The Balance of Payments

© 2002 by Stefano Mazzotta 1 Learning Outcomes 1. Definition of the balance of payments (BOP) and its accounts 2. Some macroeconomic relations 3. The link between BOP and exchange rates 4. Comments on current account deficit

1. Definition of the Balance of Payments and its Accounts

© 2002 by Stefano Mazzotta 3 The definition of BOP It is a statistical statement of all economic and financial transactions between the home country and the rest of the world during a certain time period. The net of all transactions affects the country’s international monetary reserves.

© 2002 by Stefano Mazzotta 4 What are the types of transactions? Exports of goods and services Imports of goods and services Gifts and other “one-sided” payments Income flows Capital flows

© 2002 by Stefano Mazzotta 5 The importance of the BOP Helps forecast a country’s economic potential, especially in the short run, and its competitiveness on the world markets. Indicates the pressure on a country’s foreign reserves and its currency.

© 2002 by Stefano Mazzotta 6 BOP accounts They are records of different transactions. –Any payment out is recorded as a debit (“-”) –Any payment in is recorded as a credit (“+”) Types of accounts –Current account (CA) –Capital account (KA) –Official reserves account (ORA)

© 2002 by Stefano Mazzotta 7 Current account (CA) It is the net flow of goods, services, and unilateral transactions (gifts) between countries. Example: DebitsCredits Gift to a foreignerExport of wheat Import of coffeeProfits from a US firm abroad Tourists in GermanyLeasing a ship to India

© 2002 by Stefano Mazzotta 8 Capital account (KA) It is the net result of public and private international investment and lending activities. Example: Debits Credits Purchase of JPYSale of JPY (Yen) Receipt of CHFPayment for shares.

© 2002 by Stefano Mazzotta 9 Official reserves account (ORA) It is the net holdings of gold and foreign currencies by official monetary institutions. Example: Debits Credits Purchase of EUR Sale of gold

© 2002 by Stefano Mazzotta 10 Deficit vs. surplus A country incurs a deficit (of one of its accounts), if it spends abroad more than what it earns or receives from other countries. Debits > Credits A country incurs a surplus, if it spends abroad less than what it earns or receives from other countries. Debits < Credits

© 2002 by Stefano Mazzotta 11 Relations among BOP accounts Since each account is a net supply or demand for a currency, CA + KA + ORA = 0 CA + KA = BOP Therefore, BOP = -ORA

2. Some Macroeconomic Relations

© 2002 by Stefano Mazzotta 13 Notations Y - national incomeC - private consumption I - investmentG - government expenditure X - exports M - imports S - savingsT - taxes RF - net transfers from foreigners RI - net investment income (the difference between the income of citizens of a given country abroad and foreign citizens in that country)

© 2002 by Stefano Mazzotta 14 GNP vs. GDP GNP - gross national product produced by citizens of a given country GDP - gross domestic product produced within the borders of a given country A question: What is larger: GDP or GNP?

© 2002 by Stefano Mazzotta 15 Major macroeconomic relations Y = GNP + RF GNP = C + I + G + X - M GDP = GNP - RI

© 2002 by Stefano Mazzotta 16 More relations Y = C + I + G + X - M + RF = C + S + T E = C + I + G = C + I + G Y - E = X - M + RF = (S - I) + (T - G) CA = X - M + RF

© 2002 by Stefano Mazzotta 17 How to understand these relations If a country’s expenditure is more than its income, that is, Y - E < 0, then that country: –Imports more than exports –Invests more than saves –Runs a government budget deficit If a country’s expenditure is less than its income, that is, Y - E > 0, then that country: –Exports more than imports –Saves more than invests –Runs a government budget surplus

3. The Link between BOP and Exchange Rates

© 2002 by Stefano Mazzotta 19 Relation of BOP to exchange rates: Floating exchange rates Under floating exchange rate regime (“free float”), the exchange rate is determined by the laws of supply and demand. This means no government intervention. Therefore, ORA = 0 orCA = - KA

© 2002 by Stefano Mazzotta 20 Determinants of home currency supply and demand: floating rates What does increase the demand for home currency? –Exports –Foreign investment in the home country What does increase the supply for home currency? –Imports –Home country investment abroad

© 2002 by Stefano Mazzotta 21 Economic intuition behind CA < 0 The current account deficit implies that –imports > exports –the current supply of home currency > the current demand for home currency –there exists a net demand for “investments” in home currency –there is more investments by foreigners in a country than by country’s citizens abroad –KA is in surplus

© 2002 by Stefano Mazzotta 22 Economic intuition behind CA > 0 Current account surplus implies that –imports < exports –the current supply of home currency < the current demand for home currency –there exists a net supply for “investments” in home currency –there is less investments by foreigners in a country than by country’s citizens abroad –KA is in deficit

© 2002 by Stefano Mazzotta 23 Relation of BP to exchange rates: Fixed exchange rates Under fixed exchange rates the exchange rate is fixed or varies within a narrow band. Any excess market demand for a home currency is supplied by the government. Any excess market supply for a home currency is adsorbed by the government. Therefore, CA = - (KA + ORA)

© 2002 by Stefano Mazzotta 24 Determinants of home currency supply and demand: fixed rates What does increase the demand for home currency? –Exports –Foreign investment in the home country –Government’s purchase of the home currency What does increase the supply for home currency? –Imports –Home country investment abroad –Government’s sell of the home currency

4. Comments on Current Account deficit

© 2002 by Stefano Mazzotta 26 How to “cure” the CA deficit: Argument 1 Make home currency depreciate: –Increase the demand for home products abroad –Decrease the demand for foreign products at home –Decrease the amount of foreign investments

© 2002 by Stefano Mazzotta 27 The U.S. evidence In the mid 1980s, the U.S. dollar was very strong Foreign investment in the U.S. decreased The demand for and, as a result, the value of the U.S. dollar declined There was some increase in exports

© 2002 by Stefano Mazzotta 28 Did it work? - No! The CA deficit did not decline Why? The U.S. continued to spend in excess of its national income (Y - E < 0)

© 2002 by Stefano Mazzotta 29 How to “cure” the CA deficit: Argument 2 Introduce import restrictions: –Prohibit import of particular products –Increase the price of imports –Introduce quotas on foreign goods

© 2002 by Stefano Mazzotta 30 Will it work? – Not sure Restriction of foreign goods decrease domestic demand for foreign currency Home currency appreciates Exports become more expensive for foreigners The volume of exports decrease There is less trade between home country and outside world Everyone has lost

© 2002 by Stefano Mazzotta 31 Conclusions With floating exchange rates, any given value of the home currency can neither cause problems in the balance of payments nor solve them. While there is a fundamental linkage between exchange rates and the balance of payments, things sometimes work differently. Current account deficit is not necessarily a bad thing.