets.C. transactions in both goods and services and financial assets.D. transactions in neither goods and services nor in financial assets.Answer: A7. In terms of real sector activity, world trade in goods and services:A. is important only to developed economies.B. is important only to developing economies.C. is important to both developed and developing economies.D. is important to neither developed nor developing economies.Answer: C8. In the last 35 years, the nearly 6 percent per annum growth in world trade has led toa _______-fold cumulative increase in world trade.A. twoB. threeC. fourD. fiveAnswer: D9. When measured as a multiple of world exports of goods and services, foreignexchange turnover in 2004 was approximately:A. 12:1.B. 38:1.C. 61:1.D. 50:1.Answer: D10. Over the last 35 years, the data on trade and financial flows show:A. decreased real flows and decreased financial flows.B. increased real flows and decreased financial flows.C. decreased real flows and increased financial flows.D. increased real flows and increased financial flows.Answer: D11. If domestic investment is greater than domestic saving,A. expenditures equal domestic income and net exports equal zero.B. expenditures are greater than domestic income and net exports are negative.C. expenditures are less than domestic income and net exports are positive.D. expenditures are greater than domestic income and net exports are positive zero.Answer: B12. If domestic investment is less than domestic saving,A. expenditures equal domestic income and net exports equal zero.B. expenditures are greater than domestic income and net exports are negative.C. expenditures are less than domestic income and net exports are positive.D. expenditures are greater than domestic income and net exports are positive zero.Answer: C13. If domestic savings equals 10 and domestic investment equals 6, then the currentaccount balance equals:A. -16B. -4C. +4D. +16Answer: C14.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: B15.If a nation's domestic saving is 25 and the nation's domestic investment is 30, thenthe nation is experiencing:A. a current account surplus.B. a current account deficitC. a net capital inflowD. both B and CAnswer: D16. 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 economicgrowth.D. is neither good nor bad.Answer: D17.The balance of payments systemA. 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 theworld.D. attempts to limit the fluctuation in international exchange rates.Answer: C18.The balance on merchandise trade is a component ofA. the current account.B. the capital account.C. foreign direct investment.D. portfolio investment.Answer: A19. A debit entry in the balance of payments accounts representsA. 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: B20. 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: D21.When a country faces a current account deficit, it also faces:A. a services trade deficit.B. a capital account deficit.C. a capital account surplus.D. a merchandise trade deficit.Answer: C22. In terms of balance of payments accounting, which of the following would berecorded as a debit entry?A. Exports of merchandise.B. Exports of services.C. A foreigner's purchase of a U.S. Treasure bond.D. An increase in a U.S. citizen's account at a foreign bank.Answer: D23.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. -60B. -90C. -100D. -150Answer: D24. Suppose an American tourist travels to Mexico, and uses U.S. dollars to purchase ahotel room in Mexico City. This transaction is recorded as aA. 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: C25. Foreign direct investment is a component ofA. portfolio investment.B. the current account.C. total trade in services.D. the capital account.Answer: D26.In order for the purchase of stocks to be categorized as foreign direct investment, itmust represent at least _______ percent of the foreign entity's outstanding stockA. 1B. 10C. 25D. 40Answer: B27.Purchases of stock that are too small too be considered foreign direct investment areclassified asA. depreciation.B. investment spending.C. portfolio investment.D. capital investment.Answer: C28. After accounting for statistical discrepancies, a capital accountA. 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: B29. The United States is currently a net debtor nation. This necessarily implies that theA. federal government owes money to foreign investors.B. value of U.S. held assets abroad is lower than the value of foreign held assets inthe 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: B30. A balance of payments deficit is defined as a situation in whichA. the value of payments made to foreigners exceeds the value of payments receivedfrom 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 importedmanufactured goods.D. balance of payments credits exceed balance of payments debits.Answer: A31.In recent years, the U.S. has generally had a capital accountA. 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。