The Balance of Payments

The Balance of Payment The balance of payments of a country is a systematic record of a country’s trade in goods, services, and financial assets between residents of that country and the rest of the world during a given period of time Private transactions (individuals and business firms) Official transactions (government transactions)

Economic Transaction Any transaction has two sides. From the point of view of home country, the two sides are defined as: Credit: Are those transactions that will bring foreign exchange into the country Debit: Are those transactions that would mean a loss of foreign exchange

The Balance of Payment Table 12.1 provides an example of the historic detailed balance of payments for the United States Simplified US balance of Payments for 2000

Simplified US Balance of Payments for 2000 (billions $) Credits Debits Net Merchandise 772 1224 -452 Services 292 218 74 Income 353 331 22 Unilateral transfers -53 Current Account -410 US-owned assets abroad -606 Foreign-owned assets 1015 Capital Account Statistical Discrepancy 409 .8

Current account Includes the value of trade in merchandise, services, income, and unilateral transfers Figure 12.1 shows change in balance of payments over time Current account excludes capital account transactions – purchases and sales of financial assets

United States Current Account Balance (1960-98)

Financing Current Account: Large current account deficit means large capital account surplus. Important items included in the capital account: Direct Investment Security purchases Bank claims and liabilities U.S. government assets abroad Foreign official assets in the United States

Capital Account One implication of capital account transaction pertains to the net creditor or net debtor position of a nation. A net debtor owes more to the rest of the world than it is owed. A net creditor is owed more than it owes.

National Savings, Investment and Current Account Y=C+I+G+X Where: Y = National income C= Consumption spending I = Investment spending G=Government spending X=Net export or the current account

National Savings, Investment and Current Account Rearranging the above equation: Y-C-G=I+X=S Where S = national saving The above relationship indicates that national saving is equal to the sum of investment saving plus the current account balance. Thus, current account must be equal to: X=S-I

National Savings, Investment and Current Account The country where investment greater than saving, spending greater than income, has a current account deficit. The country where saving greater than investment, income greater than spending, has a current account surplus.

The World’s Largest Debtor September 10, 1985 US became a debtor nation In 1982 US reached its all-time high as a net creditor ($147 billion) By 1985 US had massive current account deficits and corresponding capital account surpluses On September 1985, the U.S. Commerce department announced that the United States was a debtor nation for the first time since world war I. The magnitude of current account deficit in 1985 and 1986 made the U.S. the largest international debtor in the world with debt exceeding Mexico and Brazil.

The World’s Largest Debtor To consume more at home then is produced, the US must borrow from abroad US borrowed at high level Large reduction in US foreign lending US federal budget deficits made lending at home more attractive

The World’s Largest Debtor What can change this position? If dollar-denominated assets are no longer desired, dollar will tend to depreciate, interest rates will fall Capital account surplus will equal to falling current account deficit US will become a net lender

Additional Summary Measures Balance-of-merchandise trade Official settlements balance is the value of the change in financial assets held by foreign monetary agencies and official reserve asset transactions

Transactions classification 1)US bank makes a loan of $1 million to a Romanian food processor. This loan is funded by creating $1 million deposit for the Romanian firm in the US bank 2)US firm sells $1 million worth of wheat to the Romanian firm. The wheat is paid with the bank account created in transaction 1 3)US resident receives $10,000 in interest from German bonds she owned. The $10,000 is deposited in a German bank 4) A US tourist travels to Europe and spends the $10,000 German deposit

Balance of Payments Credit (+) Debit (-) Net Bal. Merchandise $1 mil (2) Services 10,000 (4) Income 10,000(3) Unilateral transfers Current account $+1 mil Official capital Private capital $1 mil (1) 10,000 (3) Totals $2,020,000

Balance of Payments Equilibrium and Adjustment Economic implications of the balance of payments Global current account balance has summed to deficit in recent years due to inaccurate measurement of international financial transactions (service transactions) 2-country example of bilateral trade imbalances (A is a wealthy creditor country and B is a poor country that run trade surpluses with A Balance of payments equilibrium – exports equal imports or credits equal debits for a particular account (current account or official settlements account)

Balance of Payments Equilibrium and Adjustment Current account equilibrium for a nation would mean unchanging net creditor or debtor position, no need for net financing Equilibrium on official settlements would mean no change in our financial assets held by foreign monetary agencies and reserve assets

Balance of Payments Equilibrium and Adjustment There is a disequilibrium in the balance of payments, in official settlements part Deficit countries will experience reserve asset losses and surplus countries – reserve accumulation International reserve assets are composed of gold, IMF special drawing rights, and foreign exchange Lets consider change in international reserve assets based on foreign exchange along

Balance of Payments Equilibrium and Adjustment 1 British pound is worth 1.50 US dollars Supply-demand for foreign exchange market Demand for pounds comes from US demand for British goods or financial assets Supply of pounds comes from British buyers of US goods or financial assets Upward sloping supply curve implies that as pound appreiciates in value US products are cheaper to Br. Buyers, more pounds supplied to this market

Balance of Payments Equilibrium and Adjustment Equilibrium is restored at the new equil. Point Flexible exchange rates - free market supply and demand determines the value of currencies Fixed exchange rates –central banks set exchange rates at desired levels Developing countries use direct controls on international trade to shift supply/demand curves