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Balance of Payments
Lecture 3


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 total credits = total 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 – Import

      • 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; country borrows 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; country lends 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 to 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 on 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 a government (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

    • Savings, S

    • Taxes, T

    • Imports, M

  3. Injections - injects money into an economy

    • 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) + (X - M) = 0

A trade deficit causes X - M to be negative, so more money flows out than in. 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.


European Union


European Union (EU) - created a common market; capital, goods, labor, and services are free to move anywhere within the EU

  1. EU has 27 members as of 2012

    • Replicate the U.S. by forming a large market with one currency

    • Spur economic growth

    • Difficult for outsiders to penetrate EU markets

    • Eurozone is 17 countries use the common currency – euro

  2. Created the institutions

    1. European Parliament

    2. European Court of Justice

    3. European Central Bank

      • Frankfurt, Germany

      • Keep euro stable with low inflation rate

      • Dominates international trade

      • Euro has appreciated against the U.S. dollar until the European Debt Crisis

  3. Removed product regulations for countries

    • Greek ice cream

    • German beer purity and labeling laws

    • Belgian chocolate

    • Remove customs among EU countries, etc.

  4. EU Membership requires

    • Democracy

    • Human rights

    • Functioning market economy

    • Turkey and Croatia want to join even in 2012

  5. Benefits of euro

    1. Cheaper transaction costs; no currency conversion

    2. Reduces exchange rate uncertainty

    3. Promotes competition; regions can specialize

  6. Problems of euro

    1. Countries give up control over monetary policy

    2. Prices are higher relative to wages under the euro

    3. A central bank cannot devalue currency to stimulate economic growth




Hegemony - richest and most powerful nation establishes the institutions for international trade

  1. Source of wealth, power, and economic growth

  2. Hegemony has three advantages

    1. Industrial and agricultural production

    2. A strong financial system

    3. Dominates international trade

  3. Three modern hegemonies

    1. The United Provinces (Holland) 18th century

    2. Great Britain 19th century

    3. United States after WWII

  4. International markets are public goods

    1. Free trade

    2. Peace and security - protect trade from rogue countries and pirates

    3. Balance of powers

    4. System of international payments, i.e. the money system

    5. Creates international institutions

  5. Public goods are costly to provide

    1. Free-riders - individuals and nations benefit from the international system without paying for it

    2. Hegemony provides the international public goods, even taking free riders into account.

    3. Hegemony benefits outweighs the cost in the beginning

  6. When a hegemony arises, the world economy tends to grow and prosper

    1. Stimulates wealth creation from markets

    2. U.S. supports a system of free trade

    3. After WWII, U.S. was the largest industrial producer

    4. European factories were in ruins

    5. U.S. greatly benefited from free trade

    6. Helped established the Bretton Woods System

  7. The hegemony's costs rise over time, weakening the hegemony's base of wealth and power.

    1. If the hegemony fails, the public goods disappear

    2. The world economy stagnates or declines

    3. Interesting theory - a rich and powerful nation gains control after a world war

      1. Hegemony falls into decline

      2. Harmonious relationships break down, and then war follows

      3. A new hegemony rises

  8. U.S. is a selfish hegemony

    1. U.S. dollar is international currency

    2. Abuse the system - The Twin Deficits

    3. U.S. has large trade deficits, causing an outflow of U.S. dollars

    4. Foreigners invest into the U.S.

    5. Foreigners buy U.S. government debt

    6. Other debtor nations cannot do this


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