The Balance of Payments Chapter 12 The Balance of Payments

Topics to be Covered Balance of Payments Components of the Balance of Payments: Current Account Financial Account Financing the Current Account Saving, Investment, and Current Account Other Balance of Payments Measures Balance of Payments Equilibrium Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Why Study the Balance of Payments? Balance of payments issues such as trade deficits and foreign indebtedness are controversial topics. Balance of payments accounts provide insights into the country’s economic performance relative to the rest of the world. The study of the economics of balance of payments allows proper evaluation of the various arguments and government policies recommended to eliminate trade imbalances. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Balance of Payments Balance of Payments (BOP)—is an accounting record of a country’s trade in goods, services, and financial assets with the rest of the world during a particular time period (year or quarter). Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Features of the BOP BOP follows the accounting procedure of double-entry bookkeeping (debits & credits). A credit entry records an item or transaction that brings foreign exchange into the country. A debit entry represents a loss of foreign exchange. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Features of the BOP (cont.) BOP will always balance. A BOP deficit (surplus) means that the debit entries exceed (are less than) the credits. This imbalance applies only to a particular account or component of the BOP. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Components of the BOP Current Account Capital Account Financial Account Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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Current Account The current account includes the value of trade in merchandise, services, income from investments, and unilateral transfers (refer to Table 12.1). Merchandise—tangible goods. Services—include travel and tourism, royalties, transport costs, and insurance. Income from investments—interest and dividends. Unilateral transfers—include foreign aid, gifts, and retirement pensions. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

U.S. Current Account Historical Trends Refer to Figure 12.1 From 1946 to 1970, the U.S. had a merchandise trade surplus. The merchandise trade balance has been in deficit since 1971 (except 1973 and 1975). U.S. income receipts from investments abroad have had sizable surpluses that the current account experienced surpluses in 1973–76 and 1980–81. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Drawing a Line in the BOP If we draw a line at the current account balance, then: Items “above the line” refer to the current account trade in goods, services, income, and unilateral transfers. Items “below the line” are the capital and financial account transactions (purchases and sales of financial assets). Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Drawing a Line in the BOP (cont.) Since the BOP always balances, then a current account deficit (above the line) implies that the country is running a net surplus below the line, so that the country is a net borrower from the rest of the world. The U.S. became a net borrower in 1985 for the first time since World War I because of the huge current account deficits in the 1980s (refer to Item 12.1). Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Capital Account This line is relatively small for the U.S. and includes primarily transactions involving debt forgiveness and financial assets accompanying migrant workers as they enter or leave the country. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Financial Account Refer to Table 12.1 (lines 40–69) The financial transactions include: Direct Investment Purchases of Equity and Debt Securities Bank Claims and Liabilities U.S. Government Assets Abroad Foreign Official Assets in the U.S. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

National Saving, Investment, and the Current Account Given the national income accounting identity: where Y is national income or GDP, C is consumption spending, I investment, G government spending, and X is net exports or the current account, we can rearrange this identity as: where Y – C – G is national income less consumption less government spending, which we can call national saving S. Thus, saving equals the sum of investment and the current account. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

National Saving, Investment, and the Current Account (cont.) Rearranging further, we get: This states that if domestic saving exceeds investment, there will be a current account surplus. A country that spends more than its income (I > S) will experience a current account deficit. This overspending must be financed by foreign investment, so there will be a financial account surplus to match the current account deficit. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

More on the Link between Saving and the Current Account Given two kinds of saving (private and government): where private saving equals income less taxes (T) less consumption, and government saving equals taxes less government spending. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Saving and Current Account (cont.) If government spends more than its tax revenues (i.e., budget deficit or government dissaving) and private saving stays constant, then the current account will run a deficit. This was the twin-deficit problem of the 1980s and early 1990s. When the U.S. budget turned surpluses in late 1990s, the current account deficit continued to grow. This was due to a substantial drop in private saving along with a rise in investment. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Saving and Current Account (cont.) Lesson: Reducing the current account deficit requires increasing private saving relative to investment, and expanding domestic output or income relative to domestic spending. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Additional BOP Summary Measures Balance of Trade—the value of merchandise exports minus imports (line 3 plus line 20 in Table 12.1). Official Settlements Balance—the value of the change in financial assets held by foreign monetary agencies and official reserve asset transactions (lines 41 and 56 in Table 12.1). Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Statistical Discrepancy Statistical Discrepancy (Line 70 in Table 12.1) refers to the measurement errors and omissions resulting from problems of incomplete or inaccurate data. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Economic Implications of the BOP It is impossible for every country in the world to have a trade surplus. If international trade is voluntary, then it is difficult to argue that deficit countries are harmed and surplus countries benefit. Deficits are not inherently bad, nor are surpluses necessarily good. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Balance of Payments Equilibrium BOP equilibrium is the situation where credit items equal debit items for a particular sub-account, such as the current account or official settlements account, of a country’s balance of payments. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Movement Towards BOP Equilibrium What happens if the country has a current account deficit? The country must borrow (sell domestic securities) to the rest of the world to finance the current account deficit. As foreigners accumulate domestic securities, the domestic currency value falls which, in turn, raises net exports and consequently income. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

Movement Towards BOP Equilibrium (cont.) What happens if the country has a current account deficit? (cont.) In addition, domestic interest rates rise which, in turn, lowers consumption and investment spending. The increase in national income relative to spending will reduce the current account deficit. Copyright © 2007 Pearson Addison-Wesley. All rights reserved.

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