10/13/20151 Outline 2: The Balance of Trade, Balance of Payments (BOP) and International Macroeconomics 2.1 Introduction to the Balance of Trade and Payments 2.2 International Macroeconomics 2.3 Conclusions on BOP

10/13/ Introduction to the Balance of Trade and Payments BOP: – Summary financial statement of a nation’s transactions with the world – 3 Accounts: Current Account (X-M) Capital Account (ΔK) Official Reserves Account (ORA)

10/13/ Introduction to the Balance of Trade and Payments BOP: Notation X = domestic currency value of exports, M = domestic currency value of imports Δ K = domestic currency value of net capital outflows (capital investment to other countries) ORA = official reserves account settlement (assume this is 0 for US BOP analysis; its very small as non-US trading partners want to hold $’s

10/13/ Introduction to the Balance of Trade and Payments BOP: Double-Entry Bookeeping (X-M) + Δ K+ ORA = 0 BOP Accounting Identity: Current account plus capital account sum to 0 as US ORA assumed equal to 0. (X-M) > 0 current account trade surplus (X-M) < 0 current account trade deficit (X-M) = - Δ K Deficit in current account is offset by net capital inflows; foreigners buy assets with US $.

10/13/ Introduction to the Balance of Trade and Payments Current Account: reflects net flow of goods and services (exports and imports), income, and unilateral transfers Capital Account: – reflects public and private lending and investment activities – Portfolio (maturities >1 year), direct investment (equity >10%), short-term investment (< 1 year) criteria

10/13/ International Macroeconomics Relationship Between Macro-Economy and BOP: Notation: Y = GDP or $ value of national output or aggregate supply C = national level of consumption expenditures S = national level of savings I = national level of investment Y d = national level of expenditures or aggregate demand

10/13/ International Macroeconomics Relationship Between Macro-Economy and BOP: Y = C + S consume or save output Y d = C + Iexpenditures are consume or invest Y – Y d = S - Icapital surplus invested abroad S > I leads to –ΔK or capital outflow S < I leads to + Δ K or capital inflow Y – Y d = X – M excess of output sold to foreigners S – I = X – M net foreign investment = trade surplus

10/13/ International Macroeconomics Relationship Between Macro-Economy and BOP: X > M leads to S > I Trade surplus leads to positive net foreign investment or capital outflows X < M leads to S < I Trade deficit leads to negative net foreign investment or capital inflows

10/13/ International Macroeconomics Relationship Between Macro-Economy, BOP, and Government Deficits: Government budget deficit occurs when government spending for a year is greater than tax receipts. Y d = (C-T) + I + G where: T=tax receipts, G=gov’t spending, and (C - T) is private consumption Y - Y d = (S - I) - (G - T) X – M = (S – I) - (G - T) Government deficits worsen current account balance and have foreign capital inflows to finance gov’t deficit.

10/13/ International Macroeconomics What does this all mean? – Nation that produces more than it spends saves more than it invests, exports more than imports, and has a capital outflow. – Nation that produces less than it spends saves less than it invests, imports more than exports, and has a capital inflow. – Nation with a gov’t deficit will exacerbate trade deficits and capital inflows.

10/13/ Conclusions on BOP What does this mean for FX rates? – A trade deficit (home goods too expensive) Appreciation of domestic currency and a fall in FX rate (e) – A trade surplus (home goods cheap Depreciation of domestic currency and a rise in FX rate (e)

10/13/ Conclusions on BOP US has consistent trade deficits. US has consistent gov’t. budget deficits: – National debt = Sum{all past budget deficits} – National debt is about $17b – 26% (46% of 57% of debt held by public) of US gov’t. bonds held by foreigners (mainly Saudi Arabia, China & Japan) US long-term savings rate ( 20%).

10/13/ Conclusions on BOP The US trade deficit has been driven by a strong dollar due to high demand for safe US stocks and bonds: – Foreigners bought US assets thereby bidding up value of $ – US bought foreign goods/services with FX from sale of $ helping to drive trade deficit. – Capital account is driving the current account in US.