The Balance of Payments What is the Balance of Payments? The structure of the balance of payments What are the BOP accounts? The BOP Recording Method: Double-Entry Bookkeeping Method Balance of Payments Balances The Balance of Payments and the FX Market

Balance of Payments The balance of payments is an accounting listing (tabulation) of the values of economic (trade and financial) transactions between the residents of a (home) country and residents of other countries. Balance of payments entries are recorded based on the double-entry bookkeeping principle. The balance of payments entries are always balanced; the entries add up to zero.

Balance of Payments Account Categories Current Accounts Merchandise Trade Service Trade Services of Capital: Interest Incomes, Dividends Unilateral Current Transfers Capital Accounts US private investments abroad Foreign private investments in the US Other investments/capital transactions Errors and statistical discrepancies Official (Capital) Accounts (Changes in) US official reserve assets abroad: gold, SDRs, foreign currencies (Changes in) foreign official assets in the US

Double-Entry Principle Each transaction affects at least two account Debit entries balance credit entries Imports are debit entries ( Autonomous transactions) The balancing (credit) entry(ies) for an import take(s) place in one (or more) sections of capital the accounts (Accommodating transactions) Exports are credit entries ( Autonomous transactions) The balancing (debit) entry(ies) for an export take(s) place in one (or more) sections of the capital accounts (Accommodating transactions) Capital inflows (increases in foreign assents) are credit entries Capital outflows (increases in US residents-owned assets abroad) are debit entries Increases in US claims against residents of other countries are debit entries Increases in foreign residents’ claims against US are credit entries

Balance of Payments Balances Balance of Merchandise Trade Balance Merchandise and Services Current Account Balance Capital Account Balances Official Settlement Balance Statistical errors Overall Balance = 0

How does the BOP balance? Debit(-) Credit (+) Exports 100(+) Imports 120(-) Current Account Balance -20 Reduction in US bank Deposit claims abroad 10 Official Settlement Balance -10 Reduction in official reserves 10 Balance of Payments 00

The Current Account Entries Merchandise Trade Exports (+) Imports (-) Service Trade Imports(-) Investment Incomes Incomes received (+) Incomes paid (-) Unilateral Transfers

Capital Accounts Entries Unofficial Capital Transactions Purchase (or sale) of foreign assets (Direct and indirect) Purchase (or sale) of home assets by foreign residents US Official Accounts US Assets Gold reserves FX reserves (deposits) SDRs Foreign Official Assets in the US (US liabilities) US government securities held by foreign officials US Treasury bills held by foreign officials Other foreign official assets in the US Other liabilities to foreign official

BOP Deficits and Surpluses Current Balance + Capital Balance+ Official Settlement Balance + Statistical discrepancies = 0 Balance of Merchandise Trade Balance of Merchandise and Service Trade Current Balance Capital Balances Current Balance + Capital Balance + Statistical discrepancies = BOP BOP = Official Settlement Balance

BOP &Foreign Exchange Markets Given that each nation state has its own currency (with which domestic transactions are carried out), all international transactions potentially generate either supply of or demand for foreign exchange. Generally, transactions resulting in debit entries in the BOP generate demand for FX(e.g., imports, investments abroad); transaction resulting in credit entries generate demand(e.g., exports, foreign investments in the US) Foreign exchange markets are places, systems, or mechanisms through which currencies are exchanged or traded. Overall (multilateral) BOP accounts and bilateral BOP accounts

A balanced set of transactions A balanced set of transactions does affect the official settlement balance: An import finance by the seller A foreign investment investment financed by an American bank holding FX deposits in a foreign bank

Foreign Exchange Markets $ S e1 eo e2 D (i$, iY, ee,ef) o Yen

Foreign Exchange Markets: A Flexible Rate System $ S e1 At parity : (i$ - iY) = p (i$ - iY) = ( ee-e)/e eo e2 D (i$, iY, ee,ef) o Yen