AP Macro: Unit 7

“The Open Economy: International Trade and Finance”

Balance of PaymentsIn a closed economy, economists keep track of transactions with the national income account (GDP).

In an open economy, (with international trade) they keep track with the “balance of payments accounts.”

Balance of PaymentsDefinition: a summary of a country’s transactions with other countries

Example: The Ryan family farm

• $100,000 revenue from selling rhubarb• Spent $110,000 on purchase of machinery,

buying food, paying bills, etc.• Received $500 in interest on bank account,

but paid $10,000 interest on mortgage• Took out a $25,000 loan for farm

improvements

The Ryan Financial Year

• Cash: spent $110,000; made $100,000 Net -$10,000

• Interest: spent $10,000; made $500 Net -$9,500

• Loans/Deposits: borrowed $25,000; deposited $5,500 after covering losses Net $19,500

• Balance $0

Sources of cash Uses of cash Net

Purchases/sales of G&SRhubarb sales:

$100,000 Expenses: $110,000 ($10,000)

Interest PaymentsBank acct revenue:

$500 Mortgage: $10,000 ($9,500)

Loans/deposits New loan: $25.000 Bank deposit: $5,500 $19,500

Total $125, 500 $125,500 $0

The Ryan’s Financial Year

Balance of Payments

• When a U.S. resident sells a good, such as wheat, to a foreigner, that’s the end of the transaction.

• But a financial asset, such as a bond, is different. That sale creates a liability in the future.

• The balance of payments accounts distinguish between transactions that create liabilities and those that don’t.

Current Account

• Transactions that don’t create liabilities are part of the current account

• This is primarily the balance of payments on goods and services

• The difference between the value of exports and the value of imports (in Unit 2 we called this “net exports”)

Financial Account

• Transactions that involve the sale or purchase of assets, and therefore create future liabilities, are part of the financial account (we used to call this the capital account)

Current / Financial Account

• General Rule: Current Account + Financial Account = 0

• The sources of cash must equal the uses of cash

• Remember the circular flow: one person’s (or country’s) expenses are another person’s (or country’s) income

United StatesRest of World

Payments to the rest of the world for assets

Payments to the United States for assets

Payments to the rest of the world for G&S(negative component of U.S. current acct)

Payments to the United States for G&S(positive component of U.S. current acct)

Payments from

foreignersPmts to

foreigners NetSales/ purchases of G&S $1,827 $2,523 ($696)Factor income $765 $646 $119 Transfers ($128)Current Account Balance ($705) Gov't Asset sales/purchases $487 $530 ($43)Private asset sales/purchases $47 ($534) $581 Financial Account Balance $538 Total ($167)

Note: -$167 is just a statistical error. Not bad when managing $3.5T!

The U.S. Balance of Payments in 2008 (billions of dollars)

Review Q: The current account plus the financial account is equal to:

a. Zerob. Onec. The trade balanced. The size of the trade deficite. Sorry, I’ve been napping.

Financial Account

• Measures capital inflows from foreign savings that become available for domestic investment

• Which brings us back to our good friend: the market for loanable funds

• Let’s look at the loanable funds market in two economies: Shieldsville and Mocabeetown