CHAPTER 4 THE BALANCE OF PAYMENTS AND INTERNATIONAL LINKAGES.

CHAPTER 4CHAPTER 4

THE BALANCE OF PAYMENTS THE BALANCE OF PAYMENTS AND INTERNATIONAL AND INTERNATIONAL

LINKAGESLINKAGES

CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. BALANCE-OF-PAYMENT BALANCE-OF-PAYMENT CATEGORIESCATEGORIES

II.II. THE INTERNATIONAL THE INTERNATIONAL FLOW OF GOODS, FLOW OF GOODS, SERVICES,SERVICES,AND CAPITALAND CAPITAL

III.III. COPING WITH CURRENT COPING WITH CURRENT ACCOUNT DEFICITSACCOUNT DEFICITS

PART I.PART I. BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

A.A. THE BALANCE OF PAYMENTS THE BALANCE OF PAYMENTS (B-O-P)(B-O-P)

1.1. PURPOSE:PURPOSE:

Measures all financial and Measures all financial and economic economic

transactions overtransactions over

a specified period of time.a specified period of time.

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

2.2. Double-entry bookkeepingDouble-entry bookkeeping

a. Currency inflows = creditsa. Currency inflows = credits

earn foreign exchangeearn foreign exchange

b. Currency outflows = debitsb. Currency outflows = debits

expend foreign exchangeexpend foreign exchange

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

3.3. Three Major Accounts:Three Major Accounts:

a.a. CurrentCurrent

b.b. CapitalCapital

c.c. Official ReservesOfficial Reserves

4.4. Current AccountCurrent Account

records net flow of goods, records net flow of goods, services, and services, and

unilateral unilateral transfers. transfers.

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

5.5. Capital AccountCapital Account

a. a. Function: records public Function: records public and private and private

investment and investment and lending.lending.

b. Inflows = creditsb. Inflows = credits

c. Outflows = debitsc. Outflows = debits

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

5.5. Capital Account (con’t)Capital Account (con’t)

d. Transactions classified asd. Transactions classified as

1.) portfolio1.) portfolio

2.) direct2.) direct

3.) short term3.) short term

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

6.6. Official Reserves AccountOfficial Reserves Account

a. Function:a. Function:

1.) measures changes in 1.) measures changes in

international reservesinternational reserves

owned by central banks.owned by central banks.

2.) reflects surplus/deficit of2.) reflects surplus/deficit of

a.) current accounta.) current account

b.) capital accountb.) capital account

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

6.6. Official Reserves Account Official Reserves Account (con’t)(con’t) b. Reserves consist b. Reserves consist of of

1.) gold1.) gold

2.) convertible securities2.) convertible securities

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

7. Net Effects:7. Net Effects:

a. a. Sum of all transactions Sum of all transactions must be zero:must be zero:

1.) current account1.) current account2.) capital account2.) capital account3.) official reserves3.) official reserves

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

8.8. The Balance-of-payment The Balance-of-payment measuresmeasures

a. Some Definitions:a. Some Definitions:

1.) Basic Balance1.) Basic Balance

a.) a.) consists of current consists of current

account and long-account and long-term capital flows.term capital flows.

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

1.) Basic Balance (con’t)1.) Basic Balance (con’t)

b.) emphasizes long-b.) emphasizes long-term trends.term trends.

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

1.) Basic Balance (con’t)1.) Basic Balance (con’t)

c.) excludes short-term capital c.) excludes short-term capital flows that heavily depend flows that heavily depend

on on temporary factors.temporary factors.

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

2.) Net Liquidity Balance:2.) Net Liquidity Balance:

measures the change inmeasures the change in

private domestic private domestic borrowingborrowing

or lending require to keep or lending require to keep

payments equal withoutpayments equal without

adjusting official reserves.adjusting official reserves.

BALANCE-OF-PAYMENTBALANCE-OF-PAYMENTCATEGORIESCATEGORIES

3.)3.) Official Reserve TransactionsOfficial Reserve Transactions

BalanceBalance

- - measures adjustmentsmeasures adjustments

needed by official needed by official

reserves.reserves.

PART II. THE INTERNATIONAL FLOW OF PART II. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

II.II. LINKS FROM INTERNATIONAL LINKS FROM INTERNATIONAL TO DOMESTIC FLOWSTO DOMESTIC FLOWS

A.A. Global LinkagesGlobal Linkages

set of basic macroeconomic set of basic macroeconomic identities which link:identities which link:

domestic spending and domestic spending and production toproduction to current current

and and capital accountscapital accounts

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

B.B. Domestic Savings and Domestic Savings and InvestmentInvestment

and the Capital Accountand the Capital Account

1.1. National Income AccountingNational Income Accounting

a.a. National Income (NI) is National Income (NI) is either spent either spent (C) or (C) or saved (S)saved (S)

NI = C + SNI = C + S (4.1)(4.1)

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

b. b. National spending (NS) is National spending (NS) is

divided into personal divided into personal spending (C)spending (C) and and

investment (I)investment (I)

NS = C + INS = C + I (4.2)(4.2)

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

c. c. Subtracting (4.2) - (4.1)Subtracting (4.2) - (4.1)

NI - NS = S - INI - NS = S - I(4.3)(4.3)

If NI >NS, S > I which impliesIf NI >NS, S > I which implies

that surplus capital spent that surplus capital spent overseas.overseas.

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

d.d. In a freely-floating system,In a freely-floating system,

excess saving = the capital excess saving = the capital account balanceaccount balance

e.e. Implications:Implications:

1.1. A nation which produces A nation which produces more than it spends will more than it spends will save more than it invests save more than it invests domestically with a net domestically with a net capital outflow producing a capital outflow producing a capital account deficit.capital account deficit.

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

2.2. A nation which spends more A nation which spends more than than it produces has a net it produces has a net capital capital inflow producing a inflow producing a capital capital account account surplus.surplus.

3.3. A healthy economy will tend A healthy economy will tend toto

run a current account deficit.run a current account deficit.

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

C.C. THE LINK BETWEEN THE THE LINK BETWEEN THE CURRENT AND CAPITAL CURRENT AND CAPITAL ACCOUNTSACCOUNTS

1.1. Beginning identityBeginning identity

NI - NS = X - MNI - NS = X - M (4.4)(4.4)

where X = exportswhere X = exports

M = importsM = imports

X-M=current account X-M=current account balance (CA) balance (CA)

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

2.2. Combining (4.3) + (4.4)Combining (4.3) + (4.4)

S - I = X - MS - I = X - M(4.5)(4.5)

3. 3. If S - I = Net Foreign If S - I = Net Foreign Investment (NFI)Investment (NFI)

NFI = X - MNFI = X - M(4.6)(4.6)

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

4.4. Implications:Implications:

a.a. If CA is in surplus, the If CA is in surplus, the nation must be a net nation must be a net exporter of capital.exporter of capital.

b.b. If CA is a deficit, the nation If CA is a deficit, the nation is a major capital importer.is a major capital importer.

c.c. When NS > NI, the excess When NS > NI, the excess must be acquired through must be acquired through foreign trade.foreign trade.

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

d.d. Solutions for Improving CA Solutions for Improving CA deficits:deficits:

1.)1.) Raise national income Raise national income (output)(output)

relative to domestic relative to domestic investment (I).investment (I).

2.)2.) Increase (S) relative to Increase (S) relative to domestic investment (I).domestic investment (I).

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

D.D. GOVERNMENT BUDGETS ANDGOVERNMENT BUDGETS AND

CURRENT ACCOUNT DEFICITSCURRENT ACCOUNT DEFICITS

1. 1. CURRENT ACCOUNT BALANCECURRENT ACCOUNT BALANCE

CA = Saving Surplus - Gov’t CA = Saving Surplus - Gov’t

budget deficitbudget deficit

THE INTERNATIONAL FLOW OF THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALGOODS, SERVICES, AND CAPITAL

2. CA Deficit means2. CA Deficit means the nation is not saving the nation is not saving

enough to finance (I) enough to finance (I) and the and the deficit.deficit.

3. CA Surplus means3. CA Surplus means the nation is saving more the nation is saving more

than needed to than needed to finance its (I) finance its (I) and deficit.and deficit.

PART III. COPING WITH THE PART III. COPING WITH THE CURRENT ACCOUNT DEFICITCURRENT ACCOUNT DEFICIT

I.I. POSSIBLE SOLUTIONS POSSIBLE SOLUTIONS UNLIKELYUNLIKELY TO TOWORK:WORK:

A.A. Currency DepreciationCurrency Depreciation

B. B. ProtectionismProtectionism

COPING WITH THE COPING WITH THE CURRENT ACCOUNT DEFICITCURRENT ACCOUNT DEFICIT

II.II. CURRENCY DEPRECIATIONCURRENCY DEPRECIATION

A. A. U.S. Experience: U.S. Experience:

Does not improve the Does not improve the trade trade deficit.deficit.

COPING WITH THE CURRENT COPING WITH THE CURRENT ACCOUNT DEFICITACCOUNT DEFICIT

B.B. Depreciations are ineffective Depreciations are ineffective becausebecause

1.1. It takes time to affect trade.It takes time to affect trade.

2.2. J-Curve EffectJ-Curve Effect

states that a decline in states that a decline in currencycurrency value will initially value will initially worsen the deficit before worsen the deficit before improvement.improvement.

THE J - CURVETHE J - CURVE

TIME

Net changein trade balance

0

Currency depreciation

Trade balance initially deteriorates

Trade balanceimproves

COPING WITH THE CURRENT COPING WITH THE CURRENT ACCOUNT DEFICITACCOUNT DEFICIT

III.III. PROTECTIONISMPROTECTIONISM

A.A. Trade Barriers used:Trade Barriers used:

1.1. TariffsTariffs

2.2. QuotasQuotas

B.B. Results:Results:

Most likely will reduce Most likely will reduce bothboth X and M.X and M.

COPING WITH THE CURRENT COPING WITH THE CURRENT ACCOUNT DEFICITACCOUNT DEFICIT

C.C. FOREIGN OWNERSHIPFOREIGN OWNERSHIP

one protectionist solution one protectionist solution would would place limits on or place limits on or eliminate eliminate foreign foreign ownership ownership leading to leading to capital inflows.capital inflows.

COPING WITH THE CURRENT COPING WITH THE CURRENT ACCOUNT DEFICITACCOUNT DEFICIT

D.D. STIMULATE NATIONAL STIMULATE NATIONAL SAVINGSAVING

change the tax regulations and change the tax regulations and rates.rates.

COPING WITH THE CURRENT COPING WITH THE CURRENT ACCOUNT DEFICITACCOUNT DEFICIT

III.III. SUMMARY: CURRENT-ACCOUNTSUMMARY: CURRENT-ACCOUNT

DEFICITSDEFICITS

- neither bad nor good inherently- neither bad nor good inherently

1.1. Since one country’s exports Since one country’s exports are another’s imports, it is are another’s imports, it is not possible for all to run a not possible for all to run a surplussurplus

COPING WITH THE CURRENT COPING WITH THE CURRENT ACCOUNT DEFICITACCOUNT DEFICIT

2.2. Deficits may be a solution to Deficits may be a solution to the problem of different the problem of different

national propensities national propensities to save to save and invest.and invest.