lecture 3- balance of payments

7/28/2019 Lecture 3- Balance of Payments

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Mukul Bhatia

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I. BALANCE-OF-PAYMENT

CATEGORIES

II. THE INTERNATIONAL FLOW OF

GOODS, SERVICES,AND CAPITAL

III. COPING WITH CURRENT ACCOUNT

DEFICITS

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Balance of payments (BoP) is a record of

all monetary transactions of a country with

rest of the world.

These transactions include payments for

the country's exports and imports of goods,

services, financial capital, and financialtransfers.

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When all components of the BOP accounts

are included they must sum to zero with nooverall surplus or deficit. For example, if acountry is importing more than it exports, itstrade balance will be in deficit, but theshortfall will have to be counterbalanced inother ways such as by funds earned from

its foreign investments, by running downcentral bank reserves or by receiving loansfrom other countries.

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Under a fixed exchange rate system, the

central bank accommodates those flows by

buying up any net inflow of funds into thecountry or by providing foreign currency fundsto the foreign exchange market to match anyinternational outflow of funds, thus preventing

the funds flows from affecting the exchangerate between the country's currency and othercurrencies

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A. THE BALANCE OF PAYMENTS

(B-O-P)

1. PURPOSE:

Measures all financial and economictransactions over a specified period of

time.

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2. Double-entry bookkeeping

a. Currency inflows = credits earnforeign exchange

b. Currency outflows = debits

expend foreign exchange

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3. Three Major Accounts:a. Current

b. Capitalc. Official Reserves

4. Current Account- records netflow of goods, services, andunilateral transfers.

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5. Capital Account

a. Function: records public and

private investment and lending.

b. Inflows = credits

c. Outflows = debits

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5. Capital Account (cont)

d. Transactions classified as

1.) portfolio2.) direct

3.) short term

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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

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6. Official Reserves Account (cont)

b. Reserves consist of

1.) gold

2.) convertible securities

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

zero:

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

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8. The Balance-of-payment measures

a. Some Definitions:

1.) Basic Balance

a.) consists of current account and long-termcapital flows.

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1.) Basic Balance (cont)

b.) emphasizes long-term trends.

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1.) Basic Balance (cont)

c.) excludes short-term capital flows that

heavily depend on temporary factors.

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2.) Net Liquidity Balance:

measures the change in private domestic

borrowing or lending require to keep

payments equal without adjusting official

reserves.

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3.) Official Reserve Transactions Balance

- measures adjustments needed by official

reserves.

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II. LINKS FROM INTERNATIONALTO DOMESTIC FLOWS

A. Global Linkages-set of basic macroeconomic identities whichlink:domestic spending and production to current

and capital accounts

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B. Domestic Savings and Investment and the

Capital Account1. National Income Accounting

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

NI = C + S

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b. National spending (NS) is divided into

personal spending (C) and investment (I)

NS = C + I

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c. Subtracting

NI - NS = S - I

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

capital spent overseas.

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d. In a freely-floating system,excess saving = the capital accountbalance

e. Implications:1. A nation which produces more than it spendswill save more than it invests domestically with anet capital outflow producing a capital account

deficit.

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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.

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C. THE LINK BETWEEN THECURRENT AND CAPITAL

ACCOUNTS1. Beginning identity

NI - NS = X - Mwhere X = exports

M = importsX-M=current account

balance (CA)

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2. Combining

S - I = X - M

3. If S - I = Net Foreign Investment

(NFI)

NFI = X - M

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4. Implications:a. If CA is in surplus, the nation must be anet exporter of capital.b. If CA is a deficit, the nation is a majorcapital importer.c. When NS > NI, the excess must beacquired through foreign trade.

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d. Solutions for Improving CA deficits:

1.) Raise national income (output)relative to domestic investment (I).

2.) Increase (S) relative to domesticinvestment (I).

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D. GOVERNMENT BUDGETS AND

CURRENT ACCOUNT DEFICITS

1. CURRENT ACCOUNT BALANCE

CA = Saving Surplus - Govt budget deficit

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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.

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I. POSSIBLE SOLUTIONS UNLIKELY

TO WORK:

A. Currency Depreciation

B. Protectionism

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II.CURRENCY DEPRECIATION

A. U.S. Experience:

Does not improve the trade deficit.

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B. Depreciations are ineffective because

1. It takes time to affect trade.

2. J-Curve Effect

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

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J Curve Effect-Following a currencydepreciation, the trade balance may at firstdeteriorate before it improves.

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Changeinthe

Trade

balance

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III. PROTECTIONISM

A. Trade Barriers used:

1. Tariffs

2. Quotas

B. Results:

Most likely will reduce both X and M.

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C. FOREIGN OWNERSHIP

one protectionist solution would place

limits on or eliminate foreign ownershipleading to capital inflows.

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D. STIMULATE NATIONAL SAVING

change the tax regulations and rates.

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III. SUMMARY: CURRENT-ACCOUNT

DEFICITS- neither bad nor good inherently

1.Since one countrys exports are

anothers imports, it is not possible forall to run a surplus

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2. Deficits may be a solution to the problem

of different national propensities to saveand invest.

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Thank You

lecture 3- balance of payments

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