Components and the Balance of Payment

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Components and the Balance of Payment

• Balance of Payment (BOP) is an account showing
  the receipts from, and payments to, foreign
  countries.
• Current Account (CA) is the part of the BOP that
  includes exports, imports, investment income and
  unilateral transfer payments to and from
  foreigners.

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Components and the Balance of Payment (Cont)

• Capital Account (KA) is the part of the BOP that
  records capital flows, which consist of purchases
  and sales of foreign assets by domestic citizens,
  and purchases and sales of domestic assets by
  foreign citizens.
• Official Reserve Account (R) measures the change
  in a countrys official reverse assets and the
  change in foreign official assets in that
  country.

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Credit Items VS Debt Items in BOP

• Credit item is any item that gives to a sale of
  foreign currency and a purchase of domestic
  currency to settle for the payment.
• Debit item is any item that gives to a sale of
  domestic currency and a purchase of foreign
  currency to settle for the payment.

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Double-Entry Bookkeeping

• It refers to the practice of recording an
  offsetting debit or credit in the BOP for every
  credit or debit transaction entered.
• Through this technique, the BOP must always in
  balance.
• Once we talk about a BOP surplus or deficit, we
  are referring to the Current plus Capital
  Accounts only.

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The Balance of Payments Account
Balance on Merchandise Trade(visible trade
balance)
/
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Balance on Services (invisible trade balance)
/
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I. Balance on Current Account (A1) (A2)
(A3) A(4) /
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II. Balance on Capital Account (B1)
(B2) /
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III. Net Balance on Official Reserves Account
/
D. Net Errors and Omissions
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IMPORTANT!
Balance of Payments 0 CA KA R e
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Net International Investment Position

• It is the difference between all foreign assets
  owned by domestic citizens and domestic assets
  owned by foreign citizens
• It depends on the Current Account balance
  position. If CA is in deficit, it must be
  financed by Capital Account surplus which implies
  that the net international investment position is
  negative, vice versa.

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How to Draw BOP Curve?

• The BP curve shows the combinations of r and Y
  that will yield equilibrium in the BOP.
• If Y increases, imports increases which worsens
  the Current Account. To make BOP to attain new
  equilibrium, r need to increase to induce capital
  inflow and reduce capital outflow so as to offset
  the worsening of the Current Account.Therefore,
  BP curve slope upward.

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How to Draw BOP Curve? (Cont)

• However, if tiny adjustment in r can offset the
  worsening Current Account caused by changing Y
  (i.e. perfect capital mobility), BP curve tends
  to be horizontal.
• Or, if infinitive adjustment in r cannot offset
  the worsening Current Account caused by changing
  Y (i.e. perfect capital immobility), BP curve
  tends to be vertical.

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Different Kinds of BOP Curves?
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Exchange Rates

• The foreign exchange rate (e) is the amount of
  domestic currency for purchasing one unit of
  foreign currency.

• Simply, we can express it as
• e pd / Pf Where
• pd domestic price in term of domestic
  currency
• pf foreign price in term of foreign currency

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Exchange Rate and BOP

• The demand for and the supply of foreign currency
  will determine the exchange rate.
• The demand for and the supply of foreign currency
  arises primarily from international BOP.
• The demand for (supply of ) foreign currency
  arises due to import (export) of goods and
  services, and make (receive) foreign investments.

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Exchange Rate Determination Floating Exchange
Rate System
The floating exchange rate is the system that
allows an exchange rate to be freely determined
by the interaction of demand and supply of
foreign currency.
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Floating Exchange Rate System Appreciation
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Floating Exchange Rate System Depreciation
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Factors Affecting the Exchange Rate

• Long run factors
• Differential inflation rates (the
  Purchasing-Power-Parity Theory)

• Structural Changes (e.g. discovering new oil)

• Short run factors
• Changing in the level of economic activity

• Changing in the level of interest rate

• Speculation

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Purchasing-Power-Parity Theory (PPPT)

• The PPPT holds that the exchange rate between any
  two national currencies adjusts to reflect
  differences in the prices levels (or inflation
  rate) in the two countries.
• For example, if country A has a faster rate of
  inflation than country B, then country As
  exchange rate must be depreciating.

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Reasons for the failure of PPPT

• Absence of free trade
• Presence of non-tradable product
• Presence of different price indices (i.e.
  different basket of goods for price indices)
• Presence of transaction costs
• Other factors government tax or subsidies,
  different profit margin set by firms, etc.

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Floating Exchange Rate and BOP
Under a floating exchange rate system, the market
mechanism would operate to restore equilibrium
simultaneously in BOP and exchange.
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Floating Exchange Rate and BOP Surplus
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Floating Exchange Rate and BOP Deficit
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Exchange Rate Determination Fixed Exchange Rate
System

• The fixed exchange rate system is the system that
  the exchange rate is set by a government or by
  the agreement among countries.
• Revaluation means that the value of a currency
  relative to one or more other currencies is
  raised by the monetary authorities.
• Devaluation means that the value of a currency
  relative to one or more other currencies is
  lowered by the monetary authorities.

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Exchange Rate Determination Fixed Exchange Rate
System
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Fixed Exchange Rate and BOP

• The BOP surplus of a country is the amount by
  which the quantity supplied of foreign currency
  exceeds its quantity demanded at the fixed rate.
• The BOP deficit of a country is the amount by
  which the quantity demanded of foreign currency
  exceeds its quantity supplied at the fixed rate.

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Fixed Exchange Rate and BOP Surplus
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Fixed Exchange Rate and BOP Deficit
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Measures to Maintain Fixed Exchange Rate?

• Buying of domestic currency and selling of
  foreign currency

• Raising domestic interest rate while lowering
  foreign interest rate

• Encouraging exports and discouraging imports

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Measures to Maintain Fixed Exchange Rate?

• Buying of foreign currency and selling of
  domestic currency

• Lowering domestic interest rate while raising
  foreign interest rate

• Encouraging imports and discouraging exports

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IS-LM-BP Model

• The IS curve shows the combinations of r and Y
  which are points of equilibrium for the goods
  market.
• The LM curve shows the combinations of r and Y
  which are points of equilibrium for the money
  market.
• The BP curve shows the combinations of r and Y
  that will yield equilibrium in the BOP.

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IS-LM-BP Model
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