Presentation on theme: "The Balance of Payments and International Linkages"— Presentation transcript:
1 The Balance of Payments and International Linkages An accounting statement which measures all financial and economic transactions between domestic and foreign residents over a specified period of time.National LevelCorporate LevelForecasting international competitivenessJudging pressure placed on exchange rateSignaling possible imposition of capital controlsFundamentals of BOP AccountingMeasures flows rather than stocks.Is based on a double-entry bookkeeping system.Always balances; i.e., it must be equal to zero.THE BALANCE OF PAYMENTS (B-O-P)PURPOSE:Measures all financial and economic transactions over a specified period of timeDouble-entry bookkeepingCurrency inflows = credits earn foreign exchangeCurrency outflows = debits expend foreign exchange
2 Balance of Payments Accounts Three Major Accounts:CurrentCapitalOfficial ReservesCurrent Accountrecords net flow of goods, services, and unilateral transfers.In other words current account can be classified asTrade Balance (BOT)Service BalanceIncome BalanceUnilateral TransfersCapital AccountFunction: records public and private investment and lending.Inflows = creditsOutflows = debitsTransactions classified asDirect InvestmentsPortfolio InvestmentsOther Financial Items
3 Balance of Payments Accounts contd. Official Reserves AccountFunction: measures changes in international reserves owned by central banks.reflects surplus/deficit ofcurrent accountcapital accountReserves consist ofgoldconvertible securitiesNet Effects:Sum of all transactions must be zero:official reservesThe Balance-of-payment measuresSome Definitions:Basic Balanceconsists of current account and long-term capital flows.emphasizes long-term trendsexcludes short-term capital flows that heavily depend on temporary factorsNet Liquidity Balance:measures the change in private domestic borrowing or lending required to keep payments equal without adjusting official reserves.Official Reserve Transactions Balancemeasures adjustments needed by official reserves.
4 Generic Balance of Payments Current Account1. Trade Balance2. Service Balance3. Income Balance4. Net TransfersA (1 through 4) = Current Account Balance____________________________________________________B. Capital AccountC. Financial Account1. Net Foreign Direct Investment2. Net Portfolio Investment3. Other Financial ItemsA + B + C = Basic BalanceD. Net Errors and OmissionsA + B + C + D = Overall BalanceE. Official Reserves and Related Items
5 Links from international to domestic flows A. Global Linkagesset of basic macroeconomic identities which link: domestic spending and production to current and capital accountsB. Domestic Savings and Investment and the Capital Account1. National Income Accountinga. National Income (NI) is either spent (C) or saved (S)NI = C + S (5.1)b. National spending (NS) isdivided into personal spending (C)and investment (I)NS = C + I (5.2)c. Subtracting (5.2) - (5.1)NI - NS = S - I (5.3)If NI >NS, S > I which impliesthat surplus capital spent overseas.d. In a freely-floating system,excess saving = the capital account balancee. Implications:A nation which produces more than it spends will save more than it invests domestically with a net capital outflow producing a capital account deficit.A nation which spends more than it produces has a net capital inflow producing a capital account surplus.A healthy economy will tend to run a current account deficit.
6 The Link between Capital and Current Accounts 1. Beginning identityNI - NS = X - M (5.4)where X = exportsM = importsX-M=current account balance (CA)2. Combining (5.3) + (5.4)S - I = X - M (5.5)3. If S - I = Net Foreign Investment (NFI)NFI = X - M (5.6)4. Implications:a. If CA is in surplus, the nation must be a net exporter of capital.b. If CA is a deficit, the nation is a major capital importer.c. When NS > NI, the excess must be acquired through foreign trade.Solutions for Improving CA deficits:1.) Raise national income (output) relative to domestic investment (I).2.) Increase (S) relative to domestic investment (I).Government budgets and current account deficitsCURRENT ACCOUNT BALANCECA = Saving Surplus - Gov’t. budget deficitCA Deficit means the nation is not saving enough to finance (I) and the deficitCA Surplus means the nation is saving more than needed to finance its (I) and deficit.
7 COPING WITH THE CURRENT ACCOUNT DEFICIT Possible solutions unlikely to work:Currency DepreciationProtectionismCurrency depreciationU.S. Experience:Does not improve the trade deficit.Depreciations are ineffective becauseIt takes time to affect trade.J-Curve Effect states that a decline in currency value will initially worsen the deficit before improvement.Trade Barriers used:TariffsQuotasResults:Most likely will reduce both X and M.
8 COPING WITH THE CURRENT ACCOUNT DEFICIT contd. Foreign ownershipone protectionist solution would place limits on or eliminate foreign ownership leading to capital inflows.Stimulate national savingchange the tax regulations and rates.Summary: current-account Deficitsneither bad nor good inherentlySince one country’s exports are another’s imports, it is not possible for all to run a surplusDeficits may be a solution to the problem of different national propensities to save and invest.