The Balance of Payments: Linking the United States to the
International Economy
Balance of payments The record of a country’s trade with other countries
in goods, services, and assets.
• Current account records a country’s net exports, net income on
investments, and net transfers... That is, payments for currently produced
goods and services including labor services (paid wages) and capital
services (paid “investment income”)
• Balance of merchandise trade (sometimes called “balance of trade”)
• Balance of trade in goods and service
• Financial account records a country’s sales of domestic asset to foreign
residents and purchase of foreign assets by domestic residents.
• Net foreign investment The difference between capital outflows from a
country and capital inflows, also equal to net foreign direct investment
plus net foreign portfolio investment.
The Current Account
The Balance of Payments of the United States, 2008 (billions of
dollars)
Trade Flows for the United
States, 2006
U.S. Imports and Exports,
1970–2006
So how do we pay for the excess of current account payments
to foreigners over what they pay to US?
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in the United
States
Increase in U.S. holdings of assets in foreign countries
1,860
−1,055
Balance on Financial Account
805
BALANCE ON CAPITAL ACCOUNT
-4
Statistical discrepancy
11
Balance of payments
0
We sell them our IOUs and other assets (stocks, bonds, real estate deeds)
Net foreign investment The difference between capital outflows from a
country and capital inflows, also equal to net foreign direct investment, FDI, (in
“factories”) plus net foreign portfolio investment (stocks and bonds).
• The “Balance of Payments” (BoP)is always zero (statistical
discrepancy makes it so)
• Sometimes BoP refers to net private transactions in goods, services,
and assets (China’s “BoP” surplus  Bank of China buys US bonds)
Exchange Rates in the Financial Pages
That was then…this is now
http://www.bloomberg.com/markets/currencies/fxc.html
The Foreign Exchange Market and Exchange Rates
Sources of demand for the U.S. dollar:
1 Foreign firms and households who want to buy goods and services
produced in the United States.
2 Foreign firms and households who want to invest
in the United States either through foreign direct investment —
buying or building factories or other facilities in the United States
— or through foreign portfolio investment — buying stocks and
bonds issued in the United States.
3 People doing international business transacted in dollars.
3 Currency traders who believe the value of the dollar will increase.
Sources of supply of the U.S. dollar are analogous: US residents
who want to buy foreign stuff or paper or hold foreign currencies
Equilibrium in the Market for Foreign Exchange
Currency
appreciation An
increase in the
market value of one
currency relative to
another currency.
Currency
depreciation A
decrease in the
market value of one
currency relative to
another currency.
How Do Shifts in Demand and Supply Affect
the Exchange Rate?
Factors that cause the demand and supply curves in the
foreign exchange market to shift:
1 Changes in the demand for U.S.-produced goods and
services and changes in the demand for foreignproduced goods and services
2 Changes in the desire to invest in the United States and
changes in the desire to invest in foreign countries
3 Changes in the expectations of currency traders about
the likely future value of the dollar and the likely future
value of foreign currencies
How Do Shifts in Demand and Supply Affect
the Exchange Rate?
Adjustment to a New Equilibrium
Shifts in the Demand
and Supply Curve
Resulting in a Higher
Exchange Rate
The Foreign Exchange Market and Exchange Rates
Some Exchange Rates Are Not Determined by the Market
Some currencies have fixed exchange rates that do not change … until they
are forced to: a payments deficit drains Central Bank foreign exchange
holdings; Ms declines; i rises  capital inflows; Y and P fall  Im decline
 Balance of Payments balances at the fixed exchange rate.
How Movements in the Exchange Rate Affect Exports and Imports
• For economy below potential GDP, real depreciation/devaluation of the
currency should increase net exports, aggregate demand, and real GDP.
• Real appreciation/revaluation of the domestic currency should have the
opposite effect .
Real exchange rate The price of domestic goods in terms of foreign goods.
 Domestic price level 
Real exchange rate = Nominal exchange rate × 

Foreign
price
level


Some international monetary arithmetic
Current Account Balance + Financial Account Balance = 0
or:
Current Account Balance = -Financial Account Balance
or:
Net Exports = Net Foreign Investment … NX = NFI
Private Saving = National Income – Consumption - Taxes
Sprivate = Y – C – T = (C + I + G + NX) - C - T = [I + (G - T) + NX]
• Private saving finances domestic and foreign investment and a
government deficit
Public Saving = Taxes – Gov’t Spending = Spublic = T – G
National Saving = Private Saving + Public Saving
S = Sprivate + Spublic
S = [I + (G - T) + NX] + (T - G) = I + NFI
Capital In = - NFI= I - S=I - Sprivate - (T-G)= (I - Sprivate) + (G - T)
The Effect of a Government Budget Deficit
on Investment
The Twin Deficits, 1978–2006
Making
the
Connection
Why Is the United States Called
the “World’s Largest Debtor”?
Large current account
deficits have resulted in
foreign investors purchasing
large amounts of U.S. assets.
Exchange Rate: Can the US Current Account Deficit be
Sustained?
Key Terms
Balance of payments
Net foreign investment
Balance of trade
Nominal exchange rate
Capital account
Open economy
Closed economy
Real exchange rate
Currency appreciation
Saving and investment equation
Currency depreciation
Speculators
Current account
Financial account