Chapter 5 The Balance of Payments and International Economic Linkages The International Flow of Goods, Services, and Capital Current Account Deficit

5.A Balance of Payments (http://www.bea.gov/international/) Balance of payments (“BOP”) – an accounting statement that summarizes all of the economic transactions between residents of the home country and residents of all other countries. Current Account – reflects the net flow of Goods and services (balance of trade); Income (interest, dividends, and compensation); and Unilateral transfers (pensions, remittances, and other transfers for which no services were rendered). Capital Account – reflects capital transfers that offset transactions undertaken without exchange in fixed assets or in their financing. Financial Account – reflects net purchases of financial assets: Portfolio investments – financial assets with maturity > one year Direct investments – financial assets for which management control is exerted (at least 10% equity ownership) Changes in reserve assets held by official monetary institutions Double-entry accounting ensures that the sum of all transactions is zero. A “statistical discrepancy” line is included to offset non-zero balances. Chapter 5: The Balance of Payments and International Economic Linkages

5.B International Flow of Goods, Services, and Capital Macroeconomic accounting identities Link domestic spending and production to savings, consumption, and investment behavior, and thus to Current Account and Financial Account balances. Manipulating accounting identities reveals the nature of the links between U.S. and world economies. Domestic savings and investment and the Financial Account Link between Current Account and Financial Account Government budget deficits and the Current Account Chapter 5: The Balance of Payments and International Economic Linkages

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account National income* is either spent or saved. Thus: National Income = Consumption + Savings Identity 5.1: National expenditures consist of consumption and investment. Thus: National Expenditures = Consumption + Investment Identity 5.2: Thus: National Income – National Expenditures = (consumption + savings) – (consumption + investment) = Savings – Investment Identity 5.3: *same as national product Chapter 5: The Balance of Payments and International Economic Linkages

5.B.i International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account If income > expenditures, then savings > investment, resulting in a capital surplus (excess savings). Surplus capital is invested overseas. Thus, surplus capital becomes net foreign investment. If positive, net foreign investment equals a Financial Account deficit. Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account Combining Identity 5.3 and Identity 5.4: Identity 5.5: Savings – Investment = Exports – Imports Thus, if savings > investment, net exports are positive and the Current Account will run a surplus. Because net foreign investment = savings - investment: Identity 5.6: Net Foreign Investment = Exports – Imports Thus, the Current Account balance = net capital outflow. If savings > investment, net foreign investment is positive and the Current Account will run a surplus. Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account By Identity 5.6, the excess of goods and services bought over goods and services produced domestically must be acquired through foreign trade and financed by an equal amount of borrowing from abroad. That is, if exports < imports, net foreign investment is negative. When exports < imports, the Current Account will run a deficit. When net foreign investment is negative, the Financial Account will run a surplus. Thus, the Current Account and Financial Account balances must exactly offset each other. Chapter 5: The Balance of Payments and International Economic Linkages

5.B.ii International Flow of Goods, Services, and Capital: Link Between Current Account and Financial Account Using identities to assess the efficacy of solutions to improve the Current Account balance Two conditions must be satisfied to reduce/increase a Current Account deficit/surplus: By Identify 5.3, raise income relative to expenditures; and Bv Identity 5.5, raise savings relative to investment. However, a Current Account surplus is not necessarily a sign of economic health. Countries that provide good investment opportunities may run trade deficits (investment > savings). Countries that grow rapidly import more goods and services and may thus run trade deficits. Weak economies may reduce their imports, given a positive correlation of income with import consumption, and may thus run trade surpluses. Chapter 5: The Balance of Payments and International Economic Linkages

5. B. iii. International Flow of Goods, Services, and Capital: Govt 5.B.iii International Flow of Goods, Services, and Capital: Govt. Budget Deficits and Current Account Deficits Current Account Balance = Private Savings Surplus – Govt. Budget Deficit Identity 5.9: Thus, a country running a Current Account deficit is not saving enough to finance its private investment and government budget deficit, and a country running a Current Account surplus has excess savings after financing private investment and the government deficit. Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (1) Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings. Devaluation An overvalued currency acts as a tax on exports and a subsidy to imports. Empirical review of currency devaluation and trade deficit 1976-1980 – dollar depreciated as trade deficit first worsened and then improved. 1980-1985 – dollar appreciated as trade deficit steadily worsened. 1985-1987 – Dollar began depreciating while trade deficit rose steadily. 2002 – Dollar began depreciating as trade deficit reached record levels Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (2) Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued Devaluation, continued Conventional explanations for disconnect between changes in currency value and changes in trade deficit Lagged effects – time is needed for an exchange rate change to affect trade. Empirical review indicates that changes in the dollar’s value explain less than 5% of the variation in the trade balance between 1970 and 2006. J-Curve theory – as currency depreciates, the trade deficit initially worsens and then improves over time. Consistent with presence of lagged effects. Empirical review indicates that the trade deficit initially worsened in 1985 but did not reach its 1985 level until four years later. Subsequent Current Account improvements may have been due to budget deficit declines, rendering the J-curve theory inconclusive. The attractive investment climate in the 1980s caused investors to expand holdings of U.S. assets, which bid up the value of the dollar such that Americans changed their assets for foreign goods and services, causing a Financial Account surplus and Current Account deficit. Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (3) Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued Protectionism Tariffs increase the prices of imports, causing domestic consumers to opt for domestic substitutes. Quotas restrict supply of imports, thereby raising prices and causing domestic consumers to opt for domestic substitutes. Protectionism thus results in increased domestic prices, erosion in purchasing power, and a decline in living standards. Protectionism does not affect the trade balance, as other imports rise or exports fall. By Identity 5.5, as imports fall, exports will fall by an equal amount absent changes in saving or investment. Chapter 5: The Balance of Payments and International Economic Linkages

5.C. Current Account Deficit (4) Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings, continued Increasing savings The prospect of receiving Social Security benefits may negatively affect American’s saving habits. Increase tax-favored savings vehicles Switch from income tax to consumption tax Reduce the government budget deficit