Lecture 7: Balance of Payments - UT · PDF fileMercian Bicycles in Darby England. ... Balance on Capital Account $444.26 ... Balance of Payments and the Exchange Rate

International FinanceFINA 5331

Lecture 7: Balance of Payments

William J. Crowder Ph.D.

Balance of Payments Accounting

• The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping.

N.B. when we say “a country’s balance of payments” we are referring to the transactions of its citizens and government.

Balance of Payments Example

• Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England.

• There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account.

• This will lead to a rise in the supply of dollars and the demand for British pounds.

• The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations.

• They are composed of the following:– The Current Account– The Capital Account– The Official Reserves Account– Statistical Discrepancy

Balance of Payments Accounts

The Current Account

• Includes all imports and exports of goods and services (invisible trade).

• Includes unilateral transfers of foreign aid.• If the debits exceed the credits, then a

country is running a trade deficit.• If the credits exceed the debits, then a

country is running a trade surplus.• It is thought that the CA responds to changes

in income and the exchange rate.

The Current Account• A credit on the current account results in

foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).

• A debit on the current account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Current Account• When a domestic company sells goods or services to

a foreign resident, there will be a credit recorded on the current account.

• When a domestic resident buys goods or services from a foreign firm, there will be a debit recorded on the current account.

• When a foreign asset pays interest to a domestic resident, or a domestic resident earns income in the foreign economy, there will be a credit recorded on the current account.

• When a domestic asset pays interest to a foreign resident, or a foreign resident earns income in the domestic economy, there will be a debit recorded on the current account.

What affects the CA?

CA deficit

0

CA(S0)

CA surplus

Domestic Income (Y)

Y0

Given the exchange rate, S0, there exists some domestic income level, Y0, where the current account is balanced.


CA deficit

0

CA(S0)

CA surplus

Domestic Income (Y)

Y0

Y1

An increase in income, Y, will cause imports to rise with no change in exports leading to a deterioration in the current account.


CA(S1)CA deficit

0

CA(S0)

CA surplus

Domestic Income (Y)

Y0 Y1

S ↑ → domestic depreciation causing imports to fall and exports to rise, both of which lead to an improvement in the current account.

J-curve Effect

What conditions are necessary for J-curve effect?

εIM is the import demand elasticity = %Δimports divided by %ΔSt.

When εIM is greater than one (in absolute value), a domestic depreciation will lead to a fall in the dollar value of imports. Import demand is said to be elastic.

When εIM is equal to one (in absolute value), a domestic depreciation will not change the dollar value of imports.

When εIM is less than one (in absolute value), a domestic depreciation will lead to a rise in the dollar value of imports. Import demand is inelastic.

The J-curve can only occur when import demand elasticities are inelastic.

Algebra of Import Demand Elasticities

$ value of imports t importsS Q= ×

% $ value of imports % %t importsS QΔ = Δ + Δ

%% $ value of imports % 1% % %

imports IMt

t t t

QSS S S

εΔΔ Δ

= + = +Δ Δ Δ

Since 0 and % 0,

0 if unit elasticity% $ value of imports 0 if elastic

%0 if inelastic

IMt

t

S

S

ε < Δ >

=⎧ ⎫Δ ⎪ ⎪<⎨ ⎬Δ ⎪ ⎪>⎩ ⎭

Will a depreciation increase your company’s exports?

• That depends on the elasticity of demand for your product.• A domestic depreciation will make your products less expensive to

foreign residents.• The law of demand tells us that quantity demanded will be higher.• But if the price falls by more than the quantity rises (inelastic

demand), total sales will be less.• An inelastic export demand will lead to lower sales. Your company

would be better off with a domestic appreciation!

• To determine the effect on company export sales of a change in St, one needs to know the foreign demand elasticity.

The Capital Account

• The capital account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.

• The U.S. enjoys about a $444,000,000,000 capital account surplus—absent of U.S. borrowing from foreigners, this “finances” our trade deficit.

• The capital account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

What affects the KA?What affects the KA?

KA deficit

r - r*

KA surplusKA


KA deficit

r - r*

KA surplusKA

If r > r* then capital will flow into the domestic economy and create a capital account surplus.


KA deficit

r - r*

KA surplusKA

If r < r* then capital will flow out of the domestic economy and create a capital account deficit.


KA deficit

r - r*

KA surplusKA

If r = r* then capital will not have any incentive to move and the capital account will be in balance.

The Capital Account• A credit on the capital account results in

foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).

• A debit on the capital account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Capital Account

• When a domestic entity (firm or individual) sells an asset to a foreign resident, there will be a credit recorded on the capital account.

• When a domestic resident buys an asset from a foreign entity, there will be a debit recorded on the capital account.

• Note – income earned on these assets is recorded on the current account, not the capital account.

Statistical Discrepancy

• There’s going to be some omissions and misrecorded transactions—so we use a “plug” figure to get things to balance.

• Exhibit 3.1 shows a discrepancy of $0.73 billion in 2000.

The Official Reserves Account• Official reserves assets include gold, foreign

currencies, SDRs, reserve positions in the IMF.

The Balance of Payments Identity

BCA + BKA + BRA = 0whereBCA = balance on current accountBKA = balance on capital accountBRA = balance on the reserves account

Under a pure flexible exchange rate regime,BCA + BKA = 0

Because BRA = 0

U.S. Balance of Payments Data

Credits DebitsCurrent Account

1 Exports $1,418.64

2 Imports ($1,809.18)

3 Unilateral Transfers $10.24 ($64.39)Balance on Current Account ($444.69)

Capital Account4 Direct Investment $287.68 ($152.44)5 Portfolio Investment $474.39 ($124.94)6 Other Investments $262.64 ($303.27)

Balance on Capital Account $444.267 Statistical Discrepancies

Overall Balance $0.30Official Reserve Account ($0.30)

0.73


In 2000, the U.S. imported more than it exported, thus running a current account deficit of $444.69 billion.


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73


During the same year, the U.S. attracted net investment of $444.26 billion—clearly the rest of the world found the U.S. to be a good place to invest.


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73


Under a pure flexible exchange rate regime, these numbers would balance each other out.


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73


In the real world, there is a statistical discrepancy.


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73


Including that, the balance of payments identity should hold:BCA + BKA = – BRA

($444.69) + $444.26 + $0.73 = $0.30= –($0.30)


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73

Balance of Payments and the Exchange Rate

Q

P

Exchange rate $Credits Debits

Current Account1 Exports $1,418.64

2 Imports ($1,809.18)





0.73

S

D

Q

P

As U.S. citizens import, they supply dollars to the FOREX market.


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73

Exchange rate $

S

D


Q

P

As U.S. citizens export, others demand dollars in the FOREX market.Credits Debits

Current Account1 Exports $1,418.64

2 Imports ($1,809.18)





0.73

Exchange rate $

S

D


Q

P S

D

As the U.S. government sells dollars, the supply of dollars increases.

S1


1 Exports $1,418.64

2 Imports ($1,809.18)





0.73

Exchange rate $


Balance of Payments Trends

• Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the capital account.

• During the same period, China has experienced the opposite.

Balances on the Current (BCA) and Capital (BKA) Accounts of the United States

-500

-400

-300

-200

-100

0

100

200

300

400

500

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

U.S. BCA

U.S. BKA

Balances on the Current (BCA) and Capital (BKA) Accounts of United Kingdom

-50

-40

-30

-20

-10

0

10

20

30

40

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000UK BCAUK BKA

Balances on the Current (BCA) and Capital (BKA) Accounts of Japan

-150

-100

-50

0

50

100

150

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Japan BCA

Japan BKA

Balances on the Current (BCA) and Capital (BKA) Accounts of Germany

-80

-60

-40

-20

0

20

40

60

80

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Germany BCA

Germany BKA

Balances on the Current (BCA) and Capital (BKA) Accounts of China

-15

-10

-5

0

5

10

15

20

25

30

35

1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

China BCA

China BKA

Balance of Payments and National Income Accounting

• GNP = Y = C + I + G + X – M• Y = C + S + T• X – M = (S- I) + (T- G)• If a developing economy experiences large

trade deficits (X-M <0), the remedies are:1. Savings must increase, S↑2. Investment must fall, I↓3. Government spending must fall, G↓4. Taxes must rise, T↑

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Lecture 7: Balance of Payments - UT · PDF fileMercian Bicycles in Darby England. ... Balance on Capital Account $444.26 ... Balance of Payments and the Exchange Rate