AP Econ Module 41 Capital Flows Balance Payments - Sunny Hills ...

Equation 41-3 is equivalent to Equation 41-1: the current account plus the financial
account-both equal to positive entries minus negarive enrries-is equal to zero.
But what determines the current account and the financial account?
Modeling the Financial Account
A country's financial account measures its net sa.les ofassets, such as currencies, securi-
ties, and Factories, to foreigners. Those assets are exchanged for a qpe ofcapital called
fnancial capital, which is funds from savings that are available for investmenr spending.
'We can thus thinl< ofthe financial account as a mea.sure of capiwlinfloas in the form of
foreign savings that become available to finance domestic investment spending.
What determines these capital inflows?
Part ofour explanation will have to wait for a little while because some internarional
capital flows are created by govemments and central banks, which somecimes act very
differendy from private investors. But we can gain insight into the motivations for capital
flows that are the result of private decisions by using rh e loanablc funds rnodel we developed
previously. In using this model, we make two important simplifications:
r Ve simplify the reality ofinternational capital flows by assuming that all flows are
in the form ofloans. In reality, capital flows take many forms, including purchases
of shares of stock in foreign companies and foreign real esttte as well as foreign direct
investment, in which companies build factories or acquire other productive assets
abroad.
r We also ignore the effects ofexpected, changes in exchange ra,tet the relative values
of different national currencies. We'll analyze the determination of exchange
rates later.
Figure 41.2 recaps the loanable funds model for a closed economy. Equilibrium corresponds
to point 4 at an interest rate of4%, at which the supply ofloanable funds (S)
intersects the demand (D). If intemational capital flows are possible, this diagram
changes and E may no longer be the equilibrium. We can anaJyze the causes and effects
of intemational capital flows using Figure 41.3 on the next page, which places the
loanable funds market diagrams for two counries side by side.
Figure 4L3 illustrates a world consisting ofonly two countries, the United States
and Britain. Panel (a) shows the loanable funds market in the United States, where
The Loanable Funds Model
Revisited
According to tie loanabl8 tunds modolofthe in-
terest rate, ft€ squilibrium interest rate is determlnod
by fie intersection of the supply ol
loanable funds curve, S, and the demand tor
loanable funds curve, AAt point E the equilib-
rium interest rah is 4%.
Quantity of loanable funds
module 41 Capital Flows and the Balance of Payments 475