BALANCE OF PAYMENTInternational flow of goods & services & coping with current account deficit

CHAPTER 5

The Balance of

Payments and

International Economic

Linkages

PART I. BALANCE-OF-PAYMENT

CATEGORIES

A. THE BALANCE OF PAYMENTS

(B-O-P)

1. PURPOSE:

Measures all financial and economic

transactions over a specified period

of time.

BALANCE-OF-PAYMENT

CATEGORIES

2. Double-entry bookkeeping

a. Currency inflows = credits earn

foreign exchange

b. Currency outflows = debits expend

foreign exchange

BALANCE-OF-PAYMENT

CATEGORIES

3. Three Major Accounts:

a. Current

b. Capital

c. Official Reserves

4. Current Account

records net flow of goods, services,

and unilateral transfers.

BALANCE-OF-PAYMENT

CATEGORIES

5. Capital Account

a. Function: records public and private

investment and lending.

b. Inflows = credits

c. Outflows = debits

BALANCE-OF-PAYMENT

CATEGORIES

5. Capital Account (con’t)

d. Transactions classified as

1.) portfolio

2.) direct

3.) short term

BALANCE-OF-PAYMENT

CATEGORIES

6. Official Reserves Account

a. Function:

1.) measures changes in

international reserves owned by

central banks.

2.) reflects surplus/deficit of

a.) current account

b.) capital account

BALANCE-OF-PAYMENT

CATEGORIES

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

1.) gold

2.) convertible securities

BALANCE-OF-PAYMENT

CATEGORIES

7. Net Effects:a. Sum of all transactions must be

zero:

1.) current account

2.) capital account

3.) official reserves

BALANCE-OF-PAYMENT

CATEGORIES

8. The Balance-of-payment measures

a. Some Definitions:

1.) Basic Balance

a.) consists of current account and long-term capital flows.

BALANCE-OF-PAYMENT

CATEGORIES

1.) Basic Balance (con’t)

b.) emphasizes long-term trends.

BALANCE-OF-PAYMENT

CATEGORIES

1.) Basic Balance (con’t)

c.) excludes short-term capital flows that

heavily depend on temporary factors.

BALANCE-OF-PAYMENT

CATEGORIES

2.) Net Liquidity Balance:

measures the change in private

domestic borrowing or lending

require to keep payments equal

without adjusting official reserves.

BALANCE-OF-PAYMENT

CATEGORIES

3.) Official Reserve Transactions

Balance

- measures adjustments needed by

official reserves.

PART II. THE INTERNATIONAL

FLOW OF GOODS, SERVICES,

AND CAPITAL

II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWS

A. Global Linkages

set of basic macroeconomic identities which link: domestic spending and production to current and capital accounts

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

B. Domestic Savings and Investment

and the Capital Account1. National Income Accounting

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

NI = C + S (5.1)

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

b. National spending (NS) is

divided into personal spending (C)

and investment (I)

NS = C + I (5.2)

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

c. Subtracting (4.2) - (4.1)

NI - NS = S - I (5.3)

If NI >NS, S > I which implies that surplus

capital spent overseas.

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

d. In a freely-floating system,

excess saving = the capital account balance

e. Implications:

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

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

2. A nation which spends more than it

produces has a net capital inflow

producing a capital account surplus.

3. A healthy economy will tend to

run a current account deficit.

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

C. THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS1. Beginning identity

NI - NS = X - M (5.4)

where X = exports

M = imports

X-M=current account balance (CA)

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

2. Combining (5.3) + (5.4)

S - I = X - M (5.5)

3. If S - I = Net Foreign Investment

(NFI)

NFI = X - M (5.6)

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

4. Implications:

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

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

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

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

d. Solutions for Improving CA deficits:

1.) Raise national income (output)

relative to domestic investment (I).

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

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

D. GOVERNMENT BUDGETS

AND CURRENT ACCOUNT

DEFICITS

1. CURRENT ACCOUNT BALANCE

CA = Saving Surplus - Gov’t budget

deficit

THE INTERNATIONAL FLOW OF

GOODS, SERVICES, AND CAPITAL

2. CA Deficit means

the nation is not saving enough to finance (I) and the deficit.

3. CA Surplus means

the nation is saving more than needed to finance its (I) and deficit.

PART III. COPING WITH THE

CURRENT ACCOUNT DEFICIT

I. POSSIBLE SOLUTIONS

UNLIKELY TO WORK:

A. Currency Depreciation

B. Protectionism

COPING WITH THE CURRENT

ACCOUNT DEFICIT

II.CURRENCY DEPRECIATION

A. U.S. Experience:

Does not improve the trade deficit.

COPING WITH THE CURRENT

ACCOUNT DEFICIT

B. Depreciations are ineffective because

1. It takes time to affect trade.

2. J-Curve Effect

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

THE J - CURVE

TIME

Net

change

in trade

balance

0

Currency

depreciation

Trade balance

initially deteriorates

Trade balance

improves

COPING WITH THE CURRENT

ACCOUNT DEFICIT

III. PROTECTIONISM

A. Trade Barriers used:

1. Tariffs

2. Quotas

B. Results:

Most likely will reduce both X and M.

COPING WITH THE CURRENT

ACCOUNT DEFICIT

C. FOREIGN OWNERSHIP

one protectionist solution would place

limits on or eliminate foreign ownership

leading to capital inflows.

COPING WITH THE CURRENT

ACCOUNT DEFICIT

D. STIMULATE NATIONAL

SAVING

change the tax regulations and rates.

COPING WITH THE CURRENT

ACCOUNT DEFICIT

III. SUMMARY: CURRENT-ACCOUNT

DEFICITS

- neither bad nor good inherently

1. Since one country’s exports are

another’s imports, it is not

possible for all to run a surplus

COPING WITH THE CURRENT

ACCOUNT DEFICIT

2. Deficits may be a solution to the problem

of different national propensities to save

and invest.