MAN 441: International Finance The Balance of Payments and International Linkages

2 CHAPTER OVERVIEW I.BALANCE-OF-PAYMENT CATEGORIES II.THE INTERNATIONAL FLOW OF GOODS, SERVICES,AND CAPITAL III.COPING WITH CURRENT ACCOUNT DEFICITS

3 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.

4 BALANCE-OF-PAYMENT CATEGORIES 2.Double-entry bookkeeping a. Currency inflows = credits earn foreign exchange b. Currency outflows = debits expend foreign exchange

5 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.

6 BALANCE-OF-PAYMENT CATEGORIES 5.Capital Account 5.Capital Account a. Function: records public and private investment and lending. b. Inflows = credits c. Outflows = debits

7 BALANCE-OF-PAYMENT CATEGORIES 5.Capital Account (con’t) d. Transactions classified as 1.) Portfolio 2.) Direct 3.) Short term

8 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 b. Reserves consist of 1.) Gold 2.) Convertible securities

9 BALANCE-OF-PAYMENT CATEGORIES 7. Net Effects: a. Sum of all transactions must be zero: 1.) Current account 2.) Capital account 3.) Official reserves

10 BALANCE-OF-PAYMENT CATEGORIES 8.The Balance-of-payment measures a. Some Definitions: 1.) Basic Balance 1.) Basic Balance a.) Consists of current account and long-term capital flows. b.) Emphasizes long-term trends. c.) Excludes short-term capital flows that heavily depend on temporary factors.

11 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. 3.) Official Reserve Transactions Balance Measures adjustments needed by official reserves.

12 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. B.Domestic Savings and Investment and the Capital Account 1.National Income Accounting a.National Income (NI) is either spent (C) or saved (S) a.National Income (NI) is either spent (C) or saved (S) NI = C + S(5.1)

13 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) c. Subtracting (5.2) - (5.1) NI - NS = S - I(5.3) If NI >NS, S > I which implies that surplus capital spent overseas.

14 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.

15 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.

16 THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL C. THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTS 1.Beginning identity NI - NS = X - M(5.4) where X = exports, M = imports X-M=current account balance (CA) 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)

17 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. d.Solutions for Improving CA deficits: 1.) Raise national income (output) relative to national spending. 2.) Increase (S) relative to domestic investment (I).

18 PART III. COPING WITH THE CURRENT ACCOUNT DEFICIT I.POSSIBLE SOLUTIONS UNLIKELY TO WORK: A.Currency Depreciation B. Protectionism

19 COPING WITH THE CURRENT ACCOUNT DEFICIT II.CURRENCY DEPRECIATION A. U.S. Experience: Does not improve the trade deficit.

20 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.

21 THE J - CURVE TIME Net change in trade balance 0 Currency depreciation Trade balance initially deteriorates Trade balance improves

22 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.

23 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

24 COPING WITH THE CURRENT ACCOUNT DEFICIT 2.Deficits may be a solution to the problem of different national propensities to save and invest.