Copyright © 2011 Pearson Addison-Wesley. All rights reserved. Chapter 9 Trade and the Balance of Payments

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-2 Introduction: The Current Account Current account: record of the goods and services into and out of the country Financial account: record of the flow of financial capital to and from the country Capital account: record of some specialized types of relatively small capital flows

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-3 The Trade Balance Trade balance- measures the difference between exports and imports of goods and services –Trade deficit: negative trade balance –Trade surplus: positive merchandise trade balance

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-4 The Current Account Balance Current account balance: Measures all current, non-capital transactions between a nation and the rest of the world –Goods and services = Exports of goods and services – Imports –Investment income = income from investments abroad – income paid to foreigners on U.S. investments –Unilateral transfers = any foreign aid or other transfers received by foreigners – that given to foreigners

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-5 TABLE 9.1 Components of the Current Account

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-6 TABLE 9.2 The U.S. Current Account Balance, 2008

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-7 TABLE 9.2 (continued) The U.S. Current Account Balance, 2008

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-8 FIGURE 9.1 U.S. Current Account Balances,

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-9 U.S. Current Account Deficit Current account deficit is not a sign of weakness –In 90s, foreign demand for US exports grew less rapidly than US demand for imports U.S. deficit is not sustainable in the long term

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Financial Account Financial account: A record of the flow of financial capital to and from a country Financial account is divided into three categories: –Net changes in the U.S. owned assets abroad –Net changes in the foreign-based assets in US –Net change in financial derivatives

Financial Account Net changes measure monetary value of the change in country’s financial stake Domestic financial outflows are payments for purchase of foreign-owned assets (debit) Financial inflows are receipts from sale of domestic country’s assets to foreigners (credit) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-11

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Capital Account Capital account: A record of the transfers of specific types of capital, such as: –Debt forgiveness –Personal assets that migrants take with them abroad –The transfer of real estate and other fixed assets, such as a military base or an embassy building

The Three Accounts are Interdependent Current account measures flow of goods and services Capital and financial accounts measure flow of financing Sum of capital account and financial accounts equal current account with the opposite sign Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-13

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 9.3 The U.S. Balance of Payments, 2008

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 9.3 (continued) The U.S. Balance of Payments, 2008

Table 9.4 Components of the U.S. Financial Account, 2008 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-16

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Types of Financial Flows Financial flows originate in the public and private sectors Some financial flows are very mobile –Brings economic volatility –Sudden financial outflows can create a financial crisis –Volatility of financial flows has increased concern about the various types of flows

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Official reserve assets: mainly currencies of largest and most stable economies in world; dollars, euros, pounds, and yen Reserve assets are used to settle international debts and used by central banks and treasuries as store of value Scarce official reserves is sign of problems There is no tracking of total reserve assets available Types of Financial Flows

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Largest Share of Financial Flows: Private Assets –Foreign Direct Investment (FDI): tangible items, physical assets –Securities and loans can be considered foreign portfolio investment—paper assets such as stocks and bonds –Both FDI and foreign portfolio investment give their holders a claim in a foreign economy’s future output –Holders of FDI have longer time horizons

Role of Expectations in Financial Flows Sudden stop refers to shifts in expectations can lead to sudden stoppages of financial inflows Leads to destabilization of outflows of financial capital Sudden stops have been involved in most financial crises in last 30 years Can’t have current account deficit with negative financial account Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-20

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Limits on Financial Flows In past most nations limited the movement of financial flows across their borders Nations have started to liberalize financial flows across borders –Desirable because restrictions on financial flows limits availability of financial capital –Thought to improve developing countries’ access to financial capital flows

Copyright © 2011 Pearson Addison-Wesley. All rights reserved Limits on Financial Flows Increased financial flows across borders should improve economic efficiency Recent volatility suggests more regulation is needed Key is to capture benefits of more investment while limiting risks of capital flight

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 9.6 The U.S Financial Accounts, (millions of dollars)

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 9.6 (continued) The U.S Financial Accounts, (millions of dollars)

The National Income and Product Accounts National income and product accounts: accounting system for a country’s total production and income –Gross domestic product (GDP): the value of all final goods and services produced within a country´s borders –Gross national product (GNP): the value of all final goods and services produced by a country’s resources no matter where they produce Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 4-25

Table 9.7 Variable Definitions Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-26

Copyright © 2011 Pearson Addison-Wesley. All rights reserved FIGURE 9.2 U.S. Savings and Investment, 1990–2007

Understanding National Accounts Nation’s savings is source for domestic investment and foreign investment No fixed relationship between the variables Each of four variables are determined by the other three A change in any one of them influences all of them opyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-28

Are Current Account Deficits Harmful? Not necessarily sign of weakness or harmful Enables more investment than otherwise which leads to higher standards of living CA deficits are vote of confidence by foreigners Increased foreign owned assets in country can lead to sudden surge in capital outflows Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 9-29

Copyright © 2011 Pearson Addison-Wesley. All rights reserved International Debt Current account deficits must be financed through inflows of financial capital (loans) External debt is money owed to individuals outside of the domestic country. External debt isn’t any worse than any debt Loaned funds must be used to expand production capacity while servicing debt

Copyright © 2011 Pearson Addison-Wesley. All rights reserved International Debt In many low and middle income countries, external debt leads to financial problems Unsustainable debt occurs for numerous reasons: –Falling commodity prices –Natural disasters –Corruption –Foreign lending behavior

Copyright © 2011 Pearson Addison-Wesley. All rights reserved TABLE 9.8 The Five Largest Developing Country Debtors, 2007