Balance of payments What is the price of a country’s currency? If we know the factors affecting demand & supply, then we shall know the factors influencing exchange rates

Hence, the considerable interest in maintaining a record of the factors behind the supply & demand of a country’s currency Can be visualised as an itemisation of the factors behind the demand & supply of a currency

Why is the BOP account published? To report the country’s international performance in trading with other nations

Factors affecting exports & hence the demand for home currency Home prices v/s comparable goods abroad Foreign income Foreign import duties & quotas

Principles of BOP accounting Double entry bookkeeping It is a cash flow statement Designed to always balance; rules for debits and credits The way it is balanced tells us how a country is doing in its transactions with other countries

Components of BOP Current account Capital/financial account Net errors and omissions Official reserves account

Current account Goods Services Investment income Transfers

Current account balance Fair indicator of a country’s international competitiveness A current account surplus will strengthen the currency

Current account balance Affected by: Inflation A comparatively high economic growth- increase in imports while demand for exports lag behind

Capital / Financial Account Capital account Transfers of financial assets and the acquisition and disposal of non-produced/ non-financial assets

Financial Account Direct investment Portfolio investment Other investment assets/ liabilities

Current & Capital Account Relationship Inverse relation between the current and capital account Countries experiencing large current account deficits “ finance” these purchases through equally large surpluses in the capital account

Official Reserves Account Total reserves held by official monetary authorities within the country. Normally composed of the major currencies used in international trade and financial transactions

Net Errors & Omissions Reasons? Capital Mobility Capital Flight

Link Between Current & Capital Account National Income = Consumption + Savings National spending= Consumption+Investment National Income- National spending = Savings – Investments Savings – Investments = surplus capital ( that must be invested overseas)

i.e Savings = Domestic Inv + Net Foreign Inv Net Foreign Inv= Nation’s net public & private capital flows = capital account deficit

Alternatively, A national savings deficit = capital account surplus( net borrowing from abroad) This borrowing finances the excess of national spending over income.

If we subtract expenses on domestic goods & services from National Product, the remaining goods & services must be exports

Similarly, subtracting spending domestic goods & services from total expenditure, the remaining goods & services must be imports

We have now another national income identity: National Income – National spending = Exports – Imports = Net Foreign Investment

Thus, in a freely floating exchange rate system, The current account balance & the capital account balance must exactly offset each other

Question A deficit or surplus in the current account is it inherently “good” or “bad”?