Chapter 2
International Flow of Funds
Lecture Outline
Balance of Payments
Current Account
Capital and Financial Accounts
Growth in International Trade
Events That Increased Trade Volume
Impact of Outsourcing on Trade
Trade Volume Among Countries
Trend in U.S.Balance of Trade
Factors Affecting International Trade Flows
Impact of Inflation
Impact of National Income
International Capital Flows
Factors Affecting Direct Foreign Investment
Factors Affecting International Portfolio Investment
Impact of International Capital Flows
Agencies that Facilitate International Flows
International Flow of Funds ❖ 2
Chapter Theme
This chapter provides an overview of the international environment surrounding MNCs. The chapter is
macro-oriented in that it discusses international payments on a country-by-country basis. This macro
discussion is useful information for an MNC since the MNC can be affected by changes in a country’s
current account and capital account positions.
Topics to Stimulate Class Discussion
1. Is a current account deficit something to worry about?
2. If a government wants to correct a current account deficit, why can’t it simply enforce restrictions
on imports?
3. Why don’t exchange rates always adjust to correct current account deficits?
POINT/COUNTER-POINT:
Should Trade Restrictions be Used to Influence Human Rights Issues?
POINT: Yes. Some countries do not protect human rights in the same manner as the U.S. At times, the
U.S. should threaten to restrict U.S. imports from or investment in a country if it does not correct
human rights violations. The U.S. should use its large international trade and investment as leverage to
ensure that human rights violations do not occur. Other countries with a history of human rights
violations are more likely to honor human rights if their economic conditions are threatened.
COUNTER-POINT: No. International trade and human rights are two separate issues. International
trade should not be used as the weapon to enforce human rights. Firms engaged in international trade
should not be penalized by the human rights violations of a government. If the U.S. imposes trade
restrictions to enforce human rights, the country will retaliate. Thus, the U.S. firms that export to that
foreign country will be adversely affected. By imposing trade sanctions, the U.S. government is
indirectly penalizing the MNCs that are attempting to conduct business in specific foreign countries.
Trade sanctions cannot solve every difference in the beliefs or morals between the more developed
countries and the developing countries. By restricting trade, the U.S. will slow down the economic
progress of developing countries.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you
support? Offer your own opinion on this issue.
International Flow of Funds ❖ 3
Answers to End of Chapter Questions
1. Balance of Payments.
a. Of what is the current account generally composed?
b. Of what is the capital account generally composed?
2. Inflation Effect on Trade.
a. How would a relatively high home inflation rate affect the home country’s current account,
other things being equal?
b. Is a negative current account harmful to a country? Discuss.
3. Government Restrictions. How can government restrictions affect international payments among
countries?
4. IMF.
a. What are some of the major objectives of the IMF?
b. How is the IMF involved in international trade?
5. Exchange Rate Effect on Trade Balance. 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 appreciated against others? Explain.
6. Demand for Exports. 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?
7. Impact on International Trade. Why do you think international trade volume has increased over
time? In general, how are inefficient firms affected by the reduction in trade restrictions among
countries and the continuous increase in international trade?
8. Effects of the Euro. Explain how the existence of the euro may affect U.S. international trade.
9. Currency Effects. 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?
10. Effects of Tariffs. Assume a simple world in which the U.S. exports soft drinks and beer to
France and imports wine from France. If the U.S. imposes large tariffs on the French wine, explain
the likely impact on the values of the U.S. beverage firms, U.S. wine producers, the French
beverage firms, and the French wine producers.
International Flow of Funds ❖ 5
Advanced Questions
11. Free Trade. There has been considerable momentum to reduce or remove trade barriers in an
effort to achieve “free trade.” Yet, one disgruntled executive of an exporting firm stated, “Free
trade is not conceivable; we are always at the mercy of the exchange rate. Any country can use
this mechanism to impose trade barriers.” What does this statement mean?
ANSWER: This statement implies that even if there were no explicit barriers, a government could
12. International Investments. 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?
ANSWER: The expectations of a strong dollar would discourage U.S. investors from investing
b. Explain how low U.S. interest rates can affect the tendency of U.S.-based MNCs to invest
abroad.
c. In general terms, what is the attraction of foreign investments to U.S. investors?
13. Exchange Rate Effects on Trade.
a. 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.
b. 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.
ANSWER: A current account deficit reflects a net sale of the home currency in exchange for other
c. Why does the exchange rate not always adjust to a current account deficit?
14. Impact of Government Policies on Trade. Governments of many countries enact policies that
can have a major impact on international trade flows.
a. Explain how governments might give their local firms a competitive advantage in the
international trade arena.
b. Why might different tax laws on corporate income across countries allow firms from some
countries to have a competitive advantage in the international trade arena?
c. If a country imposes lower corporate income tax rates, does that provide an unfair advantage?
15. China – U.S. Balance of Trade. There is an ongoing debate between the U.S. and China regarding
whether the Chinese yuan’s value should be revalued upward. The cost of labor in China is
substantially lower than that in the U.S.
International Flow of Funds ❖ 7
a. Would the U.S. balance of trade deficit in China be eliminated if the yuan was revalued upward
by 20%? Or by 40%? Or by 80%?
ANSWER: This is an open question without a perfect answer. Yet, it should at least make students
b. If the yuan was revalued to the extent that it substantially reduced the U.S. demand for Chinese
products, would this shift the U.S. demand toward the U.S. or toward other countries where wage
rates are relatively low? In other words, would the correction of the U.S. balance of trade deficit
have a major impact on U.S. productivity and jobs?
Solution to Continuing Case Problem: Blades, Inc.
1. How could a higher level of inflation in Thailand affect Blades (assume U.S. inflation remains
constant)?
2. How could competition from firms in Thailand and from U.S. firms conducting business in
Thailand affect Blades?
ANSWER: Blades would be favorably affected relative to Thai roller blade manufacturers and
relative to other U.S. roller blade manufacturers with operations in Thailand. Both groups of firms
3. How could a decreasing level of national income in Thailand affect Blades?
4. How could a continued depreciation of the Thai baht affect Blades? How would it affect Blades’
relative to U.S. exporters invoicing their roller blades in U.S. dollars?
ANSWER: A continued depreciation of the Thai baht would hurt Blades, especially because the
firm invoices its roller blades in baht. A continued depreciation of the baht means that the baht-
5. If Blades increases its business in Thailand and experiences serious financial problems, are there
any international agencies that the company could approach for loans or other financial assistance?
Solution to Supplemental Case: Maple Leaf Paper Company
This case reflects the actual experience of a Canadian exporting firm (although the name and industry
have been changed) to the free-trade agreement on January 2, 1989. The appreciation in Canadian
dollars (resulting from the agreement) offset the tariff, so that the firm was no better off with the
free-trade agreement. The case shows that the effects of free trade are not always so obvious and may
differ across firms.
a. While the tariff allowed for a 12 percent decline in price, the U.S. clients will have to pay more
dollars to obtain Canadian dollars in the future, based on the forecast of the exchange rate. The
exchange rate is expected to rise by 13.15 percent. Given that the 12 percent tariff is removed
along with the exchange rate movement, the net effect will be an increase in price to U.S. clients
b. The precise forecast is not as important as the general concept here. What seemed to be a
favorable event does not benefit Maple Leaf. While the free-trade agreement allows for the
removal of tariffs, it causes a shift in international trade flows, which places upward pressure on
International Flow of Funds ❖ 9
Small Business Dilemma
Identifying Factors That Will Affect the Foreign Demand at the Sports Exports
Company
Identify the factors that affect the current account balance between the U.S. and the U.K. Explain how
each factor may possibly affect the British demand for the footballs that are produced by the Sports
Exports Company.
ANSWER:
1. High inflation in the U.K. could cause a shift in the demand for U.S. products instead of British
2. High national income in the U.K. could increase the amount of spending by British consumers,
3. Government restrictions could be imposed by the British government on goods (such as the
4. The exchange rate of the British pound will change over time. However, since the Sports Exports
Company is willing to accept pounds when it sells footballs to the distributor, the distributor does