Higher degree of openness => structure of production and employment, and economic growth, are more likely to be affected by external events

The balance of payments provides and indication of how international trade and external events feed back into the macroeconomy

This presentation describes how balance of payments accounts are recorded and then explores the link between the balance of payments and a countrys exchange rate

The International Balance of Payments

The components of the balance of payments: Current account Capital account Official financing

National income determination and foreign trade

Economies are becoming more open (in terms of trade as % of GDP), but some countries are more open than others

Exports and imports as % of GDP1990 2003

Mauritius 153 121Zambia 99 76Chile 64 68China 29 66UK 51 54Argentina 15 40Bangladesh 20 37India 17 31Brazil 14 30United States 20 23Source: World Bank World Development Indicators

Higher degree of openness => structure of production and employment, and economic growth, are more likely to be affected by external events

The balance of payments provides and indication of how international trade and external events feed back into the macroeconomy

This presentation describes how balance of payments accounts are recorded and then explores the link between the balance of payments and a countrys exchange rate

The balance of payments (BoP) accounts

A countrys balance of payments accounts record its international trading position and its lending and borrowing

=> records transactions between countries

Each transaction is classified according to the payment or receipts that it generates

Transactions that generate a receipt of a payment from foreigners are a credit item in the accounts with a + sign

These represent a supply of foreign exchange ($) and a demand for the local currency ()

Transactions that comprise a payment to foreigners are reported as a debit item with a - sign

=> These represent demand for foreign exchange ($) and a supply of the local currency ()

Three Balance of Payments (BoP) Accounts

a) The balance of payments on Current Account

b) The balance of payments on Capital Account

c) The balance for Official Financing (International reserves account operated by central bank)

Let us consider two countries:

the United Kingdom: local or domestic currency: British pounds ()

the United States: foreign currency: US follars ($)

a) The balance of payments on Current Account

Records transactions arising from trade in goods and services

The visible trade balance payments and receipts from the import/export of tangible

goods (cars, food, textiles,)

The invisibles trade balance payments and receipts for financial services, shipping and

tourism, interest and dividends payments on investments, etc.

b) The balance of payments on Capital Account

Records transactions related to international movements in the ownership of financial assets

The purchase of foreign investments by UK citizens brings assets to the UK (in exchange for money) and are referred to as a capital outflow

to purchase these foreign assets, locals have to buy $

=> debit (negative) entry in the Capital Account

b) The balance of payments on Capital Account (cont.)

Foreign investment into the UK increases UK liabilities to foreigners, and it is a capital inflow foreigners have to buy to undertake their investments

credit (positive) entry in the Capital Account

The Capital Account is further divided into short-term and long-term capital flows

The supply of s reflects imports to the UK and UK purchases of foreign assets

=> outflows in the UK balance of payments

The demand for s reflects UK exports and sales of UK assets to foreigners

inflows in the UK balance of payments

The exchange rate is the price of the in terms of other currencies (e.g. $)

If the exchange rate is freely floating then it will adjust to ensure that the demand for s = the supply of s inflows = outflows in the BoP BoP is exactly = zero

Since BoP = Current Account + Capital Account:

a Current Account surplus => a Capital Account deficit

a Current Account deficit => a Capital Account surplus

c) The balance for Official Financing

If the exchange rate is fixed, and there is a BoP deficit outflows > inflows supply of s > demand for s

The Central Bank must offset this excess supply of s by buying them with foreign currency ($); i.e. runs down its reserves of foreign exchange

c) The balance for Official Financing (cont)

The balance for official financing shows the net increase or decrease in a countrys holdings of foreign currency reserves:

A decrease in the official reserves is reported as a credit item (+), since it involves the purchase of s

an increase is reported as a debit item (-)

=> If the exchange rate is freely floating, then the balance for official financing is zero

The balance of payments must always balance since the accounts are constructed such that this must be true by definition

However, there can be measurement error and unreported borrowing from abroad and other illegal activities

The discrepancy represents a combination of unrecorded current and capital account transactions

This requires the inclusion of what is referred to as a balancing item, to ensure the accounts balance in practice

National Income Identities and the Current Account Balance

Recall the aggregate expenditure equation in our study of macroeconomics:

AE (=AD) = C + I + G + X - M Leakages are:

S + T + M Injections are:

I + G + X

=> In equilibrium: injections = leakagesS + T + M = I + G + X

The balance of payments on Current Account could be re-written as:

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

or (M - X) = (G - T) + (I - S)

trade = government + private sector deficit balance balance

Trade deficit = government deficit + priv. sector deficit

An increase in govt. expenditure (G), or a reduction in private saving (S) worsens the trade balance (i.e. raises trade deficit)

Are trade deficits a problem?

A trade deficit is not necessarily a bad thing (e.g. when growing domestic industries attract foreign investments) if borrowing is financing investment (which generates

economic growth and income in future) then it is not a problem

However, if a country persistently runs a trade deficit this is something to worry about (e.g. vulnerability to loss of foreign investors confidence) excessive borrowing on capital account to finance

consumption on current account will incur higher interest payments and eventually lead to reduction consumption

Slide 1The International Balance of PaymentsSlide 3Slide 4The balance of payments (BoP) accountsSlide 6Three Balance of Payments (BoP) AccountsSlide 8a) The balance of payments on Current AccountSlide 10Slide 11Slide 12Slide 13Slide 14Slide 15Slide 16National Income Identities and the Current Account BalanceSlide 18Slide 19Are trade deficits a problem?