INTERNATIONAL FINANCE

Homework Topic 2
International Flows of Funds

MCQ:
1. Recently, the U.S. experienced an annual balance of trade representing a ____.
a. large surplus (exceeding $100 billion)
b. small surplus
c. level of zero
d. deficit
2. A high home inflation rate relative to other countries would ____ the home
country's current account balance, other things being equal. High growth in the home
income level relative to other countries would ____ the home country's current account
balance, other things being equal.
a. increase; increase
b. increase; decrease
c. decrease; decrease
d. decrease; increase
3. If a country's government imposes a tariff on imported goods, that country's
current account balance will likely ____ (assuming no retaliation by other governments).
a. decrease
b. increase
c. remain unaffected
d. decrease AND remain unaffected is possible
4. An increase in the current account deficit will place ____ pressure on the home
currency value, other things being equal.
a. upward
 b. downward
c. no
d. upward or downward (depending on the size of the deficit)
5. If the home currency begins to appreciate against other currencies, this should
____ the current account balance, other things being equal (assume that substitutes are
readily available in other countries, and that the prices charged by firms remain the
same).
a. increase
b. have no impact on
c. reduce
d. All of these are equally possible.
6. Which of the following would likely have the least direct influence on a
country's current account?
a. inflation
b. national income
c. exchange rates
d. tariffs
e. a tax on income earned from foreign stocks
7. The "J-curve" effect describes:
a. the continuous long-term inverse relationship between a country's
current account balance and the country's growth in gross domestic product.
b. the short-run tendency for a country's balance of trade to
deteriorate even while its currency is depreciating.
c. the tendency for exporters to initially reduce the price of goods when
their own currency appreciates.
d. the tendency of a country's currency to initially depreciate after the
country's inflation rate declines.
8. An increase in the use of quotas is expected to:
a. reduce the country's current account balance, if other governments do
not retaliate.
b. increase the country's current account balance, if other governments
do not retaliate.
c. have no impact on the country's current account balance unless
other governments retaliate.
d. increase the volume of a country's trade with other countries.
 9. The primary component of the current account is the:
a. balance of trade.
b. balance of gifts.
c. balance of aid payments.
d. balance of grant payments.
10. Which of the following is mentioned in the text as a possible means by which
the government may attempt to improve its balance-of-trade position (increase its
exports or reduce its imports)?
a. The government could attempt to reduce its home currency's
value.
b. The government could require firms to engage in outsourcing.
c. The government could provide subsidies to importers.
d. All of these are mentioned.
11. The demand for U.S. exports tends to increase when:
a. economic growth in foreign countries decreases.
b. the currencies of foreign countries strengthen against the dollar.
c. U.S. inflation rises.
d. None of these are correct.

Questions and application:

1. Balance of Payments
a. What are the main components of the current account?
(1) merchandise (goods) and services,
(2) primary income,
(3) secondary income.
b. What are the main components of the capital account?
Originally included the financial account.
b. What are the main components of the financial account?
(1) direct foreign investment,
(2) portfolio investment,
(3) other capital investment.
2. Outsourcing
What are the positive and negative sides of outsourcing?
- Positive sides:
 + Increased international trade activity because MNCs now
purchase products or services from another country.
+ Lower cost of operations and job creation in countries with low
Wages
- Negative sides:
+ Outsourcing may reduce jobs in the United States.
3. Factors Affecting International Trade Flows
a. Briefly explain how changes in various economic factors affect the U.S. current
account balance.
- Cost of labor: Firms in countries where labor costs are low commonly have an
advantage when competing globally, especially in labor intensive industries.
- Inflation: an increase in the country’s inflation may cause its current account to
decrease. If a country’s inflation rate increases relative to the countries with which it
trades, this could cause its exports to decrease (if foreign customers shift to cheaper
alternatives in other countries) and its imports to increase (if local individuals and firms
shift to cheaper alternatives).
- Natinonal income: If a country’s income level (national income) increases by a higher
percentage than those of other countries, then its current account should decrease, other
things being equal. As the real income level (adjusted for inflation) rises, so does
consumption of goods. A percentage of that increase in consumption will most likely
reflect an increased demand for foreign goods.
- Credit Conditions: Tend to tighten when economic conditions weaken, causing banks
to be less willing to extend financing to MNCs -> MNCs reduce their corporate
spending -> reduce the demand for imported supplies.
- Government policies:affect their respective balance-of-trade:
+ Restrictions on Imports (tariffs and quotas):
tax on imported goods -> customers pay more -> purchase fewer foreign goods and
more domestically produced goods.
a government can reduce its country’s imports by enforcing a quota, or a maximum
limit that can be imported.
+ Subsidies for Exporters: A government may offer subsidies to its domestic firms to
enable them to produce products at a lower cost than their global competitors. The firms
may then be able to price their products lower than competitors’ products, thereby
attracting more demand for their exports. Some subsidies are more obvious than others,
and it could be argued that every government provides subsidies in some form.
+ Restrictions on Piracy: A government that does not act to minimize piracy may
indirectly reduce imports and may even discourage MNCs from exporting to that
market.
+ Environmental Restrictions:
Environmental restrictions impose higher costs on local firms, placing them at a global
disadvantage compared to firms in other countries that are not subject to the same
restrictions
+ Labor Laws:Countries with more restrictive laws that protect workers' rights will incur
higher labor expenses, other factors being equal
+ Business Laws: Firms in countries with more restrictive bribery laws may not be able
to compete globally in some situations. When government officials of an agency
soliciting specific services from MNCs expect to receive bribes from the MNCs
attempting to secure that business.
+ Tax Breaks: Though not necessarily a subsidy, still a form of government financial
support that might benefit many firms that export products. U.S.-based MNCs can
benefit from tax breaks when they invest in research and development or in equipment
and machinery
+ Country Trade Requirements: Requiring various forms or obtaining licenses before
countries can export to the country is a strong trade barrier.
Bureaucracy
+ Government Ownership or Subsidies:
Many expect countries to restrict imports from countries that:
• Fail to enforce environmental laws and child labor laws.
• Initiate war against another country.
• Are unwilling to participate in a war
+ Country Security Laws:
Every government implements some policies.
No formula ensures a completely fair contest for market
share.
+ Policies to publish country governments:
+ Summary of government policies:
- Exchange Rates:
Current account decreases if the home currency appreciates
relative to other currencies
• exports decrease and imports increase.
A strong US dollar results in a lower, or more negative, current account balance
■ US products more expensive to non-US firms and makes non-US products less
expensive to US firms.
■ US exports will decrease, and US imports will increase
- Government Restrictions
■ US government imposes new barriers on imports:
• US imports decline
• US Balance of Trade to increase, or to be less negative
■ Non-US government impose new barriers on imports from the US:
• US BOT may decrease or be more negative.
b. How would a relatively high domestic inflation rate affect the home country’s
current account, other things being equal?
A high home inflation rate causes home goods to be more expensive and foreign
goods to be less expensive, resulting in more imports and less exports, thus the current
account will decrease, or be more negative.
c. Is a negative current account harmful to a country? Discuss.
This question is intended to encourage opinions and does not have a perfect
solution. A negative current account is thought to reflect lost jobs in a country, which is
unfavorable. Yet, the foreign importing reflects strong competition from foreign
producers, which may keep prices (inflation) low.
d. How can government restrictions affect international payments among
countries?
Governments impose restrictions on imports through tariffs and on exports
through quotas. They can also impose taxes on income from foreign securities,
discouraging investors from purchasing foreign securities.
e. Would the U.S. balance-of-trade deficit be larger or smaller if the dollar
depreciates against all currencies, versus depreciating against some currencies but
appreciating against others? Explain.
If the dollar weakens against all currencies, the U.S. balance of trade deficit will
likely be smaller. Some U.S. importers would have more seriously considered
purchasing their goods in the U.S. if most or all currencies simultaneously strengthened
against the dollar. Conversely, if some currencies weaken against the dollar, the U.S.
importers may have simply shifted their importing from one foreign country to another.
f. A relatively small U.S. balance-of-trade deficit is commonly attributed to a
strong demand for U.S. exports. What do you think is the underlying reason for the
strong demand for U.S. exports?
The strong demand for U.S. exports is commonly attributed to strong foreign
economies or to a weak dollar.
g. Explain why a stronger dollar could enlarge the U.S. balance-of-trade deficit.
Explain why a weaker dollar could affect the U.S. balance-of-trade deficit.
A stronger dollar could enlarge the U.S. balance of trade deficit, the main reason
for this is that, when U.S. dollar is stronger, U.S. residents would be able to buy more
foreign products since they would be cheaper and therefore exports would be reduced
because they would be more expensive for foreigners leading to an increase of imports
and decrease of exports which would result in the enlargement of the trade deficit. On
the other hand, a weaker dollar would affect in the opposite direction, imports would be
reduced since the foreign goods would be more expensive and exports would increase
since they would be cheaper for foreigners resulting in a a reduction of the trade deficit.
h. It is sometimes suggested that a floating exchange rate will adjust to reduce or
eliminate any current account deficit. Explain why this adjustment would occur.
 A current account deficit is very often linked to a depreciation of the home
currency due to the market forces (derived from the negative trade balance) which push
down the value of a country's currency. This will derive in an increase of
competitiveness and therefore increase of exports since home products are cheaper for
foreigners. This depreciation will also affect the imports since residents of the home
country will have difficulties to buy foreign products due to the loss in the value of the
home currency, that is, foreign products would be more expensive, decreasing the
imports. Higher exports and lower imports is equal to a reduction or an eventual
elimination of any current account deficit.
i. Why does the exchange rate not always adjust to a current account deficit?
Firms don’t adjust prices to consumers but have exchange rate movements absorbed in
their own margins. This is one reason why a movement in the exchange rate often takes
time to affect the current account.
A country running large current account deficit is always at risk of seeing the value of
the currency fall. If there are insufficient capital flows to finance the deficit, the
exchange rate will fall to reflect the imbalance of foreign flows of funds.
j. When South Korea’s export growth stalled, some South Korean firms suggested
that South Korea’s primary export problem was the weakness in the Japanese yen. How
would you interpret this statement?
One of South Korea's primary competitors in exporting is Japan, which produces
and exports many of the same types of products to the same countries. When the
Japanese yen is weak, some importers switch to Japanese products in place of South
Korean products. For this reason, it is often suggested that South Korea's primary export
problem is weakness in the Japanese yen.
k. Explain how the existence of the euro may affect U.S. international trade.
The euro allowed for a single currency among many European countries. It could
encourage firms in those countries to trade among each other since there is no exchange
rate risk. This would possibly cause them to trade less with the U.S.
l. Assume a simple world in which the United States exports soft drinks and beer
to France and imports wine from France. If the United States imposes large tariffs on
French wine, explain the likely impact on the values of U.S. beverage firms, U.S. wine
producers, French beverage firms, and French wine producers.
The U.S. wine producers benefit from the U.S. tariffs, while the French wine
producers are adversely affected. The French government would likely retaliate by
imposing tariffs on the U.S. beverage firms, which would adversely affect their value.
The French beverage firms would benefit.
m. Briefly explain the limitations of a weak home currency solution for a balance
of trade deficit.
 A weak home currency may not be a perfect solution to correct a balance-of-trade
deficit because it:

 Reduces the prices of imports paid by local companies.

 Increases the prices of exports by local companies.
 Prevents international trade transactions from being prearranged.
4. International Capital Flows
U.S.-based MNCs commonly invest in foreign securities.
a. Assume that the dollar is presently weak and is expected to strengthen over
time. How will these expectations affect the tendency of U.S. investors to invest in
foreign securities?
 The expectations of a strong dollar would discourage U.S. investors from
investing abroad.
 If the dollar is relatively weak now, U.S. investors need more dollars to make
purchase foreign currency (when investing).
 If the dollar strengthens over their investment horizon, they will exchange the
foreign currency (as the investment is liquidated) into dollars at a less favorable
exchange rate than the exchange rate at which they converted dollars into the
foreign currency. That is, the exchange rate effect would reduce the yield that
they earn on their investment.
 When the dollar is strong, we get more shares for the same amount of dollars.
so, when dollar is weak and is expected to strengthen then investments will
increase when dollars strengthens

b. Explain how low U.S. interest rates can affect the tendency of U.S.-based
MNCs to invest abroad.
Low U.S. interest rates can encourage U.S-based MNCs to invest abroad, as
investors seek higher returns on their investment than they can earn in the U.S.
c. In general terms, what is the attraction of foreign investments to U.S. investors?
The main attraction is potentially higher returns. The international stocks can
outperform U.S. stocks, and international bonds can outperform U.S. bonds. However,
there is no guarantee that the returns on international investments will be so favorable.
Some investors may also pursue international investments to diversify their investment
portfolio, which can possibly reduce risk.
5. Impact of International Capital Flows
 Why does access to international funding allow more growth in the country
receiving funds?
First, financial aid from international organizations and countries can help developing
nations overcome economic devastation caused by events such as the COVID-19
pandemic. This assistance can provide much-needed resources to rebuild economies,
support small- and medium-sized businesses, and address the needs of vulnerable
populations.
Second, access to concessional financing can be of critical importance in rebooting an
economy. It can help countries invest in infrastructure development, education,
healthcare, and other sectors that contribute to long-term growth.
Third, debt relief and access to multilateral institutions can provide developing
countries with the necessary financial stability and influence to navigate global
economic challenges. By having a seat at the table, these nations can advocate for their
interests and ensure that their unique perspectives are taken into account when making
decisions that affect them.

6. IMF
a. What are some of the major objectives of the IMF?
The major objectives of the International Monetary Fund (IMF) are:
 To improve and promote global monetary cooperation of the world.
 To secure financial stability by eliminating or minimizing the exchange rate
stability.
 To facilitate a balanced international trade.
 To promote high employment through economic assistance and sustainable
economic growth.
 To reduce poverty around the world
b. How is the IMF involved in international trade?
The IMF is an international organization that promotes international trade and
development by providing financial assistance, technical support, and policy advice to
its member countries. The IMF aims to foster global financial stability, economic
growth, employment, and poverty reduction. The IMF also facilitates the expansion and
balanced growth of international trade by acting as a reservoir of currencies and
supporting trade finance.