1. Lecture 13: Balance of Payments Benjamin Graham

2. Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham
The U.S. has a “floating” exchange rate
Some other countries peg to the U.S. Dollar
Upside: stability, which allows borrowing & investing
Downsides: 1. no flexibility to have inflation during recessions
2. Currency crises
Also M3, which includes some other large time deposits and long-term deposits
Lecture 12: Money, Exchange Rates, and Interest Rates Benjamin Graham

3. Currency Unions Many countries use the Euro, some use the US Dollar
An unbreakable peg
Upsides: stability, ease of borrowing & trade
Downsides: No inflation during recession
Also M3, which includes some other large time deposits and long-term deposits

4. Current Account Balance
X-M
Exports - Imports
Y - (C + I + G)
Total income – (private consumption + investment + government spending)
A current account surplus is when exports are greater than imports
A current account deficit is the reverse
Note: The government’s surplus/deficit is T - G
(taxes - government spending)
This is different that the current account balance, but it affects the current account balance
Also M3, which includes some other large time deposits and long-term deposits

5. Capital Account Balance
Current Account refers to goods and services (trade)
Capital account refers to capital
If you run a current account deficit you have to borrow to cover it
That borrowing is a capital account surplus (take in more capital than you send out)
And vice versa
Also M3, which includes some other large time deposits and long-term deposits
Lecture 13: Balance of Payments Benjamin Graham

6. International Accounting Identities
National Income = Domestic consumption + taxes + savings
Exports balance with imports
If this doesn’t balance: trade deficit/surplus
Taxes balance with government spending
If this doesn’t balance: government deficit/surplus
Savings balance with investment
If this doesn’t balance, it’s a capital account surplus/deficit
Also M3, which includes some other large time deposits and long-term deposits
Lecture 13: Balance of Payments Benjamin Graham

7. International Accounting Identities
National Income = Domestic consumption + taxes + savings
National Income + Imports = Domestic consumption + Government consumption + Investment + Exports
Exports – Imports = National Income - (Domestic Consumption + Investment + Government Spending)
Also M3, which includes some other large time deposits and long-term deposits
Lecture 13: Balance of Payments Benjamin Graham

8. International Accounting Identities
Y = C + T + S eq. 1
Y + M = C + G + I + X eq. 2
X - M = Y - (C + I + G) eq. 3
X - M = (C + T + S) - (C + I + G) = (S - I) + (T - G) eq. 4
First at the individual level
X = Exports M = Imports
Y = National Income C = Domestic consumption S = Savings I = Investment
T = Taxes G = Government consumption
Lecture 13: Balance of Payments Benjamin Graham

9. Lecture 13: Balance of Payments Benjamin Graham

10. Is a current account deficit bad?
Actually, it’s fun!
You are spending and investing more than you are producing
But you acquire debt
Both public and private
Too much debt -> crisis
Lecture 13: Balance of Payments Benjamin Graham

11. What to do about a current account deficit?
If you have a fiat currency, one tempting solution is:
Change the exchange rate
Create inflation (print money) to deflate the value of your currency.
Your exports become cheaper in other countries
They buy more
Imports into your country from abroad become more expensive
Your citizens buy less of them
Lecture 13: Balance of Payments Benjamin Graham

12. What to do about a current account deficit?
Change the exhange rate
Create inflation (print money) to deflate the value of your currency.
Your exports become cheaper in other countries
They buy more
Imports into your country from abroad become more expensive
Your citizens buy less of them

13. What to do about a current account deficit?
Change the exhange rate
Create inflation (print money) to deflate the value of your currency.
Your exports become cheaper in other countries
They buy more
Imports into your country from abroad become more expensive
Your citizens buy less of them
POLI 12: Lecture Benjamin Graham

14. Lecture 13: Balance of Payments Benjamin Graham
Clicker Question
If the US allows the dollar to depreciate in value, what are the effects?
Our exports become cheaper and more competitive abroad
Our exports become more expensive and less competitive abroad
Imported goods become more expensive
Imported goods become less expensive
Both A and C
Lecture 13: Balance of Payments Benjamin Graham

15. Lecture 13: Balance of Payments Benjamin Graham
Clicker Question
If the US allows the dollar to depreciate in value, what are the effects?
This is bad for retirees on fixed incomes, because their dollars buy less.
This is good for people with a lot of debt (like a mortgage).
This is bad for people with a lot of debt (like a mortgage).
Both A and B
Both A and C
Lecture 13: Balance of Payments Benjamin Graham

16. Lecture 13: Balance of Payments Benjamin Graham
How can we eliminate a current account deficit if our exchange rate is fixed?
Not everyone has a floating currency, some are pegged
And Eurozone countries don’t control their own currency
X-M = (S-I) + (T-G)
Exports - Imports = (Savings - Investment) + (Taxes - Government Consumption)
To fix a current account deficit, we can either:
Boost savings
Reduce investment
Raise taxes
Reduce government spending
Lecture 13: Balance of Payments Benjamin Graham

17. Lecture 13: Balance of Payments Benjamin Graham
How can we eliminate a current account deficit if our exchange rate is fixed?
X-M = (S-I) + (T-G)
Exports - Imports = (Savings - Investment) + (Taxes - Government Consumption)
To fix a current account deficit, we can either:
Boost savings (less spending)
Reduce investment (less capital per worker, lower productivity)
Raise taxes (disincentive for work, also less spending)
Reduce government spending (less spending)
All of these things reduce growth
Eurozone countries will suffer to fix current account deficits
Lecture 13: Balance of Payments Benjamin Graham

18. Checking understanding: The current account
Which of the following improve a country’s current account balance (i.e. reduce a current account deficit)?
Increasing government spending
Increasing private sector investment
Increasing household savings
A and B
B and C
Lecture 13: Balance of Payments Benjamin Graham

19. Borrowing Abroad: The Temporary Fix
Balance of Payments = (X-M) - net foreign assets
Exports - Imports = (Savings - Investment) + (Taxes - Government Consumption)
If you have a current account deficit:
You can borrow money from abroad to cover it
Sell off assets to foreigners
If you have a current account surplus:
Loan money to other countries
Use the surplus to buy assets (e.g. real estate, companies) in other countries.
This only works for so long. As the debt grows, will or can the borrowing country repay?
Lecture 13: Balance of Payments Benjamin Graham

20. Over-borrowing and Debt Crises
Step 1: The debt is growing, questions arise about the country’s willingness or ability to pay it all back.
Step 2: Cautious investors pull back or demand higher interest to cover the higher risk.
Step 3: Higher interest payments make the current account deficit worse, debt rises more.
Step 4: More investors pull back, interest rates rise more, debt gets bigger, and so on...
When you can’t borrow enough to cover your current account deficit, we call this a “balance of payments” crisis.
Lecture 13: Balance of Payments Benjamin Graham

21. Checking Understanding
How long can a country keep borrowing to cover a current account deficit?
Forever
Until debt reaches the size of GDP
Until lenders get scared that the country can’t afford to pay back its loans
Lecture 13: Balance of Payments Benjamin Graham

22. Checking Understanding
How do currency crises start?
As lenders get scared, interest rates fall, causing the country to borrow more
As lenders get scared, interest rates rise, making the existing debt even harder to pay back
Currency crises usually start with a default by the government
Lecture 13: Balance of Payments Benjamin Graham