1. The Balance of Payments
The balance of payments is a statistical record of all economic transactions between the residents of the reporting country and residents of the rest of the world. These include purchases or sales of goods, services or financial assets such as bonds, equities and banking transactions.
The statistics are divided into two main sections:
The current account: refer to income flows
The capital account: refers to changes in assets and liabilities
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2. The Balance of Payments
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3. The Balance of Payments
Trade balance: the visible balance, refers to imports and export of goods that can be seen crossing borders. Receipt for exports is a credit; payment for imports is a debit.
The current account balance: also includes the invisible balance, related to activities such as shipping, tourism, insurance, banking, and receipts and payments of interest, dividends and profits.
The capital account balance: records movements of financial capital into and out of the country. Capital inflows (outflows) are recorded as a credit (debit), but they represent a decrease (increase) in a country’s holding of foreign assets or increase (decrease) in liabilities to foreigners.
Official settlements balance: includes a statistical discrepancy for differences between the sum of credits and debits
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4. The Balance of Payments
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5. The Balance of Payments
The Fundamental Balance of Payments Identity
Any international transaction automatically gives rise to two offsetting entries in the balance of payments resulting in a fundamental identity:
Current account + financial account + capital account = 0
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6. The Balance of Payments
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7. The Balance of Payments
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8. Open economy identities
The identity for an open economy is given by:
Deducting taxation we get the disposable income:
Denoting private savings as S = Yd- C we obtain:
Current account deficit has a counterpart in either private dissaving and/or government deficit.
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9. Open economy multipliers
Domestic consumption is partly autonomous and partly determined by national income:
Import expenditure is also assumed to be a linear function of income:
Substituting in the open economy identity and denoting the marginal propensity to save as s = 1 - c we obtain:
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10. Open economy multipliers
The last equation can be transformed into difference form:
The government expenditure multiplier: the effect of increase in government expenditure on income, depends on the marginal propensity to save and the marginal propensity to import:
This is also the multiplier effect of an increase in exports on national income (the foreign trade or export multiplier)
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11. Open economy multipliers
To study the effects of government expenditure and exports on the current account (CA) we can use the previous relationships and write:
This can be expressed in difference form as:
So the current account multipliers are:
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12. US current account deficit
The US economy has been consistently spending abroad more than it has been earning from abroad. In 1982 the US was the world’s biggest creditor nation, but now is the world’s biggest debtor nation.
Source: U.S. Department of Commerce, Bureau of Economic Analysis.
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13. US current account deficit
Its current account deficit in 2009 was $378 billion dollars, so that net foreign wealth continues to decrease.
The value of foreign assets held by the U.S. has grown since 1980, but liabilities of the U.S. (debt held by foreigners) has grown faster.
Source: U.S. Department of Commerce, Bureau of Economic Analysis, June 2010.
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14. US current account deficit
About 70% of foreign assets held by the U.S. are denominated in foreign currencies and almost all of U.S. liabilities (debt) are denominated in dollars.
Changes in the exchange rate influence value of net foreign wealth (gross foreign assets minus gross foreign liabilities).
Appreciation of the value of foreign currencies makes foreign assets held by the U.S. more valuable, but does not change the dollar value of dollar-denominated debt for the U.S.
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15. US current account deficit
For a discussion look at the Economist article:
For some the current-account deficit is a meaningless concept, it just means that the US have a lot of capital inflows.
The CA is the sum of the trade deficit and interest payments to foreigners on previous borrowing.
US can borrow in its own currency and has the world’s largest and most liquid stock and bond markets, therefore it can borrow more than others.
This can only continue if the interest rates it pays remain low.
The US external debt represents a lower domestic income drain than other countries at just around 25% of GDP.
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16. EC3067 International Finance
Elasticity approach
Elasticity approach provides an analysis of the effects of a devaluation (depreciation) of exchange rate on the current account balance.
There are two effects of a devaluation of a country’s currency:
Price effect: Exports become cheaper measured in foreign currency – contributes to worsening CA
Volume effect: As exports become cheaper there should be an increase in the volume of exports – contributes to improving CA
The net effect will depend on the dominating effect.
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17. EC3067 International Finance
Elasticity approach
The CA balance expressed in terms of the domestic currency is given by:
Simplifying by setting the domestic (P) and foreign price (P*) levels to 1, we get:
where S is the exchange rate (domestic currency units per unit of foreign currency).
Taking differences and dividing by changes in the exchange rate we get:
(1)
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18. EC3067 International Finance
Elasticity approach
Price elasticity of demand for exports ηx: is the percentage change in exports caused by a 1% change in the exchange rate. So we can write:
Price elasticity of demand for imports ηm: is the percentage change in imports caused by a 1% change in the exchange rate. So we can write:
Therefore we can substitute into (1) and get the Marshall-Lerner condition:
Starting from a balanced CA, a devaluation will improve CA only if the sum of the elasticities is greater than 1.
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19. EC3067 International Finance
Elasticity approach
Original exchange rate is £0.5/$1. After devaluation is becomes £0.666/$1.
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20. EC3067 International Finance
Elasticity approach
Difference between short-run and long-run responses (the J-curve-effect).
In the short run the volume effect is small, so devaluation can lead to deterioration of the CA, while in the long-run the Marshall-Lerner condition is generally met.
Some explanations:
Delayed consumer responses
Delayed producer responses
Imperfect competition
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21. EC3067 International Finance
Absorption approach
Changes in exports and imports will have effects in national income, so this approach concentrates on how currency devaluation affect income. Remember the equation for national income:
Domestic absorption is the sum of consumption, investment and government spending, so we can write:
So the current account balance represents the difference between domestic output and domestic absorption. The effects of a devaluation on CA will depend upon how it affects national income relative to how it affects domestic absorption:
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22. EC3067 International Finance
Absorption approach
Absorption can be divided into direct absorption Ad and a linear function of income, where the proportional of change is given by marginal propensity to absorb, a.
A devaluation can affect CA by changing the marginal propensity to absorb, changing the level of income, and by affecting direct absorption:
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23. EC3067 International Finance
Absorption approach
Effects of devaluation on national income:
Employment effect: at less than full employment and if the Marshell-Lerner condition is satisfied, a devaluation will increase national income via the foreign trade multiplier.
Terms of trade effect: terms of trade are the price of exports divided by the price of imports. A devaluation deteriorates terms of trade, so terms of trade lower national income.
Overall effects are ambiguous.
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24. EC3067 International Finance
Absorption approach
Effects of devaluation on direct absorption:
Real balance effect: a devaluation will lead to a raise in consumer price index. To maintain the amount of real money balances, agents will have to increase their money balances by selling bonds therefore raising domestic interest rate. This rise in interest rates will reduce investment and consumption, so reduce direct absorption.
Income redistribution effect: to which extent does a devaluation redistributes income form those with a low propensity to absorb (those on variable incomes, firms) to those with a high marginal propensity to absorb (those on fixed incomes), therefore increasing direct absorption?
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25. EC3067 International Finance
Absorption approach
Money illusion effect: devaluation raises prices, but some agents may suffer from money illusion and don’t change their behaviour, therefore increasing direct absorption. The opposite can also happen. Whatever the direction this should only be a smal temporary effect.
Expectational effects.
Laursen-Metzler effect: deteriorations in terms of trade have an income effect and a substitution effect. If the positive substitution effect (towards domestically produced goods) outweigths the negative income effect, a devaluation may lead to a rise in absorption.
Again the effects of a devaluation on direct absorption are ambiguous.
However, a devaluation is more likely to succeed if it is accompanied by income policy measures that concentrate on raising income while constraining absorption.
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