The Financial Account.

What are the primary sub-components of the financial

account? Analytically, what would cause net deficits or surpluses in these
individual components?
The main components and possible examples are as follows:

Direct investment.
Debit: Ford Motor Company builds a factory in Australia.
Credit: Ford Motor Company sells its factory in Britain to British investors .

Portfolio investment.
Debit: An American buys shares of stock of a European food chain on the Frankfurt
Stock Exchange.
Credit: The government of Korea buys U.S. treasury bills to hold as part of its
foreign exchange reserves

Net financial derivatives.

Debit: A U.S. firm purchases a financial derivative like a currency swap in London
Credit: A U.S. firm sells a financial derivatives like a forward contract on the dollar
versus the pound to a London buyer

Other investment. Debit: A U.S. firm deposits $1 million in a bank balance in

London.

Advantages & Disadvantages of Fixed Exchange Rate

A fixed exchange rate system removes exchange rate uncertainty and so
encourages international trade. It also imposes economic disciplines on
countries in deficit or surplus. However, this restricts independence of
domestic economic policies. A government might be forced to keep
interest rates high or to reduce demand in the domestic economy (for e.g. by
raising taxes and so cutting the demand for imports) in order to
maintain a currency’s exchange rate and avoid a devaluation.
If levels of inflation differ widely in countries subscribing to a fixed
exchange rate regime, the regime may not survive for long. The high
inflation countries will be forced to devalue in order to keep their exports
competitive and to reduce imports.
There is inevitable some loss of flexibility in economic policy making
once a country joins a fixed exchange rate regime

Current Account. What are the main component accounts of the current
account? Give one debit and one credit example for each component
account for the United States.

The main components and possible examples are:

Trade in goods:

Debit: U.S. firm purchases German machine tools.

Credit: Singapore Air Lines buys a Boeing jet.

Trade in services:

Debit: An American takes a cruise on a Dutch cruise line.

Credit: The Brazilian tourist agency places an ad in The New York Times.

Income

Debit: The U.S. subsidiary of a Taiwan computer manufacturer pays dividends

to its parent.

Credit: A British company pays the salary of its executive stationed in New
York.

current transfers:

Debit: The U.S.-based International Rescue Committee pays for an American

working on the Afghan border.

Credit: A Spanish company pays tuition for an employee to study for an MBA
in the United States
Explain the meaning of the term impossible trinity:

a situation when a country gives up one of the three goals which are explained by
the three sides of the triangle:

Exchange rate stability: It refers to a situation where investors and traders of a

country are certain about the foreign exchange value of the currency at the present
and in near future as the value of currency is fixed and compared to currencies of
other countries.

Full financial integration: As there is complete freedom for the monetary flows,
hence the traders and investors can easily exchange and move funds from one
country to another and also currency from one country to another as there is full
independence of monetary flows.

Monetary independence: In order to follow, influence and focus on the desired

national economic policies, the domestic monetary and interest rate policies would
be established by every country.

The Impossible Trinity states that you can have two of the following three:

1. A fixed exchange rate

2. No capital controls
3. Independent monetary policy

You cannot have all three. We'll break down the constituent aspects before looking
at the combination.
IMF Exchange Rate Classifications
• Category 1: Hard Pegs

– Countries that have given up their own sovereignty over monetary

policy

– E.g. dollarization or currency boards

• Category 2: Soft Pegs

– AKA fixed exchange rates, with five subcategories of classification

• Category 3: Floating Arrangements

– Mostly market driven, these may be free floating or floating with

occasional government intervention

• Category 4: Residual

– The remains of currency arrangements that don’t well fit the previous
categorizations

• Financial account consists of three components and uses maturity and

degree of control over assets to classify them
– Direct Investment – Net balance of long term capital which is
dispersed from and into a country for the purpose of exerting control
over assets.
– Portfolio Investment – Net balance of short term capital which flows
in and out of the country but does not reach the 10% ownership
threshold of direct investment.
• This capital is purely return motivated
– Other Investment Assets/Liabilities – Consists of various short and
long-term trade credits, cross-border loans, currency and bank
deposits and other accounts receivable and payable related to cross-
border trade