14' The Balance of Payments

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14. The Balance of Payments

• The components of the balance of payments
• Current account
• Capital account
• Official financing
• National income determination and foreign trade

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• Economies are becoming more open (in terms of
  trade as of GDP), but some countries are more
  open than others

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• Higher degree of openness gt structure of
  production and employment, and economic growth,
  are more likely to be affected by external events
• The balance of payments provides and indication
  of how international trade and external events
  feed back into the macroeconomy
• This lecture describes how balance of payments
  accounts are recorded and then explores the link
  between the balance of payments and the exchange
  rate

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The balance of payments (BoP) accounts

• A countrys balance of payments accounts record
  its international trading position and its
  lending and borrowing
• gt records transactions between countries

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• Each transaction is classified according to the
  payment or receipts that it generates
• Transactions that generate a receipt of a payment
  from foreigners are a credit item in the accounts
  with a sign
• These represent a supply of foreign exchange ()
  and a demand for the local currency ()
• Transactions that comprise a payment to
  foreigners are reported as a debit item with a -
  sign
• gt These represent demand for foreign exchange
  () and a supply of the local currency ()

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Three Balance of Payments (BoP) Accounts

• The balance of payments on Current Account
• The balance of payments on Capital Account
• The balance for Official Financing

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• Let us consider two countries
• the United Kingdom
• local or domestic
• currency British pounds ()
• the United States
• foreign
• currency US follars ()

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a) The balance of payments on Current Account

• Records transactions arising from trade in goods
  and services
• The visible trade balance
• payments and receipts from the import/export of
  tangible goods (cars, food, textiles,)
• The invisibles trade balance
• payments and receipts for financial services,
  shipping and tourism, interest and dividends
  payments on investments, etc.

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• b) The balance of payments on Capital Account
• Records transactions related to international
  movements in the ownership of financial assets
• The purchase of foreign investments by UK
  citizens brings assets to the UK (in exchange for
  money) and are referred to as a capital outflow
• to purchase these foreign assets, locals have to
  buy
• gt debit (negative) entry in the Capital Account

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• b) The balance of payments on Capital Account
  (cont.)
• Foreign investment into the UK increases UK
  liabilities to foreigners, and it is a capital
  inflow
• foreigners have to buy to undertake their
  investments
• credit (positive) entry in the Capital Account
• The Capital Account is further divided into
  short-term and long-term capital flows

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• The supply of s reflects imports to the UK and
  UK purchases of foreign assets
• gt outflows in the UK balance of payments
• The demand for s reflects UK exports and sales
  of UK assets to foreigners
• inflows in the UK balance of payments

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• The exchange rate is the price of the in terms
  of other currencies (e.g. )
• If the exchange rate is freely floating then it
  will adjust to ensure that the demand for s
  the supply of s ? inflows outflows in the BoP
  ? BoP is exactly zero
• Since BoP Current Account Capital Account
• a Current Account surplus gt a Capital Account
  deficit
• a Current Account deficit gt a Capital Account
  surplus

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• c) The balance for Official Financing
• If the exchange rate is fixed, and there is a BoP
  deficit ? outflows gt inflows ? supply of s gt
  demand for s
• The Central Bank must offset this excess supply
  of s by buying them with foreign currency ()
  i.e. runs down its reserves of foreign exchange

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• c) The balance for Official Financing (cont)
• The balance for official financing shows the net
  increase or decrease in a countrys holdings of
  foreign currency reserves
• A decrease in the official reserves is reported
  as a credit item (), since it involves the
  purchase of s
• an increase is reported as a debit item (-)
• gt If the exchange rate is freely floating, then
  the balance for official financing is zero

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• The balance of payments must always balance since
  the accounts are constructed such that this must
  be true by definition
• However, there can be measurement error and
  unreported borrowing from abroad and other
  illegal activities
• The discrepancy represents a combination of
  unrecorded current and capital account
  transactions
• This requires the inclusion of what is referred
  to as a balancing item, to ensure the accounts
  balance in practice

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National Income Identities and the Current
Account Balance

• Recall the aggregate expenditure identity in our
  first lecture
• Y C I G X - M
• Leakages are
• S NT M
• Injections are
• I G X
• gt In equilibrium injections leakages
• S T M I G X

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• The balance of payments on Current Account could
  be re-written as
• (36) (X - M) (T - G) (S - I)
• or
• (M - X) (G - T) (I - S)
• trade government private sector
• deficit balance balance

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• Trade deficit government deficit priv. sector
  deficit
• An increase in govt. expenditure (G), or a
  reduction in private saving (S) worsens the trade
  balance (i.e. rises trade deficit)

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Are trade deficits a problem?

• Mercantilists believed that a country should
  accumulate reserves (in the form of gold) through
  trading
• A trade deficit is not necessarily a bad thing
  (e.g. when growing domestic industries attract
  foreign investments)
• However, if a country persistently runs a trade
  deficit this is something to worry about (e.g.
  vulnerability to loss of foreign investors
  confidence)