Chapter 5 The Balance of Payments and International Economic Linkages
A. Balance of Payments
B. The International Flow of Goods, Services, and Capital
C. Current Account Deficit
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5.A

Balance of Payments (http://www.bea.gov/international/)
Balance of payments (“BOP”) – an accounting statement that
summarizes all of the economic transactions between residents of the
home country and residents of all other countries.
– Current Account – reflects the net flow of
• Goods and services (balance of trade);
• Income (interest, dividends, and compensation); and
• Unilateral transfers (pensions, remittances, and other transfers for which no
services were rendered).
– Capital Account – reflects capital transfers that offset transactions
undertaken without exchange in fixed assets or in their financing.
– Financial Account – reflects net purchases of financial assets:
• Portfolio investments – financial assets with maturity > one year
• Direct investments – financial assets for which management control is exerted (at
least 10% equity ownership)
• Changes in reserve assets held by official monetary institutions
– Double-entry accounting ensures that the sum of all transactions is zero.
– A “statistical discrepancy” line is included to offset non-zero balances.
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5.B

International Flow of Goods, Services, and Capital
Macroeconomic accounting identities
–
Link domestic spending and production to savings, consumption, and
investment behavior, and thus to Current Account and Financial
Account balances.
–
Manipulating accounting identities reveals the nature of the links
between U.S. and world economies.
i.
Domestic savings and investment and the Financial Account
ii. Link between Current Account and Financial Account
iii. Government budget deficits and the Current Account
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5.B.i International Flow of Goods, Services, and Capital:
Savings and Investment and the Financial Account

National income* is either spent or saved. Thus:
Identity 5.1:

National Income = Consumption + Savings
National expenditures consist of consumption and investment.
Thus:
Identity 5.2: National Expenditures = Consumption + Investment

Thus:
National Income – National Expenditures =
Identity 5.3: (consumption + savings) – (consumption + investment) =
Savings – Investment
*same as national product
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5.B.i International Flow of Goods, Services, and Capital:
Savings and Investment and the Financial Account

If income > expenditures, then savings > investment, resulting
in a capital surplus (excess savings).

Surplus capital is invested overseas.

Thus, surplus capital becomes net foreign investment.

If positive, net foreign investment equals a Financial Account deficit.
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5.B.ii International Flow of Goods, Services, and Capital:
Link Between Current Account and Financial Account

Combining Identity 5.3 and Identity 5.4:
Identity 5.5:
–

Savings – Investment = Exports – Imports
Thus, if savings > investment, net exports are positive and the Current
Account will run a surplus.
Because net foreign investment = savings - investment:
Identity 5.6:
Net Foreign Investment = Exports – Imports
–
Thus, the Current Account balance = net capital outflow.
–
If savings > investment, net foreign investment is positive and the
Current Account will run a surplus.
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5.B.ii International Flow of Goods, Services, and Capital:
Link Between Current Account and Financial Account

By Identity 5.6, the excess of goods and services bought over goods
and services produced domestically must be acquired through
foreign trade and financed by an equal amount of borrowing from
abroad.

That is, if exports < imports, net foreign investment is negative.

–
When exports < imports, the Current Account will run a deficit.
–
When net foreign investment is negative, the Financial Account will run
a surplus.
Thus, the Current Account and Financial Account balances must
exactly offset each other.
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5.B.ii International Flow of Goods, Services, and Capital:
Link Between Current Account and Financial Account

Using identities to assess the efficacy of solutions to improve the
Current Account balance

Two conditions must be satisfied to reduce/increase a Current
Account deficit/surplus:

–
By Identify 5.3, raise income relative to expenditures; and
–
Bv Identity 5.5, raise savings relative to investment.
However, a Current Account surplus is not necessarily a sign of
economic health.
–
Countries that provide good investment opportunities may run trade
deficits (investment > savings).
–
Countries that grow rapidly import more goods and services and may
thus run trade deficits.
–
Weak economies may reduce their imports, given a positive correlation
of income with import consumption, and may thus run trade surpluses.
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5.B.iii International Flow of Goods, Services, and Capital:
Govt. Budget Deficits and Current Account Deficits
Identity 5.9:
–
Current Account Balance =
Private Savings Surplus – Govt. Budget Deficit
Thus, a country running a Current Account deficit is not saving enough
to finance its private investment and government budget deficit, and a
country running a Current Account surplus has excess savings after
financing private investment and the government deficit.
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5.C. Current Account Deficit (1)

Responses to a Current Account deficit include currency
devaluation, protectionism, and increasing savings.
–
Devaluation
•
An overvalued currency acts as a tax on exports and a subsidy to
imports.
•
Empirical review of currency devaluation and trade deficit
– 1976-1980 – dollar depreciated as trade deficit first worsened
and then improved.
– 1980-1985 – dollar appreciated as trade deficit steadily
worsened.
– 1985-1987 – Dollar began depreciating while trade deficit rose
steadily.
– 2002 – Dollar began depreciating as trade deficit reached record
levels
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5.C. Current Account Deficit (2)

Responses to a Current Account deficit include currency
devaluation, protectionism, and increasing savings, continued
–
Devaluation, continued
•
Conventional explanations for disconnect between changes in currency value
and changes in trade deficit
–
Lagged effects – time is needed for an exchange rate change to affect
trade. Empirical review indicates that changes in the dollar’s value
explain less than 5% of the variation in the trade balance between 1970
and 2006.
–
J-Curve theory – as currency depreciates, the trade deficit initially
worsens and then improves over time. Consistent with presence of
lagged effects. Empirical review indicates that the trade deficit initially
worsened in 1985 but did not reach its 1985 level until four years later.
Subsequent Current Account improvements may have been due to
budget deficit declines, rendering the J-curve theory inconclusive.
–
The attractive investment climate in the 1980s caused investors to
expand holdings of U.S. assets, which bid up the value of the dollar such
that Americans changed their assets for foreign goods and services,
causing a Financial Account surplus and Current Account deficit.
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5.C. Current Account Deficit (3)

Responses to a Current Account deficit include currency
devaluation, protectionism, and increasing savings, continued
–
Protectionism
•
Tariffs increase the prices of imports, causing domestic consumers
to opt for domestic substitutes.
•
Quotas restrict supply of imports, thereby raising prices and causing
domestic consumers to opt for domestic substitutes.
•
Protectionism thus results in increased domestic prices, erosion in
purchasing power, and a decline in living standards.
•
Protectionism does not affect the trade balance, as other imports rise
or exports fall.
•
By Identity 5.5, as imports fall, exports will fall by an equal amount
absent changes in saving or investment.
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5.C. Current Account Deficit (4)

Responses to a Current Account deficit include currency
devaluation, protectionism, and increasing savings, continued
–
Increasing savings
•
The prospect of receiving Social Security benefits may negatively
affect American’s saving habits.
•
Increase tax-favored savings vehicles
•
Switch from income tax to consumption tax
•
Reduce the government budget deficit
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