Ch. 3 - Balance of Payments

3 sub-accounts

• current account

• capital account

• financial account

3 main processes of measuring international economic activity

1. Defining an international economic transaction

2. Understanding how the flow of goods, services, assets, and money creates debits and credits to the overall BOP

3. Understanding the bookkeeping procesures for BOP accounting

Defining international economic transaction examples

• exporting merchandise

• Imports like french wine, japanese cameras, german automobiles

What type of statement is the Balance of Payments (BOP)

Cash Flow statement

Types of BOP transactions

1. Exchange of Real Assets (exchange of goods & services)

2. Exchange of Financial Assets (exchange of financial claims like stocks & bonds)

Current Account

All international economic transactions with income or payment flows occuring within the year, the current period

Current Account subcategories

1. Goods trade: export & import of goods, merchandise trade

2. Services trade: export & import of services

3. Income: Current income associated with investments made in previous periods

4. Current Transfers: Financial settlements associated with the change in ownership of real resources or finanicals items —> one way transfers

Global Remittances

Transfer payments made by guest workers back to their home countries (current transfer)

Capital Account

Measure all international economic transactions of financial assets.

• The capital account is made up of transfers of financial assets and the acquisition and disposal of nonproduced/nonfinancial assets

Financial Account

• Direct Investment —> long term, investor has control

• Portfolio Investment —> short term, no control

• Net Financial Derivatives

• Other asset investment

  • Short-term and long-term trade credits, cross-border loans, currency and bank deposits, receivables and payables related to cross-border trade

Financial Assets can be classified in different ways, such as:

• length of the life of the asset (maturity)

• nature of ownership (public/private)

Direct Investment

Net balance of capital dispersed from and into a country for the purpose of exerting control over assets

• Control = minimum 10% ownership interest

When capital flows out the US, it enters the BOP as a _____ cash flow

negative

If a foreign firm purchases a firm in the US, it is considered a __________

capital inflow

Portfolio Investment

Net balance of capital that flows into and out of a country that does not reach 10% of ownership threshold of direct investment

Net International Investment Position (NIIP)

Annual measure of the assets owned abroad by its citizens, companies, and government

Official reserves account

Total reserves held by official monetary authorities within a country, normally composed of the major currencies used in international trade

Legend denominations

X = exports

M = imports

CI = capital inflows

CO = capital outflows

FI = financial inflows

FO = financial outflows

FXB = change in reserves balance

BOP = Balance of payments, sum of the individual account balances

BOP

(X - M) + (CI - CO) + (FI - FO) + FXB = BOP

Current account balance + Capital account balance + financial accout balance + reserve balance = BOP

BOP under Fixed Exchange Rate Countries

Government bears the responsibility that BOP is near zero

• If current and capital accounts are not zero, then government is expected to intervene in the foreign exchange market by buying/selling official foreign exchange reserves

If the sum of the current and capital accounts is greater than zero, a _____ _____ exists for the domestic currency.

To preserve the fixed exchange rate, government must _____ domestic currency for foreign curencies to bring the BOP back to zero

surplus demand, sell

If the sum of a current and capital accounts is negative, an ____ ______ of the domestic currency exists in the world markets.
The government must intervene by ______ the domestic currency with its reserves of foreign currencies & gold

excess supply, buying

Under a floating exchange rate system, the government of a country _____ peg its foreign exchange rate

should not

Countries who have managed floats exchange, their primary action taken by these governments is to ___________

change exchange rates, by altering the capital account balance CI - CO

3 stages of the trade balance adjustment process

1. currency contract period

2. pass through period

3. quantity adjustment period

Currency contract period

Sudden devaluation of the domestic currency

• importers would spend more money, while revenues to local country would remain the same

Pass through period

Importers/exporters pass the exchange rate changes through product price increases

Quantity adjustment period

Achieves the balance of trade adjustment that is expected from a domestic currency devaluation

• Demands to new prices are adjusted

• Imports are more expensive, quantity demanded decreases

• Exports are cheaper, quantity demanded increases

• Balance of trade improves

US Trade Balance

(PxQx)-(SPmQm)

Eras of the global monetary system

• 1870’s-1914: Classical Gold Standard

• 1923-1938: Inter war years

• 1944-1973: Fixed Exchange rates

• 1973-1997: Floating Exchange rates

• 2000-2020: Emerging Era

Classical Gold Standard (1870-1914)

Era in which trade and capital began to flow more freely, dominated by industrialized nation economies that were dependent on gold convertibility to maintain confidence in the system

Impact on trade: Trade dominated capital flows

Impact on economies: Increased world trade with limited cash flows

Interwar Years (1923-1938)

Era in which major economic powers returned to policies of isolationism and protectionism, restricting trade and eliminating capital mobility.

Devastating results included financial crisis, global depression, rising international political and economic disputes that drove nations into a second world war

Impact on Trade: Increased barriers to trade & capital flows

Impact on Economies: Protectionism & nationalism

Fixed Exchange Rates (1944-1973)

Dollar-based fixed exchange rate system under Bretton Woods gave rise to a long period of economic recovery and growing openness of both international trade and capital flows into and out of countries

Impact on Trade: Capital flows begin to dominate trade

Impact on Economies: Expanded open economies

Floating Exchange Rates (1973-1997)

Rise of growing schism between industrialized and emerging market nations.

Industrialized nations moved to floating exchange rates by capital mobility, while emerging markets opened trade but maintained restrictions on capital flows

Impact on Trade: Capital flows domiante trade

Impact on Economies: Industrial economies increasingly open; emerging nations open slowly

Emerging Era (1997-Present)

Emerging economies like China and India open their markets to global capital, but must either give up ability to manage currency values or conduct independent monetary policies

Impact on Trade: Selected emerging nations open capital markets

Impact on Economies: Capital flows drive economic development

Capital control

Restriction that limits or alters rate or direction of capital movement in/out a country

Credit

• Event that records foreign exchange earned

• Inflow of foreign exchange to the country

• Ex: export of a good/service

Debit

• Foreign exchange spent

• Payments for imports/purchases of services

• Outflow of foreign exchange

There is an ______ relationship between current and financial accounts

inverse

Imports have the potential to _____ a country’s interest rate

lower

As lower priced imports substitute for domestic production and employment, GDP will be ____ as the balance on the current account ____ with _____ imports

lower, falls, rising

Types of capital control

• General Revenue/Finance War effort (outflows)

• Financial Repression/Credit Allocation

• Correct a BOP Deficit

• Correct a BOP Surplus

• Prevent Potentially volatile inflows

• Prevent Financial destabilization

• Prevent Real Appreciation

• Restrict foreign ownership of domestic assets

• Preserve savings for domestic use

• Protect domestic Financial Firms

General Revenue/Finance War Effort (outflows)

Controls on capital outflows permit a country to run higher inflation with a given fixed-exchange rate and also hold down domestic interest rates

Financial Repression/Credit Allocation (outflows)

Governments use the financial system to reward favored industries or to raise revenue, may use capital controls to prevent capital from going abroad to seek higher returns

Correct a BOP Deficit (outflows)

Controls on outflows reduce demand for foreign assets without contractionary monetary policy or devaluation. This allows a higher rate of inflation than otherwise would be possible

Correct a BOP Surplus (Inflows)

Controls on inflows reduce foreign demand for domestic assets without expansionary monetary policy or revaluation. This allows lower rate of inflation than would otherwise be possible

Prevent potentially volatile inflows (inflows)

Restricting inflows enhances macroeconomic stability by reducing the pool of capital that can leave a country during a crisis

Prevent Financial Destabilization (Inflows)

Capital controls can restrict or change the composition of international capital flows that can exacerbate distorted incentives in the domestic financial system

Prevent Real Appreciation (Inflows)

Restricting inflows prevents the necessity of monetary expansion and greater domestic inflation that would cause a real appreciation of the currency

Restrict Foreign Ownership of domestic assets (inflows)

Foreign ownership of domestic assets (especially natural resources) can generate resentment

Preserve savings for domestic use

The benefits of investing in the domestic economy may not fully accrue to savers so the economy as a whole can be made better off by restricting the outflow of capital

Protect Domestic Financial Firms (inflows and outlfows)

Controls that temporarily segregate domestic financial sectors from the rest of the world may permit domestic firms to attain economies of scale to compete in world markets

Primary concern over capital flows

They are short term in duration, may flow out with short notice, and are characteristics of the politically and economically unstable emerging markets