1. INTERNATIONAL ECONOMICS, 15E Robert Carbaugh © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. The Balance-of-Payments Chapter 10 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Chapter Outline Double Entry Accounting Double Entry Accounting Balance-of-Payments Structure Balance-of-Payments Structure U.S. Balance-of-Payments U.S. Balance-of-Payments What Does a Current Account Deficit (Surplus) Mean? What Does a Current Account Deficit (Surplus) Mean? Balance of International Indebtedness Balance of International Indebtedness The Dollar as the World’s Reserve Currency The Dollar as the World’s Reserve Currency © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. The Balance of Payments The Balance-of-Payments is a record of the economic transactions between the residents of one country and the rest of the world Records are kept annually and quarterly An international transaction is an exchange of goods, services, or assets between residents of one country and those of another ◦ Residents include businesses, individuals and government agencies that make the country their legal domicile © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Double Entry Accounting (1 of 2) Arranging international transactions into a balance-of-payments account requires that each transaction be entered as a credit or a debit – Double Entry Accounting ◦ A credit transaction results in a receipt of a payment from foreigners; recorded with a + ◦ A debit transaction is one that leads to a payment to foreigners; recorded with a - © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Double Entry Accounting (2 of 2) Examples of credits  Income received from investments abroad  Gifts received from foreign residents  Aid received from foreign governments  Investments in the U.S. by overseas residents Examples of Debits  Merchandise imports  Transportation and travel expenditures  Income paid on the investments of foreigners  Gifts to foreign residents  Overseas investment by U.S. residents © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Balance-of-Payments Structure (1 of 5) Current Account ◦ The monetary value of international flows associated with transactions in goods, services, income flows, and unilateral transfers ◦ Merchandise trade balance includes all goods the U.S. exports or imports; combining exports & imports gives the merchandise trade balance  When balance is negative, trade deficit  When balance is positive, trade surplus © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Balance-of-Payments Structure (2 of 5) Capital and Financial Account ◦ Transactions include all international purchases or sales of assets, including private sector and central bank transactions ◦ Broadly defined to include titles to real estate, corporate stocks & bonds, government securities and ordinary commercial bank deposits ◦ Major types of capital transfers are debt forgiveness and migrants’ goods and financial assets accompanying them as they leave or enter the country ◦ Includes the sale and purchase of rights to natural resources, patents, copyrights, trademarks, and more © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Figure 10.1- International Payments Process © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Balance-of-Payments Structure (3 of 5) Official Settlements Transactions ◦ The movement of financial assets among official holders such as the U.S. Federal Reserve and Bank of England  Official reserve assets (U.S. government assets abroad)  Liabilities to foreign official agencies (foreign official assets in the U.S.) ◦ Official holds of reserves used for two purposes  Provide a country sufficient international liquidity to finance short run trade deficits, currency crises, etc.  Central banks sometimes buy or sell official reserve assets in the private sector to stabilize their currencies’ exchange rates © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Balance-of-Payments Structure (4 of 5) Official reserve assets ◦ Stock of gold reserves held by U.S. Government ◦ Convertible currencies such as Japanese yen, readily acceptable as payment for international transactions ◦ Reserve position that U.S. maintains in International Monetary Fund ◦ Special drawing rights, a new reserve asset  Can be transferred among nations in settlement of balance-of-payments deficits or stabilization of exchange rates  Defined as the basket of currencies which includes U.S. dollar, Japanese yen, UK pound, and the euro © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Table 10.1- U.S. Reserve Assets, 2013 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Table 10.2- Selected U.S. Liabilities to Foreign Official Institutions, 2013 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Balance-of-Payments Structure (5 of 5) Statistical Discrepancy: Errors & Omissions ◦ Data collection process for balance-of-payments figures imperfect ◦ Government statisticians base figures partly on information collected & partly on estimates ◦ When statisticians sum credits & debits, rarely match ◦ Since debits must equal credits, insert a residual to make them equal ◦ This correcting entry is statistical discrepancy, or errors and omissions © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. U.S. Balance-of-Payments (1 of 2) The merchandise trade balance, commonly referred to as the trade balance In 2011, U.S. had a merchandise trade deficit of -$738.4 billion, resulting from difference between U.S. merchandise exports and imports Trade deficits not popular with U.S. residents & policymakers ◦ Negatively affect terms-of-trade, employment levels, stability of international money markets © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Table 10.3- U.S. Balance-of- Payments, 2011(billions of dollars) © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Table 10.4- U.S. Balance-of-Payments, 1980-2012… © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. U.S. Balance-of-Payments (2 of 2) Taken as a whole, U.S. international transactions always balance ◦ Any force leading to an increase or decrease in one balance-of-payments account leads to exactly offsetting changes in balances of other accounts ◦ In Table 10.3, U.S. had deficit of -$465.9 billion ◦ Offsetting this deficit was a combined surplus of $465.9 billion in remaining capital & financial accounts © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. What Does a Current Account Deficit (Surplus) Mean? (1 of 11) Net Foreign Investment & the Current Account Balance ◦ Current account balance synonymous with net foreign investment in national income acctg  Current account surplus means an excess of exports over imports; nation becomes a lender to rest of world  Current account deficit means an excess of imports over exports; nation becomes a borrower of funds from rest of world © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. What Does a Current Account Deficit (Surplus) Mean? (2 of 11) Impact of Capital Flows on Current Account ◦ Capital and financial flows can initiate changes in the current account  1980s, a massive financial inflow caused a current account deficit for the U.S., a result of an increase in the U.S. interest rate relative to interest rates abroad  Higher interest rate because of U.S.’ growing budget deficit and decline in private savings rate  It may be that current account deficit is driven by capital flows: capital inflows keep dollar stronger than it would be, boosting imports and suppressing exports, thus leading to a current account deficit © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. What Does a Current Account Deficit (Surplus) Mean? (3 of 11) Is a Current Account Deficit a Problem? ◦ Current account deficit arises because domestic economy spends more than it produces  Excess of demand met by net inflow of foreign goods and services leading to deficit  Problem? Not necessarily  Foreign capital inflows augment domestic sources, and keep domestic interest rates lower than they would be  Benefit of deficit is ability to spend more than produce  Cost is debt service that must be paid on borrowing © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. What Does a Current Account Deficit (Surplus) Mean? (4 of 11) Is a Current Account Deficit a Problem? (cont.) ◦ Is it good or bad for country to incur debt?  Depends on whether the deficit used to finance more consumption or more investment  If used for investment, burden slight  If used for consumption, no boost to future productivity  To meet debt service expense, future consumption must be reduced  1980s, U.S. domestic saving decreased; U.S. used foreign borrowing to increase current consumption  1990s, deficits driven by increases in domestic investment, made possible by foreign lending to U.S. © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Table 10.5- Global Production & Manufacturing Cost of the iPhone © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. What Does a Current Account Deficit (Surplus) Mean? (5 of 11) Business Cycles, Economic Growth, and the Current Account ◦ Rapid growth of production & employment associated with growing trade & current account deficits ◦ Slow output & employment growth associated with growing surpluses ◦ During recession, saving & investment tend to fall; current account balance tends to rise; trade balance improves ◦ Opposite occurs during periods of boom © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. What Does a Current Account Deficit (Surplus) Mean? (6 of 11) How U.S. Has Borrowed at Very Low Cost ◦ Past 4 decades, U.S. current account has moved from a small surplus to a large deficit, financed either by borrowing from or selling assets to foreigners ◦ U.S. has become a large net debtor; must make larger payments of interest & principal to foreign lenders ◦ Past 2 decades, paradox: U.S. residents earned more from foreign investments than foreigners earn from U.S. investments  U.S. has been able to be a large debtor nation without bearing negative debt service cost; current account deficits might be less burdensome than portrayed © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. What Does a Current Account Deficit (Surplus) Mean? (7 of 11) How U.S. Has Borrowed at Very Low Cost ◦ What accounts for paradox?  Asymmetric investment returns; rate of return advantage has generally been 1-2% points; U.S. firms take greater risks investing in foreign firms because of political and economic instability; higher risk, reward  U.S. considered a safe haven; foreign investors more likely to buy U.S. assets that offer low risk, return ◦ Future U.S. borrowing may not be as favorable  If interest rates rise, U.S. will pay higher rates  Could swing U.S. investment income balance from surplus to deficit © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. What Does a Current Account Deficit (Surplus) Mean? (8 of 11) Do Current Account Deficits Cost Americans Jobs? ◦ Per Federal Reserve Bank of New York & Cato Institute, employment statistics do not confirm  Trade deficit may hurt employment at some firms & industries as workers displaced by imports, but  Economy wide, deficit matched by equal inflow of foreign funds sustaining investment spending that would otherwise not occur  Current Account deficit produces jobs for the economy from higher employment in investment oriented industries and from indirect effect of higher investment © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. What Does a Current Account Deficit (Surplus) Mean? (9 of 11) Can the U.S. Continue to Run Current Account Deficits Indefinitely? ◦ Foreigners have remained willing buy U.S. assets such as Treasury securities ◦ Large increase in U.S. current account deficit not possible without inflows of foreign capital from nations with high savings rates such as Japan & China ◦ China is a major supplier of capital to the U.S.  China’s exchange rate policy of keeping value of its yuan low to export goods to U.S. & create jobs for its workers © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Table 10.6- Foreign Holders of U.S. Securities as of 2012 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. What Does a Current Account Deficit (Surplus) Mean? (10 of 11) Can the U.S. Continue to Run Current Account Deficits Indefinitely? ◦ China’s central bank has converted its dollar holdings into U.S. securities that pay interest  Puts U.S. in unique position to benefit from willingness of China to finance current account deficit  U.S. can “print money” that Chinese hold in order to finance its excess spending  Some analysts concerned that Chinese investors may view increasing U.S. foreign debt as unsustainable or more risky, and shift their capital elsewhere  U.S. also politically reliant on China, giving it leverage © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. What Does a Current Account Deficit (Surplus) Mean? (11 of 11) Can the U.S. Continue to Run Current Account Deficits Indefinitely? (cont.) ◦ No automatic or economic reasons why U.S. cannot sustain current account deficit indefinitely as long as foreigners desire to purchase U.S. assets ◦ Consequence of current account deficit is growing foreign ownership of capital stock of U.S., and rising fraction of U.S. income that must be paid as interest & dividends to foreigners  Serious problem could emerge if foreigners lose confidence inability of U.S. to repay © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

32. Balance of International Indebtedness (1 of 3) Balance of international indebtedness ◦ A statement that summarizes a fixed stock of assets and liabilities against the rest of the world ◦ Record of the international position of the U.S. at a particular time ◦ Accumulated value of U.S.-owned assets abroad ◦ When accumulated value of U.S. owned assets abroad exceeds value of foreign-owned assets in U.S., U.S. is a net creditor to rest of world © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

33. Balance of International Indebtedness (2 of 3) Balance of international indebtedness (cont.) ◦ When reverse occurs, U.S. is a net debtor ◦ Balance of international indebtedness breaks down international investment holdings into several categories so that policy implications can be drawn from each separate category about the liquidity status of the nation © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

34. Balance of International Indebtedness (3 of 3) U.S. As a Debtor Nation ◦ In early industrial development, U.S. was a net international debtor, relying on foreign funds to build its industries ◦ After World War I, U.S. became a net international creditor ◦ By 1987, U.S. had become a net international debtor and has continued in that position ◦ Foreign investors placed more funds in U.S. than U.S. residents invested abroad © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

35. Table 10.7- International Investment Position of U.S. at Year-End… © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

36. The Dollar as the World’s Reserve Currency (1 of 5) Dollar is the main reserve currency in world today 2/3 of world’s official foreign exchange reserves held in dollars 4/5 of daily foreign exchange trades involve dollars Euro, second most important reserve currency, lags far behind dollar But widening trade deficits & expanding foreign debt of U.S. have weakened prestige of dollar Widespread use of dollar makes it difficult to displace as world’s main reserve currency © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

37. The Dollar as the World’s Reserve Currency (2 of 5) Benefits to the United States ◦ Americans can purchase products at marginally cheaper rate than nations that must exchange their currency and pay a transaction cost ◦ Americans can borrow at lower interest rates for homes & autos, & U.S. government can finance larger deficits longer and at lower interest rates ◦ U.S. can issue debt in its own currency, pushing exchange rate risk onto foreign lenders  Fall in dollar’s value could wipe out their returns © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

38. The Dollar as the World’s Reserve Currency (3 of 5) Benefits to the United States (cont.) ◦ But rising concern about continuing role of dollar as world’s main reserve currency  China fears that U.S. digging a hole with economy based on huge deficits & massive borrowing  Worries about volatility of dollar & destabilizing effect it can have on international trade & finance  Critics claim credit based reserve currency (dollar) inherently risky, promotes spread of financial crises ◦ Alternatives: not British pound (past), not Chinese yuan (future), not euro © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

39. The Dollar as the World’s Reserve Currency (4 of 5) A New Reserve Currency? ◦ In 2009, China proposed an overhaul of international monetary system in which special drawing right would eventually replace the dollar as the world’s main reserve currency  Disconnected from a single country  Stable in the long run ◦ Chinese advocated new reserve currency based on a basket of currencies  SDR now based on euro, yen, pound, and dollar based on their importance in trade & finance © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

40. The Dollar as the World’s Reserve Currency (5 of 5) A New Reserve Currency? (cont.) ◦ 2009, China proposed that currency basket be expanded to include all major currencies, including Chinese yuan and Russian ruble  SDR would be managed by International Monetary Fund  Several steps would be necessary to broaden SDR’s use so that it could be used as a reserve currency  Benefit: currency risk would be diversified  Pitfall: SDR backed only by good faith ◦ For U.S. costly to lose reserve currency position © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.