Chapter 9

The Balance of Payments Balance of Payments (BOP): measures all international economic transactions b/n residents & foreign residents. Monetary and fiscal policy must take the BOP into account at the national level BOP data may be important Indicates pressure on exchange rate Helps forecast country’s market potential

For example… BOP transactions (US side) Daimler-Chrysler (German) purchases manufacturer in Chicago. GM China pays dividends to parent in US. An American tourist purchases a necklace in India. A Mexican lawyer purchases US bond via investment broker in Cleveland. Rule of thumb: “follow the cash flow”

B of P Basic Balance = A+B+C Overall Balance = A+B+C+D Current Account Net exports/imports goods&services (Balance of Trade) Net Income (investment income from direct portfolio investment plus employee compensation Net transfers (sums sent home by migrant abroad) B. Capital Account Capital transfers related to purchase and sale of fixed assets such as real estate C. Financial Account Net foreign direct investment Net portfolio investment Other financial items Basic Balance = A+B+C Net Errors and Omissions Missing data such as illegal transfers Overall Balance = A+B+C+D E. Reserves and Related Items Changes in official monetary reserves including gold and foreign exchange reserves Σ (A:E) = Overall Balance

The Current Account Goods Trade or Balance of Trade (BOT) – export/import of goods. VISIBLE TRADE Services Trade – export/import of services (financial, construction, and tourism). INVISIBLE TRADE Income – predominately current income associated with investments made in previous periods, + wages & salaries paid to non-resident workers. Current Transfers – financial settlements due to change in ownership of real resources or financial items. Any transfer b/n countries which is one-way, a gift or a grant. CA typically dominated by export/import of goods, for this reason Balance of Trade (BOT) is widely quoted.

For example… Trade balance Debit: Sun Microsystems buys LCDs from Hong Kong. (Going out) Credit: Singapore Airlines buys Boeing jet. (Coming in) Trade in services Debit: American rents an apartment in Singapore. Credit: TUI - Germany places an ad in the NYT. Income payments Debit: Honda US pays dividend to Honda Japan. Credit: Bank Austria pays salary to rep in NY office. Unilateral Current Transactions Debit: Peace Corps pays US volunteer teachers in Bosnia. Credit: TotalFina pays tuition of employee for Stern MBA USA.

Current Account

Current Account Surplus and Deficit A current account surplus means exports of goods and services, investment income and transfers exceed imports and outflows. A current account deficit means imports of goods and services, and outflows are greater than exports and inflows; must be financed by borrowing (capital account inflows).

The Capital/Financial Account Capital account: transfers of fixed assets, real estate, acquisitions/disposal of non-produced/non-financial -assets leaving the country. Financial account: three components; classified by degree of control, Direct Investment – Net balance of capital which is dispersed from and into US for the purpose of exerting control over assets. E.g. US company acquires foreign company stake (-) Foreign company acquires US company stake (+) foreign direct investment (FDI): 10%+ of voting shares acquired.

The Capital/Financial Account Portfolio Investment – Net balance of capital which flows in/out of US but does not reach 10% ownership. No voting or control rights over the asset. Purchase/sale of equity securities. Purchase/sale of debt securities. E.g. T-bill purchases by foreigners (net portfolio investment) E.g. US$ debt issues by foreign companies/ governments. Risk/Return motivated. Other Investment Assets/Liabilities –Short & long-term trade credits, cross-border loans, currency & bank deposits, & other accounts receivable and payable in cross-border trade.

Chapter 9.2

Exchange Rates Exchange Rates 5/26/2018 Exchange Rates Exchange Rates Nominal exchange rate: price of one currency in terms of another currency (bilateral exchange rate) example: 1.30 dollars per euro or .76 euros per dollar determines price of imports foreign exchange market foreign currency per unit of domestic currency Nominal effective exchange rate: average nominal exchange over several other important trade-related currencies

Exchange Rates Real Exchange Rate (RER): the price of domestic goods relative to foreign goods says how much foreign good you could get for domestic good The price of the average domestic good or service relative to the price of the average foreign good or service, when the prices are expressed in terms of a common currency

Exchange Rates RER Example Should you buy a Japanese or American computer for your company? Price of U.S. computer = $2,400 Price of Japanese computer = 242,000 yen Exchange rate = 110 yen/dollar Price in dollars = price in yen/yen-dollar exchange rate Price in yen = price in dollars x value of dollar in terms of yen Price in dollars = 242,000 yen/110 = $2,200 Japanese computer is cheaper. Real exchange rate = $2,400/$2,200 = 1.09

Exchange Rates

Purchasing Power Parity Law of One Price and Purchasing Power Parity Identical goods & services should sell at same price no matter where they are sold…otherwise opportunity for profits (i.e. arbitrage) Law of one price: same price for a commodity Candy bar in Port-of-Spain versus San Fernando Purchasing Power Parity (PPP) The theory that nominal exchange rates are determined as necessary for the law of one price to hold Exchange rates should move to equalize prices across countries

Purchasing Power Parity Example How many Indian rupees equal to one Australian dollar? Bushel of grain cost 5 Australian dollars or 150 rupees 5 Australian dollars = 150 rupees Or, a 30 rupee to 1 Aus. Dollar ratio Nominal exchange rate should equal 30 rupees/Australian dollar

Purchasing Power Parity How many Indian rupees equal one Australian dollar? Suppose price of grain in India increases from 150 to 300 rupees Price of grain in Australia still equals 5 Australian dollars Originally: implied exchange rate 5:150 or 1:30 Now: implied exchange rate 5:300 or 1:60 1 Australian dollar = 60 rupees Nominal exchange rate increased from 30 to 60 rupees/Australian dollar Indian currency depreciated Australian currency appreciated

Purchasing Power Parity Does not hold up well in short run Transportation costs Border effect – tariffs, technical requirements, regional monopoly power Pricing to market Goods prices are “sticky” Reduces exchange rate “pass through” Nontradable sector Higher productivity, higher nontradable wages, higher nontradable inflation non-tradable goods include such items as electricity, water supply, all public services, hotel accommodation, real estate, construction, local transportation; goods with very high transportation costs such as gravel; and commodities produced to meet special customs or conditions of the country. Works better in the long run. Prices have time to change.

Exchange Rate Mechanism Is a system which was set up by a group of European countries in 1979 with the objective of keeping member countries currencies relatively stable against each other.

Hot Money Hot money: stocks of funds that are moved around the globe from country to country in search of the best returns.

Balance of Payments Problems A government has to be committed to a fixed exchange rate. A floating exchange rate the economy if the economy has a sustained deficit on the current account it will not be able to continue forever. If you have a deficit you have to make sure that your home assets remain attractive to foreign investors.