1. The Balance of Payment

2. National Income Account and BOP
Y = C + I + G + CA
Y = GDP
C = consumption
G = government spending
CA = current account balance
This is called National Income Identity

3. Current Account CA = X – M = net export of goods and services
X = export; M = import
Strictly speaking CA = X – M +UT but, for a while, we ignore UT = unilateral transfer
In a closed economy, we do not have CA. (because X = M = 0)

4. National Income Account
Consumption
= spending by households, including consumer spending on durable goods
Investment
= Business sector’s adding to the physical stock of capital, including inventories. (individual household’s purchases of stocks, bonds or real estates are not included)
Government purchases
= spending by federal, state, or local governments

5. National Income Account
1999
C 67.6% $6.3 trillion
I % $1.6
G 17.6% $1.6
CA -2.7% -$0.25

6. Current account balance
(Domestic spending on goods and services produced domestically)
= C + I + G – M
(Foreign spending on goods and services produced domestically)
= X

7. Current account balance (cont’d)
CA = X – M
When X > M or CA > 0, we say current account surplus.
When X < M or CA < 0, we say current account deficit.
CA = Y – (C + I + G) = Y – A
where A = domestic absorption

8. Current account balance (cont’d)
A country with current account deficit is buying more from foreigners than it sells to them
It has to increase net foreign debts.
CA = net foreign wealth
US has been a net debtor since 1985.
In 1998, debt = $5.5 trillion

9. Saving and Investment Let S = national saving = Y – C – G. Then
S = I + CA
(In a closed economy S = I)
where
I = domestic investment = capital stock accumulation
CA = foreign wealth acquisition = net foreign investment
An open economy can increase investment by borrowing abroad.

10. Saving S = SP + SG where SP = Yd – C = Y – T – C SG = T – G
SP = private saving; SG = government saving;
Yd = disposable income; T = net tax.
Then SP = (C + I + G + CA) – T – C
= I + CA + (G - T)
where G – T = government budget deficit.
So CA = SP – I – (G – T)
A large gov’t budget deficit leads to a large current account deficit.

11. Balance of Payment Accounts
Double-entry bookkeeping
each entry is recorded twice.
A debit entry  a payment to foreigners
A credit entry  a receipt from foreigners

12. Current Account (CA) the record of commodity and services transaction
A. Exports (credit)
B. Imports (debit)
1. Merchandise: commodity transaction
2. Services: travel, tourism, royalties, transportation costs, insurance premiums.
3. Income
Income receipts on US assets abroad (credit)
Income payments on foreign assets in US (debit)
Direct investment receipts and payments
Interest, dividends.

13. Current Account (cont’d)
C. Unilateral Transfers (debit)
US foreign aid, gifts, retirement pensions, interest payments to foreigners on their US gov’t debt, workers’ remittances.
CA > 0: current account surplus
 the country is a net lender to the rest of world
CA < 0: current account deficit
 the country is a net borrower from the rest of world

14. Capital Account (KA) the record of financial assets transaction
A. US assets abroad
1. US official reserve assets (Gold, SDR, reserve in IMF, foreign currencies)
2. US gov’t assets
3. US private assets (direct investment, foreign securities)
B. Foreign assets in US
1. Foreign official assets in US (US gov’t securities, …)
2. Other foreign assets in US (direct investment, US treasury securities)

15. Example (a)
An American buys a share of German stock, paying by writing a $10,000 check on his account with a Swiss Bank.
Debit: US asset held abroad $10,000
Credit: US asset held abroad $10,000.
For Germany
Credit: Foreign asset held in Germany
Debit: German asset held abroad

16. Example (b)
An American buys a share of German stock, paying the seller with a $10,000 check on an American bank.
Debit: US asset held abroad $10,000
Credit: Foreign asset held in US $10,000

17. Example (c)
The French government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens.
Debit: Foreign asset held in US $1 million
Credit: Foreign asset held in US $1 million
(US official reserve asset)

18. Example (d)
A tourist from Detroit buys a meal at an expensive restaurant in Lyons, France, paying with a VISA credit card. VISA uses a checking account in France to make payments.
Debit: Import, Services $300
Credit: US assets held abroad $300

19. Example (e)
A California winegrower contributes a case of his best cabernet sauvignon for a London wine tasting.
No market transaction!

20. Statistical Discrepancy
Theoretically, current account and capital account should add up to zero. But in reality, there is a discrepancy due to errors, time lags, and so on.

21. Official Reserve Assets
purchase or sale of foreign assets held by the central bank
Official international reserves: gold, SDR, foreign currencies, etc.
(current account) + (non-reserve capital account) + (statistical discrepancy)
= Balance of Payment (official settlement)

22. Balance of Payment Balance of Payment (official settlement)
= current account deficit needed to be covered by the central bank’s official reserve transactions.
BOP deficit  the country is running down its official reserves.