Balance of Payments I 2012
Principal Items:
Trade Account
+ Exports of goods
- Imports of goods
+ Net Factor Income from Abroad
= Current Account
+ Capital Account
= Balance of Payments
= Transaction changes in foreign exchange reserves held by the central bank
(RFX)
Comment on items! Link to the income statement and net savings, as well as the money supply
process, Fixed v.s. floating exchange rate regimes. Basic definition: RFX = 0 if the exchange rate is
freely floating. A fixed rate implies that RFX  0, the central bank must buy and sell foreign currency
to clear the FX market at the fixed parity.
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Income and Balance of Payments
The basic income equation in terms of spending:
Y=C+I+G+X-M
If X-M = Trade Balance/account
GDP = C + I + G + Trade Balance
If X-M = current account (trade account + net factor income)
GNI = Gross Domestic Income
GNI = C + I + G + Trade Balance + Net Factor Income From Abroad
GNI = Y = C + I +G + X - M
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Balance of Payments and Net
Savings
Y=C+I+G+X-M
Use Y – C - G = S (savings by definition). Thus we have
S - I = X – M (Net savings equal the current account)
Current account surplus implies that the country is a net saver (invests abroad).
A positive current account implies that the country is saving more than it consumes and buys foreign
assets.
A negative current account implies that the country is sending more and is borrowing from the rest of
the world. Or, that the rest of the world is investing in the country.
2004: US current account deficit >6% with respect to GDP, big deficit.
China on the other hand has surplus, and is investing in the US.
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Balance of Payments and the Money
Supply Process
Money Demand is a function of income (+) and interest rates (-) :
Md = f(y,P,i) = Pye-1
Money supply is a function of the monetary base MB and the kreditmultiplier (a):
Ms = a(MB)
Money market equilibrium: Md = Ms
MB = Monetary base = Domestic Credit + Foreign Exchange Reserves = DC + RFX
Under fixed exchange rates RFX change as a function of keeping the exchange rate fixed. => The
central bank cannot control the money supply process and in the end not the inflation. If the
central bank accommodates inflation => balance of payment crisis and devaluations.
Under floating rates, RFX = 0, the central bank control the money supply and can chose the inflation
rate.
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How central banks (try to) control the money
supply, the interest rate, and inflation?
Central banks intervene in domestic money market to change DC
DC = Government papers + Bank sector net position in Central Bank (Repos)
By changing DC central banks affect short-term money market interest rates (and the money
supply). Given the slope of the yield curve changes in the short-term interest rates are
transmitted to medium and long-run interest rates.
But, with fixed rates (dirty float) foreign exchange reserves changes through
RFXt = RFXt + RFXt-1
RFXt-1 = Exchange rate * Value of Reserves in foreign currency
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Fixed v.s. Floating Exchange Rates
Principle differences
Exchange rate : Demand and Supply of foreign exchange
Fixed rates: The price of foreign exchange is fixed  Quantity
changes
CB adds net demand for foreign currency to guarantee the price.
Floating rates: The price of foreign exchange (the exchange rate)
adjust to clear market D = S
This has implications for monetary policy, especially under fixed rates.
Money supply must ‘control’ or support the fixed parity.
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The Balance of Payments II
Current Account
Capital Account
= Transaction changes in foreign exchange reserves (RFXt)
Fixed rates : RFXt (  0) changes to clear the market at S = D
Floating rates : RFXt = 0 exchange rates changes to clear the market
Between the two : various forms of managed foreign exchange rate
systems
RFXt  0 CB intervention in FX markets
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The Balance of Payments III - Details
Current account
Goods export – Goods import
Trade Account
+ Capital account
Foreign Direct Investment
Portfolio Investments
Equity (no control posts)
Debt
Financial Derivatives
Other Investment
Monetary Authorities
Government
Banks
Other sectors
Errors and Omissions
= RFX Change in foreign exchange reserves. RFX is known! Zero if freely floating
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Notice the Error and Omissions Term
Current account
+ Capital account
= RFX
- Errors and Omissions It can be big!!
Or,
Currenct account
+Capital account
+ Errors and Omissions (The errors and omissions are added here
to make the identity hold)
+ RFX
=0
From where comes the EO - term? What can be done?
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Official Balance of Payment
Statistics
IFS recommendations
Current Account
+Trade Balance
+ Exports f.o.b.
- Imports f.o.b.
+ Service Balance
+ Credit
- Debit
+ Income
+ Credit
- Debit
+ Current Transfers
+ Credit
- Debit
= Current account
+ Capital Account (WARNING: This is a Central Bank item, not the Capital Account from above)
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+ Financial Account
+ Errors and Omissions
= Overall balance
[= - Official settlement balance ( - Change in foreign exchange reserves)]
= - Financing
- Change in foreign exchange reserves
Use of fund credit and loans
Exceptional financing
Current Account + Capital Account + Financial Account +Financing = 0
Notice that a positive BoP, positive overall balance leads to a negative sign on Financing (and
change in foreign exchange reserves)
Overall balance - Financing = 0
A surplus or a deficit is financed. This is accounting only. For our purposes, (-1) x "Changing in
foreign exchange reserves" = Transaction changes in foreign exchange reserves!
This item will go up when the overall balance is positive (sum of exports, or sum of inflows of money
is larger than sum of imports, sum of outflows of money).
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The Financial Account is Split into:
Direct investment (Abroad + Domestic)
- Portfolio Investment : Assets = Equity + Debt
+ Portfolio Investment : Liabilities = Equity + Debt
- Financial Derivatives Assets
+ Financial Derivatives Liabilities
- Other Investments Assets
Monetary authorities
Government
Banks
Others
+ Other Investments Liabilities
Monetary authorities
Government
Banks
Others
Plus or minus refers to inflow or outflow of money
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