balanceofpayments-121004173925-phpapp02

7/30/2019 balanceofpayments-121004173925-phpapp02

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Presented by :Anuj Goyal

NMIMS Mumbai


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The components of the balance of payments:

Current account

Capital account

Official financing

National income determination and foreign trade


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

Exports and imports as % of GDP

1990 2003

Mauritius 153 121

Zambia 99 76

Chile 64 68

China 29 66

UK 51 54

Argentina 15 40

Bangladesh 20 37

India 17 31

Brazil 14 30

United States 20 23

Source: World Bank World Development Indicators


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Higher degree of openness => structure ofproduction and employment, and economicgrowth, are more likely to be affected byexternal events

The balance of payments provides andindication of how international trade andexternal events feed back into themacroeconomy

This presentation describes howbalance ofpayments accounts are recorded and thenexplores the linkbetween the balance ofpayments and a countrys exchange rate


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A countrys balance of payments accountsrecord its international trading position and its

lending and borrowing

=> records transactions between countries


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Each transaction is classified according to thepayment or receipts that it generates

Transactions that generate a receipt of apaymentfrom foreignersare a credititem in the accounts witha +signThese represent a supply of foreign exchange ($) and ademand for the local currency()

Transactions that comprise a payment to foreignersare reported as a debititem with a -sign=> These represent demand for foreign exchange($) and a

supply of the local currency()


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a) The balance of payments on CurrentAccountb) The balance of payments on CapitalAccountc) The balance for Official Financing

(International reserves account operated by

central bank)


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Let us consider two countries:

the United Kingdom: local or domestic

currency: British pounds()

the United States: foreign

currency: US follars($)


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Records transactions arising from trade ingoods and services The visibletrade balance

payments and receipts from the import/export oftangible goods (cars, food, textiles,)

The invisibles trade balance

payments and receipts for financial services, shippingand tourism, interest and dividends payments oninvestments, etc.


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b) The balance of payments on CapitalAccount

Records transactions related to internationalmovements in the ownership offinancial assets The purchase of foreign investments by UK

citizensbrings assets tothe UK (in exchange formoney) and are referred to as acapital outflow to purchase these foreign assets, locals have to buy $=> debit(negative) entry in the Capital Account


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b) The balance of payments on CapitalAccount (cont.)

Foreign investment into the UK increases UKliabilities to foreigners, and it is acapital inflow foreigners have to buy to undertake their investmentscredit (positive) entry in the Capital Account

The Capital Account is further divided into short-termand long-termcapital flows


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The supply of s reflects importsto the UK andUK purchases of foreign assets

=>outflowsin the UK balance of payments

The demand for s reflects UK exportsandsales of UK assets to foreigners

inflowsin the UK balance of payments


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

If the exchange rate is freely floatingthen it willadjust to ensure that the demand for s = thesupply of s inflows = outflows in the BoPBoP is exactly = zero

Since BoP = Current Account + Capital Account:

a Current Account surplus => a Capital Accountdeficit

a Current Account deficit => a Capital Accountsurplus


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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


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c) The balance for Official Financing(cont)The balance for official financing shows the netincrease or decrease in a countrys holdings offoreign currency reserves:

A decreasein the official reserves is reported as acredititem (+), since it involves the purchase of s an increaseis reported as a debit item (-)

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


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The balance of payments must always balancesince the accounts are constructed such that

this must be true by definition

However, there can be measurement error andunreported borrowing from abroad and other illegalactivities

The discrepancy represents a combination ofunrecorded current and capital account transactions

This requires the inclusion of what is referred toas a balancing item , to ensure the accountsbalance in practice


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Recall the aggregate expenditureequation in our study ofmacroeconomics:

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

S + T + M

Injections are:

I + G + X

=> In equilibrium:injections= leakages

S + T + M=I + G + X


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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 balancebalance


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Trade deficit = government deficit + priv.sector deficit

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


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

economic growth and income in future) then it is not aproblem

However, if a country persistently runs a tradedeficit 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 interestpayments and eventually lead to reduction consumption

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