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Balance of Payments
Lecture 11

 

Balance of Payments

 

  1. Balance-of-Payments – record of all transactions between a country and the rest of the world

    1. Cash Flow Statement

      • Not a balance sheet

      • Measured in a country's currency

      • Uses accounting double entry system, where credits = debits

    2. Deficit item – A resident, business, or government pays money to another country

      • The number is negative

      • Money is leaving the country

      • Examples

        • Pay for imports

        • Send money to relatives in foreign countries

        • Traveling abroad

    3. Credit item - a residents, business, or government receives money for a foreign country

      • The number is positive

      • Money is entering the country

      • Examples

        • Receive money for exports

        • Residents receive money from foreigners

        • Foreigners travel within the country

  2. Current account – summarize the purchases and sales of goods and services Includes:

    1. Trade balance = Exports – Imports

      • Trade surplus: Trade balance > 0

      • Money flows into the country

      • Trade deficit: Trade balance < 0

      • Money flows out of the country

    2. Shipping, brokerage, and insurance

    3. Income from investments; investments were done in a previous period

    4. Unilateral transfers between nations, including foreign aid and private gifts

    5. The U.S. current account balance was -$465.9 billion in 2011

  3. Financial Account – records all transactions in assets, such as stocks, bonds, and real estate between the country and the rest of the world

    1. If financial account is positive, then money is flowing into the country

      • Financial inflow; the country is borrowing from foreigners

      • Foreigners are buying more assets in the country than the amount of foreign assets bought by domestic residents

    2. If the financial account is negative, then money is flowing out of the country

      • Financial outflow; the country is lending to foreigners

      • Residents buy more foreign assets than foreigners buying domestic assets

    3. Equaled $555.1 billion in 2011 for U.S.

  4. Equation

    1. Balance of Payments (BOP) = current account + financial account = 0

    2. The U.S. has a current account deficit, than the deficit is financed by a financial surplus

      • The U.S. has had current account deficits for the last 40 years

      • The United States imports more goods and services than what it exports

        • U.S. dollars flow to foreigners (i.e. current account deficit)

        • Foreigners take these U.S. dollars and re-invest back into the United States (i.e. a financial account surplus)

        • Foreigners buy government securities, stocks, bonds, and real estate in the United States

      • If foreign investors do not want to invest in the United States, then BOP deficit causes the U.S. dollar to weaken (depreciate)

        • A weaker dollar results from a surplus of U.S. dollars on the international markets

        • A weaker U.S. dollar will cause the current account to become smaller over time, as imports decrease and exports increase

  5. Financing a Balance-of-payment deficit

    1. More money is leaving the country than flowing in

    2. BOP = current account + financial account < 0

    3. Example - The U.S. has a BOP deficit

      • Official settlements balance - financial transactions by the central bank or government

      • Included in the financial account

      • Federal Reserve buys the surplus of U.S. dollars back from foreign exchange markets

      • Methods

        1. Sell gold to buy U.S. dollars

        2. Sell foreign currencies and buy U.S. dollars

        3. Borrow from foreign central banks

        4. Use its reserves at the IMF

        5. Borrow from the IMF

        6. Use Special Drawing Rights (SDRs)

    4. Official settlements balance is -$15.9 billion in 2011

    5. Government may impose foreign exchange rate controls

      • Government could change rules and regulations, especially for foreigners; impose special taxes

      • Interest, dividend payments, license fees, etc

  6. Statistical discrepancy – occurs when the current and financial accounts do not equal zero

      1. U.S. statistical discrepancy was -$89.2 billion in 2011

      2. Why?

        • Measurement errors

        • Some financial activities are not reported

          • Illegal businesses

          • tax evasion

          • Hide money from aggressive governments (i.e. capital flight)

  7. China and the Asian tigers

    1. Weaken their currencies, boosting their exports

    2. Creates trade surpluses (and possibly balance-of-payments surpluses)

      • current account + financial account > 0

      • More money flows in than out

    3. Have three options for this money

      • These countries buy U.S. government debt, real estate, and stocks and bonds in U.S. corporations

      • Purchase machines and equipment from developed countries, boosting their investment

      • Have a cache of U.S. dollars to manipulate exchange rates

      • Note - U.S. is losing its manufacturing industries

Note - For students who are strong in macroeconomics

  1. Define GDP = C + G + Ig + X - M

    • Terms

    • Consumption, C

    • Government expenditures, G

    • Gross Investment, Ig

    • Imports, M

    • Exports, X

  2. Leakages - removes money from an economy

    • Types

    • Savings, S

    • Taxes, T

    • Imports, M

  3. Injections - injects money into an economy

    • Types

    • Government expenditures, G

    • Gross Investment, Ig

    • Exports, X

  4. Equilibrium - GDP is not growing or contracting

    • Leakages = Injections

    • Define equation

Ig + G + X = S + T + M

Pair leakages and injections, so

(Ig - S) + (G - T) = M - X

A trade deficit causes M - X to be positive, so more money flows in than out. However, foreigners invest in the country. If the country has a low savings, then investment can still be high, because Ig - S is positive. If the country has a large budget deficit, then foreigners can buy government securities, because G - T is positive.

Note - Ig - S implies the savers deposit their savings into a banking system and the banking system grants loans to businesses. Thus, these equations imply a country has a well-developed banking system.

 

Exchange Rate Regimes

 

  1. Fixed Rate Regime – government ensures balance-of-payments (BOP) is close to zero

    1. Weakens monetary policy

      • Changing the money supply changes the interest rates which could change the flow of money into and out of a country

      • Central bank has to maitain exchange rate; reduces focus on other goals

    2. If BOP < 0

      • Excess supply of currency on exchange markets

      • Government intervenes to bring BOP = 0

      • Government has to buy its currency back using official settlements reserves, such as foreign currencies, gold, SDRs, etc.

      • If government has no reserve assets, then it has to either devalue its currency or a black market forms

    3. If BOP > 0

      • Shortage of currency on exchange markets

      • Government sells it currency to buy foreign currencies

      • Government garners official reserves

  2. Floating exchange rate regime - government lets the exchange rate changes

    1. Balance-of-Payment deficit

      • Currency depreciates

      • Exports increase while imports decrease

      • J-curve Effect - trade deficit get temprarily worse as currency depreciates

      • Usually t1 to t2 is 3 to 6 months

J-Curve Effect

    1. Balance-of-Payment surplus

      • Currency appreciates

      • Exports decrease while imports increase

  1. Managed floats - government changes the interest rates to intervene in the foreign exchange market

    1. Balance-of-Payment deficit

      • Central bank decreases the money supply

      • Interest rate increases

      • Investors want to invest in the country for higher interest rate

      • Financial account increases until BOP = 0

    2. Balance-of-Payment surplus

      • Central bank increases the money supply

      • Interest rate decreases

      • Investors reduce investments in the country, so financial account decreases until BOP = 0

 

Capital Flight

 

  1. Capital Flight – foreign investors withdraw investments from a country

    • Massive financial account outflows

    • Causes problems for a government

    • Could cause a country's currency to depreciate rapidly

    • Examples - Argentina, Asian Financial Crisis 1997, Brazil, Italy 1992/1993, Mexico 1994/1995, Russia 1998, etc.

  2. An event triggers a crisis

    • Example 1

      • The Thai government maintained a fixed exchange rate of the baht

      • When it devalued the currency, the foreigners cashed in their investments, leading to outflows

      • Crisis spread to other Asian countries

    • Example 2

      • France passed a new wealth tax in 2006

      • Collects $2.6 billion per year in new taxes

      • Lost over $125 billion in capital

    • Example 3 - gov. begins nationalizing industries

  3. Methods for countries to get investment out of the country

    1. International bank transfers until a government freeze international transfers

    2. Smuggle currency out of the country (illegal???)

    3. Convert currency to precious metals and smuggle metals outside of country

    4. Money laundering

    5. False invoices

      1. Over price imports

      2. Under price exports

 

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