Balance of Payments The balancing act of international trade

Balance of Payments Balance of Payments (“BOP”) is an accounting of a country’s international transactions over a certain time period. Balance of Payments (“BOP”) is an accounting of a country’s international transactions over a certain time period. BOP includes two main components: BOP includes two main components:  Current Account  Capital Account The Current Account and Capital Account always balance each other out. The Current Account and Capital Account always balance each other out.

Current Account Record of daily trade of goods and services between a nation and the rest of the world. Record of daily trade of goods and services between a nation and the rest of the world. Split into two pieces: Split into two pieces:  Merchandise trade (or Visible) account – records trade in goods  Invisible account – records trade in services Current Account includes investment income flows (interest and dividends), private transfers and direct foreign aid, in addition to “pure” goods and services. Current Account includes investment income flows (interest and dividends), private transfers and direct foreign aid, in addition to “pure” goods and services.

Current Account The net exports (exports minus imports) of goods and services for a country is its trade balance (balance of trade). The net exports (exports minus imports) of goods and services for a country is its trade balance (balance of trade). If a country has positive net exports of goods and services (more exports than imports), it has a trade surplus. If a country has positive net exports of goods and services (more exports than imports), it has a trade surplus. Negative net exports of goods and services means the country has a trade deficit. Negative net exports of goods and services means the country has a trade deficit. Welker

Capital Account Records the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners. Records the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners. Includes direct purchases of hard assets (land or mineral rights, production facilities, etc.) and financial assets (stocks, bonds, bank deposits). Includes direct purchases of hard assets (land or mineral rights, production facilities, etc.) and financial assets (stocks, bonds, bank deposits). The net change in the Capital Account is a country’s net capital outflow (or net foreign investment). The net change in the Capital Account is a country’s net capital outflow (or net foreign investment). Welker

Why does BOP Balance? Remember – BOP is an accounting of a country’s international transactions. Remember – BOP is an accounting of a country’s international transactions. What do you know about accounting? What do you know about accounting? In a country, what 2 numbers should equal to have a “balanced” budget? In a country, what 2 numbers should equal to have a “balanced” budget? Basic principle is that the two offsetting sides of every entry (debits and credits) must always be equal – and therefore are always in balance. Basic principle is that the two offsetting sides of every entry (debits and credits) must always be equal – and therefore are always in balance. Welker

Balance of Payments BOP works exactly the same way. BOP works exactly the same way. For every change in the Current Account (think net exports) there must be an equal change in net capital outflow. For every change in the Current Account (think net exports) there must be an equal change in net capital outflow. Let’s walk through a couple of examples … Let’s walk through a couple of examples …

Import Transaction 1. Domestic Oil Company buys $1 billion of petroleum from foreign government supplier (transaction is denominated in US$). 2. U.S. net exports declines by $1 billion. 3. Foreign government purchases $1 billion of US Treasury bonds. 4. U.S. net capital outflow (Capital Account) declines by $1 billion. 5. Change in Current Account = Change in Capital Account

Export Transaction 1. Boeing sells 20 new aircraft to a foreign carrier for 500 million Euro. 2. U.S. net exports increases by 500 million Euro. 3. Boeing exchanges 500 million Euro for $385 million at their money center bank of choice. 4. Bank purchases 500 million Euro of short- term LIBOR based securities. 5. U.S. net capital outflows increase by 500 million Euro.

Balance of Payments The equation to remember: Net Balance of Payments = Current Account Balance + Capital Account Balance = 0 And, if it’s helpful: Net Capital Outflow = Net Exports

Are Trade Deficits Bad? It depends … It depends … First, all countries cannot have a trade surplus (positive Current Account balance). First, all countries cannot have a trade surplus (positive Current Account balance). All open economies are part of the same global economic system – one country’s surplus must eventually be balanced by another country’s deficit. All open economies are part of the same global economic system – one country’s surplus must eventually be balanced by another country’s deficit.

Trade Deficits (Cont’d) Would a country normally prefer to be a net exporter (run a trade surplus)? Would a country normally prefer to be a net exporter (run a trade surplus)? Perhaps, but like an individual who takes on personal debt, whether or not they are better off in the long run depends on how they got into debt and what they do with the money. Perhaps, but like an individual who takes on personal debt, whether or not they are better off in the long run depends on how they got into debt and what they do with the money. Which is why a discussion of trade deficits inevitably leads to an analysis of the underlying causes – and often a debate about trade policy. Which is why a discussion of trade deficits inevitably leads to an analysis of the underlying causes – and often a debate about trade policy.

Current Account Any guesses on the current trade balance for the United States? Any guesses on the current trade balance for the United States? Let’s take a look. Let’s take a look.

U.S. Trade Deficit You have analyzed the flow of goods and services underlying the current U.S. trade deficit. You have analyzed the flow of goods and services underlying the current U.S. trade deficit. What do you think? What do you think? Is it sustainable? Is it sustainable? Is it dangerous (or healthy)? Is it dangerous (or healthy)? Are we in trouble? Are we in trouble?