Chapter 9
Trade and
the Balance
of Payments
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Chapter Objectives
• Present the accounting system of a nation´s
international transactions: current, capital, and financial
accounts
• Explain the relationship among domestic investment,
domestic savings, and international flows of goods,
services, and financial assets
• Examine the meaning of international indebtedness and
discuss its consequences
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Introduction
• The international transactions of a nation are divided
into three separate accounts
– Current account: record of the goods and services into and
out of the country
– Financial account: record of the flow of financial capital to
and from the country
– Capital account: record of some specialized types of
relatively small capital flows
• Let’s examine each of these in greater detail…
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Merchandise Trade Balance
• Let’s first define merchandise trade balance—
part of the current account; measures the
difference between exports and imports of
goods, but not services
– Trade deficit: negative merchandise trade balance
– Trade surplus: positive merchandise trade balance
• In 2002, the U.S. had a trade deficit of $418.0 billion
• However, the U.S. had a large trade surplus in services
($64.8 billion)
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Current Account
• Current account balance: measures all current, non-capital
transactions between a nation and the rest of the world
• Current account has three main components:
– Goods and services = the value of goods and services exported – the value
of imports
– Investment income = income from investments abroad – income paid to
foreigners on their U.S. investments
– Unilateral transfers = any foreign aid or other transfers received by
foreigners – that given to foreigners
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TABLE 9.1 Components of the
Current Account
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TABLE 9.2 The U.S. Current Account
Balance, 2005 (Millions of Dollars)
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FIGURE 9.1 U.S. Current Account
Balance, 1950–2005
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U.S. Current Account Deficit
• U.S. current account deficit looks ominous
• However, the deficit is not a sign of weakness:
U.S. economic boom of the 1990s increased the
demand for imports, while sluggish growth
abroad limited the expansion if U.S. exports
• But the U.S. deficit is not sustainable in the long
term
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Financial Account
• Financial account: record of the flow of
financial capital to and from a country
• Two main components
– Net changes in the country’s assets abroad
– Net changes in the foreign-based assets in the
country
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Capital Account
• Capital account: record of the transfers of
specific types of capital, such as
– Debt forgiveness
– Personal assets that migrants take with them abroad
– The transfer of real estate and other fixed assets,
such as a military base or an embassy building
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TABLE 9.3 The U.S. Balance of
Payments, 2005 (Millions of Dollars)
•
Balance of
payments =
current account +
capital account +
financial account
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Balance of Payments
•
Three accounting caveats
1. Both the capital account and the financial account present
the flow of assets during the year in question and not the
stock of assets that have accumulated over time
2. All flows are net changes (differences between assets sold
and bought, for example) rather than gross changes
3. As long as the capital account balance is zero, financial
account balance = current account balance, but with the
opposite sign
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Statistical Discrepancy in Balance
of Payments
• Statistical discrepancy: the amount by which the sum
of the current, capital, and financial accounts is off the
total of zero
• Statistical discrepancy is calculated as the sum of the
current, capital, and financial accounts, with the sign
reversed
– In 2005, U.S. statistical discrepancy was
[(–1)  (–791,508 – 4,351 + 785,499)] = 10,410
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Statistical Discrepancy (cont.)
• Statistical discrepancy exists because the record
of all the transactions in the balance of payments
is incomplete
– Errors tend to lie in the financial account calculation,
as it is the hardest to measure correctly
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Financial Flows
• Financial flows originate in the public and private
sectors
• Some financial flows are very mobile: move quickly in
response to investor expectations
– Mobility of financial flows brings economic volatility
– Upon sudden financial outflows, a country can sink into a
financial crisis
– The volatility of financial flows has increased concern about
the various types of flows
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Five Types of U.S. Financial
Flows (A–C)
1. U.S. assets abroad (outflows)
A. Official reserve assets: gold bullion, IMF’s special drawing
rights (SDRs), major currencies
B. Government assets: loans to foreign governments,
rescheduled loans to foreign governments, payments
received on outstanding loans, changes in non-reserve
currency holdings (e.g., Mexican pesos)
C. Private assets: direct investment, foreign securities, loans to
foreign firms and banks
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Five Types of U.S. Financial
Flows (D–E)
2. Foreign assets in the U.S. (inflows)
D. Foreign official assets: gold bullion, IMF´s special
drawing rights (SDRs), major currencies
E. Other foreign assets: direct investment, U.S.
securities and currency, loans to U.S. firms and
banks
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TABLE 9.4 Components of the U.S.
Financial Account, 2005 (Millions of
Dollars)
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Largest Share of Financial Flows:
Private Assets
• Private assets: foreign direct investment (FDI), foreign
securities, loans to foreign firms and banks
– FDI: tangible items: real estate, factories, warehouses,
transportation facilities, and other physical (real) assets
– Securities and loans can be considered foreign portfolio
investment—paper assets such as stocks and bonds
– Both FDI and foreign portfolio investment give their holders
a claim in a foreign economy’s future output
– However, holders of FDI have longer time horizons
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TABLE 9.5 Private Flows in the U.S.
Financial Account, 2005 (Millions of
Dollars)
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Limits on Financial Flows
• Until recently, most nations limited the
movement of financial flows related financial
account transactions across their borders
– The European Union liberalized financial flows
between member countries only in 1993
– However, current account transactions were less
heavily regulated
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Financial Account Liberalization
• The movement toward open markets over the
1980s and 1990s has resulted in the lifting of
controls on financial flows
– Developing countries, in particular, have liberalized
financial account transactions in order to get access
to financial capital for development
– Although financial flows can be volatile, economists
agree that free flows are best for economic efficiency
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The Current Account and the
Macroeconomy
• Why study the balance of payments?
– Balance of payments help understand the broader
implications of current account imbalances and how
to tame current account deficits
– Balance of payments give cues how nations can
avoid crises brought by volatile financial flows and
how they can minimize the damage of financial
crises if such occur
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National Income and Product
Accounts
• National income and product accounts: accounting
system for a country’s total production and income
• Two fundamental concepts of the system:
– Gross domestic product (GDP): the value of all final goods
and services produced within a country´s borders during a
period of time (usually a year)
– Gross national product (GNP): the value of all final goods
and services produced by the labor, capital, and other
resources of a country within the country as well as abroad
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National Income and Product
Accounts
• GNP = GDP + foreign investment income
received – investment income paid to foreigners
+ net unilateral transfers
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TABLE 9.6 Variable Definitions
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Understanding National
Accounts
• Interplay of the variables of the national accounts
1. GDP = C + I + G + X – M
2. GNP = GDP + (net foreign investment income + net transfers)
3. GNP = (C + I + G) + (X – M + net foreign investment income + net
transfers)
4. GNP in terms of current account balance:
GNP = C + I + G + CA
5. GNP is also the value of income received: GNP = C + S + T
6. Since 4 and 5 are equivalent definitions of GNP,
C + I + G + CA = C +S + T
7. I + G + CA = S + T
8. S + (T – G) = I + CA
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Understanding National Accounts
(cont.)
• S + (T – G) = I + CA summarizes the current
account balance, investment, and public and
private savings in the economy
• The following figure illustrates the equation in
the U.S. in 1991–2005
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FIGURE 9.2 U.S. Saving
and Investment, 1991–2005
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TABLE 9.7 Key Macroeconomic
Indicators, Percent of GNP, 2004
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International Debt
• Current account deficits must be financed
through inflows of financial capital (loans)
• Loans from abroad add to a country’s stock of
external debt and generate debt service
obligations
• All countries, rich and poor, have external debt
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International Debt (cont.)
• In many low and middle income countries,
external debt leads to financial problems
• Unsustainable debt occurs for numerous
reasons:
–
–
–
–
Falling commodity prices
Natural disasters
Corruption
Foreign lending behavior
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TABLE 9.8 The Five Largest
Developing Country Debtors, 2004
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The International Investment
Position
• If a country runs a current account deficit, it borrows
from abroad and increases its indebtedness
• If a country runs a current account surplus, it lends to
foreigners and reduces its overall indebtedness
• International investment position = domestically owned
foreign assets –foreign owned domestic assets
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The International Investment
Position (cont.)
• A positive international investment position =
the home country could sell all its foreign assets
and have more than enough revenue to
purchase all the domestic assets owned by
foreigners
– In 2005, the U.S. international investment position =
$11,079 billion – $13,625 billion = –$2,546 billion
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