Objectives
• Accounting system of a nation's international transactions:
current, capital, and financial accounts
• Explain the relationship between GDP and international
flows of goods, services, and financial assets
• Examine the meaning of international indebtedness and
discuss its consequences
• Balance of Payment to demand and supply for foreign
exchange and the exchange rate
Name Economic Actions one can have with a foreign country
and say if this will trigger Foreign Currency demand or supply.
Introduction:
The Balance of Payment
• 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
The Trade Balance
• Let’s first define the trade balance- measures
the difference between exports and imports of
goods and services
– Trade deficit (this is not the current account balance):
negative trade balance
• In 2008, the U.S. had a trade deficit of $695.0 billion
• In 2011: $332.9 billion
The Current Account Balance
• Current account balance: Measures all current, non-capital
transactions between a nation and the rest of the world
• The current account has three main components:
– Goods and services = the value of goods and services
exported – the value of imports
– income received/paid = income from investments and
compensation (wage) abroad – income paid to foreigners
on their U.S. investments and paid compensation
– Unilateral transfers = any foreign aid or other transfers
received by foreigners – that given to foreigners
Components of the Current Account
Leads to Foreign
Currency Supply
Leads to Foreign
Currency Demand
The U.S. Current Account Balance, 2008
The U.S. Current Account Balance, 2008
How does the current account look today:
http://www.bea.gov/iTable/index_ita.cfm
The National Income and
Product Accounts (cont.)
• GNP = GDP + foreign income received –
income paid to foreigners + net unilateral
transfers
Distinction between GDP and GNP is not relevant for the exam!
Review GDP
GDP Industry 1
C
GDP Industry 2
GDP Industry 2
...
GDP Industry N
GDP US
I
G
X
Is this correct?
Review GDP
GDP Industry 1
C
GDP Industry 2
GDP Industry 2
GDP US
I
G
...
GDP Industry N
X
A certain part of C,I,G, and even X
comes from foreign production and
was imported.
-M
Review GDP
GDP Industry 1
C
GDP Industry 2
GDP Industry 2
I
GDP US
G
...
GDP Industry N
GDP = C + I + G + X -M
GDP = C + I + G + (X –M)
Trade Balance
X
-M
Beggar Thy Neighbor Policy
GDP = C + I + G + (X-M)
GDP = C + I + G + (X-M)
How?
Increase Trade Balance
will increase GDP
• Manipulate (increase) exchange rate
• Subsidize Exports
• Penalize Imports
• Tariffs
• Quotas
• Non-tariff trade restrictions
Beggar Thy Neighbor Policy
- From neighbor’s view-
GDP = C + I + G + (X-M)
US
GDP = C + I + G + (X-M)
Neighbor
GDP*
= C + I + G + (X*-M*)
How will neighbor react?
Increase Trade Balance
will increase GDP
Increase Trade Balance
will increase GDP
Retaliate!!!
Beggar Thy Neighbor Policy
- Is not easy to avoid because it creates a Prisoners Dilemma situation -
Possible Payoff Matrix
Neighbor
US
open economy closed economy
10, 10
2, 15
open economy
15, 2
4, 4
closed economy
Solution: International Agreements:
next session with Dr. Wihlborg
U.S. Current Account Deficit
• There were two periods of large current
account deficits in the U.S.:
- The first lasted through most of the 80’s
- The second began in the early 1990s and
continues today
FIGURE 9.1
U.S. Current Account Balances, 1950-2008
How does this chart looks today:
http://www.bea.gov/iTable/index_ita.
cfm
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
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
Possible Reasons for CA Deficits
• Consumption of foreign goods due to high
income in the US
• Investments of booming US companies
• War expenditures (especially cost abroad,
transportation, energy, and partially weapons
and ammunition)
• (Globalization. Note, globalization can only
explain that exports AND imports increased but
not the deficit)
What do the data say :
http://www.bea.gov/iTable/index_ita.
cfm
Are Current Account
Deficits Harmful?
• The relationship between the trade deficit, production and domestic
demand is an identity
• if domestic demand is greater than GDP => trade deficit
(argument ignores transfers and income payment)
• Consequently, current account balance does not tell us why an
economy runs the current account deficit or surplus
U.S. Current Account Deficit
(cont.)
• A current account deficit is not necessarily a
sign of weakness: in the U.S., the economic
boom of the 1990s increased the demand for
imports, while sluggish growth abroad limited
the expansion of U.S. exports
• However, everyone agrees the U.S. deficit is
not sustainable in the long term
CAPITAL ACCOUNT
AND
FINANCIAL ACCOUNT
The U.S. Balance of Payments, 2008
• Balance of payments =
current account + capital account + financial account
The U.S. Balance of Payments, 2008
Try it yourself for 2011:
http://www.bea.gov/iTable/index_ita.
cfm
Capital Account
• Capital account: A record of the
transfers of specific types of capital, such
as:
– Debt forgiveness
– Personal assets that migrants take with
them abroad
– The transfer of official real estate and other
fixed assets, such as a military base or an
embassy building
The U.S. Balance of Payments, 2008
• Balance of payments =
current account + capital account + financial account
The U.S. Balance of Payments, 2008
Try it yourself for 2011:
http://www.bea.gov/iTable/index_ita.
cfm
Financial account: A record of the flow of financial
capital to and from a country
• Financial account is divided into three categories:
– Net (!) changes in the country’s assets abroad
Increases are – why?
• e.g. an U.S. resident transfers money in his Italian bank account.
(Note, if he transfers all or part of the money back this would reduce the amount
of the position)
– Net (!) changes in the foreign-based assets in the country
• e.g. a Canadian resident transfers money in her U.S. bank
account.
Increases are + why?
(Note, if he transfers all or part of the money back this would reduce the amount
of the position)
– Net change in financial derivatives
Introduction to the
Financial and Capital Accounts:
Financial Account (cont.)
• Assets include bank accounts, stocks and
bonds, and real property such as factories,
businesses, and real estate
• Financial derivatives are instruments linked
to an asset or indicator to mediate financial
risks and can be traded in financial markets
What do the data say Plot data from
1980 – now! Compare with current
account.
http://www.bea.gov/iTable/index_ita.cfm
TABLE 9.3 (continued)
The U.S. Balance of Payments, 2008
Try it yourself for 2011:
http://www.bea.gov/iTable/index_ita.
cfm
Table 9.4 Components of the U.S. Financial
Account, 2008
Main Categories of U.S. Financial Flows
1. U.S. assets abroad (outflows)
A. U.S. Official reserve assets: gold bullion, IMF’s
Special Drawing Rights (SDRs), EU euros, British
pounds, or Japanese yen
B. U.S. 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. U.S. Private assets: direct investment, foreign
securities, loans to foreign firms and banks
The Three Accounts are
Interdependent
• The current, capital, and financial accounts
are interdependent
• Current account measures flow of goods
and services
• Capital and financial accounts measure flow
of financing
• Therefore, sum of capital account and
financial accounts equal to current account
with opposite sign
The U.S. Balance of Payments, 2008
Try it yourself for 2011:
http://www.bea.gov/iTable/index_ita.
cfm
International Debt
• External debt is defined as money owed to
nonresidents.
• 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
Statistical Discrepancy
• 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
Statistical Discrepancy in the
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 2008, U.S. statistical discrepancy was
[(–1)  (–706,068 + 506,013)] = 200,055
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 (stock)
changes
3. As long as the capital account balance is zero (and there
is no financial discrepancy), financial account balance =
current account balance, but with the opposite sign
American buys BMW
Pays out of his German Account
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Capital Account
Capital account transactions, net
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Statistical Discrepancy
American buys BMW
Pays out of his German Account
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Capital Account
Capital account transactions, net
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Statistical Discrepancy
$50,000
American donates money to Red Cross Haiti
Pays out of his Bank of America Account (BA pays Red Cross
out of its Haiti account)
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Capital Account
Capital account transactions, net
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Statistical Discrepancy
$5,000
American donates truck to Red Cross Haiti
Pays out of his Bank of America Account (BA pays Red Cross
out of its Haiti account)
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Capital Account
Capital account transactions, net
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Statistical Discrepancy
American donates truck to Red Cross Haiti
Pays out of his Bank of America Account (BA pays Red Cross
out of its Haiti account)
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Capital Account
Capital account transactions, net
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Statistical Discrepancy
$80,000
Your Example transaction
Counter transaction
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services and income receipts
Imports of goods and services and income payments
Unilateral current transfers, net
Capital Account
Capital account transactions, net
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Statistical Discrepancy
$0,000
Chapter Objectives
• Crucial Question:
If at the end FC demand = FC supply what determines
the exchange rate ???
•
Definition of Exchange Rate
• Exchange rate (e) is the price of one unit
of foreign courancy (FC)
• We will use the $/€ exchange rate as an
example
• An exchange rate of 1.43 $/€ means that
one € costs $1.43.
• Note, some textbooks and websites use
the reciprocal (how many € can I buy for
$1) here 1/1.43 => €0.70
What causes Demand or Supply on the Foreign
Currency Market
(for example the €/$-Market)
•
•
•
•
•
•
U.S. Imports cause € demand
U.S. Exports cause € supply
Spent Transfers cause €demand
Received Transfers cause € supply
Financial asset exports cause € demand
Financial asset imports cause € supply
Some Definitions and Mathematical
Conclusions
Adding-Up Constraint:
Since every trade has a counter trade:
FA+CA + KA = 0
KA is very small for the U.S. and will be neglected
in what follows: KA:=0
Definition of BP:
BP = CA + FA
Expost by definition CA + FA = 0
Important Terms to Agree on
• Ex Post: Measures what already
happened during a certain time period
(month/year)
• Ex Ante: Measures (?) what economic
agents are going to do (what they are
planning) in terms of economic activities in
this time period (month/year)
An Example for Expost
and Exante
At an auction flowers are sold.
1. The auctioneer first calls the same price that s/he called at
the end of yesterdays auction.
2. Bidders submit their bids (how many flowers they want to
buy or sell).
3. No sell or buy is made until D=S
4. Based on the overall demand and supply the auctionateer
tries a higher or lower price until a price generates D=S
After the Auctioneer called a lot of price P=$10
generates an expost equilibrium
• Flower Seller A:
1000 Flowers
• Flower Seller B:
500 Flowers
• Flower Seller C:
1000 Flowers
S=D
• Flower Shop 1:
500 Flowers
• Flower Shop 2:
1000 Flowers
• Flower Shop 3:
1000 Flowers
Valentines Day Morning
first call P=$10 generates an exante disequilibrium
• Flower Seller A:
1100 Flowers
• Flower Seller B:
600 Flowers
• Flower Seller C:
1100 Flowers
S<D
• Flower Shop 1:
700 Flowers
• Flower Shop 2:
1300 Flowers
• Flower Shop 3:
1200 Flowers
Valentines Day at the end of the auction.
P=$14 generates an expost equilibrium
• Flower Seller A:
1100 Flowers
• Flower Seller B:
600 Flowers
• Flower Seller C:
1100 Flowers
S=D
• Flower Shop 1:
600 Flowers
• Flower Shop 2:
1150Flowers
• Flower Shop 3:
1050 Flowers
Summary: Expost -Exante
1. Expost: D=S
2. Exante: Plans change =>D<S or D>S
3. Adjustment: P changes => D and/or S
change(s)
4. New Equilibrium: D=S
5. Expost: D=S
Some Assumptions
• Pure Flexible Exchange Rates (Centralbank does not buy or sell
FC)
• FA is determined by expected exchange rates and not by current
exchange rate (this assumption needs to be explored further at a
later stage)
• Transfers and Capital Account (KA) depend on none financial
determinants
• Demand in the U.S. and abroad depends only on domestic prices
(domestic prices abroad is E times domestic price for the U.S.)
• Domestic and foreign supply of goods does not depend on domestic
or foreign prices (infinite elastic supply).
Equilibrium FX Market
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services (possivily correlated with e)
Imports of goods (negatively correlated with e)
Unilateral current transfers, net
in US-$
100
-162
-10
Capital Account
Capital account transactions, net
-2
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Net FC Demnd (-) or Supply (+)
250
-180
4
0
Euro Crisis Worsens
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services (possivily correlated with e)
Imports of goods (negatively correlated with e)
Unilateral current transfers, net
in US-$
100
-162
-10
Capital Account
Capital account transactions, net
-2
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Net FC Demand (-) or Supply (+)
S>D
=> w goes down
+10
+5
260
-175
4
15
How does a change in a foreign exchange rate
influence the elements of the balance of payment?
• X will normally increase, if FC exchange rate
increases et vice versa.
• IM normally will decrease, if FC exchange rate
increases et vice versa.
• Transfers are exogenous.
• FA depend not on the level of the exchange rate.
They depend on the expected future change in the
FC exchange rate.
w decreased => X decreased, M increased
After Exports/Imports Adjusted
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services (possivily correlated with e)
Imports of goods (negatively correlated with e)
Unilateral current transfers, net
-9
-8
in US-$
91
-168
-10
Capital Account
Capital account transactions, net
-2
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Net FC Demnd (-) or Supply (+)
260
-175
4
0
Summary: Expost -Exante
1. Expost: FXD=FXS
2. Exante: Plans change => FXD>FXS or FXD<FXS
3. Adjustment: w changes => FXD and/or FXD
change(s) because X and/or M change(s)
4. New Equilibrium: FXD=FXS
5. Expost: FXD=FXS
Diagram of the Exchange Rate Market
$/€
Demand
Supply
(e.g. Imports)
(e.g. Exports)
€ demand and supply
Diagram of the Exchange Rate Market
The FC demand curve is not only based on imports. It
builds on capital exports and spent transfers too. But only
imports respond to the exchange rate. A change in capital
exports and /or spent transfers would result in a shift of
the curve.
The FC supply curve is not only based on exports. It
builds on capital imports and transfers too. But only
exports respond to the exchange rate. A change in capital
imports and/or received transfers would result in a shift
of the curve.
Try It Yourself:
Equilibrium FX Market
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services (possivily correlated with e)
Imports of goods (negatively correlated with e)
Unilateral current transfers, net
in US-$
100
-162
-10
Capital Account
Capital account transactions, net
-2
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Net FC Demnd (-) or Supply (+)
250
-180
4
0
Try It yourself:
US Debt Rating Worsens Significantly
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services (possivily correlated with e)
Imports of goods (negatively correlated with e)
Unilateral current transfers, net
in US-$
100
-162
-10
Capital Account
Capital account transactions, net
-2
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Net FC Demand (-) or Supply (+)
S?D
=> w goes ?
250
-180
4
0
++-
After Exports/Imports Adjusted
(Credits + (FC Supply); debits - (FC Demand)
Current Account
Exports of goods and services (possivily correlated with e)
Imports of goods (negatively correlated with e)
Unilateral current transfers, net
in US-$
100
-160
-10
Capital Account
Capital account transactions, net
-2
Financial Account
U.S.-owned assets abroad (increase/financial outflow (-))
Foreign-owned assets in the United States (increase/financial inflow (+))
Financial derivatives, net
Net FC Demnd (-) or Supply (+)
250
-180
4
2
Diagram of the Exchange Rate Market
Flexible Exchange Rate: S < D
Demand
$/€
Supply
from Imports
from
Exports
$/€0
From
From
FAFA
S<D
€ demand and supply
Diagram of the Exchange Rate Market
Flexible Exchange Rate: S < D
$/€
$/€0
Demand
Supply
(e.g. Imports)
(e.g. Exports)
S<D
€ demand and supply
Diagram of the Exchange Rate Market
Flexible Exchange Rate: S > D
$/€
$/€0
Demand
Supply
(e.g. Imports)
(e.g. Exports)
S>D
€ demand and supply
Diagram of the Exchange Rate Market
Fixed Exchange Rate: S < D
$/€
$/€ 0
Demand
Supply
(e.g. Imports)
(e.g. Exports)
S<D
CB
sells €
€ demand and supply
Diagram of the Exchange Rate Market
Fixed Exchange Rate: S > D
$/€
$/€0
Demand
Supply
(e.g. Imports)
(e.g. Exports)
D<S
CB
buys €
€ demand and supply
Case Study
China's Exchange Rate Regime
For nearly ten years now, the Chinese have maintained a fixed exchange rate for their currency,
the Yuan, relative to the Dollar. The rate has been pegged at about 8.28 Yuan/dollar for the
entire period. Thus, as the dollar has appreciated or depreciated in value relative to other
currencies, such as the Euro, the Yuan has appreciated or depreciated by the same amount
relative to these other countries. To maintain this fixed exchange rate, the central bank of China
has had to intervene in the foreign exchange market. It sells Yuan in exchange for dollar
denominated assets when the demand for the Yuan increases and it buys Yuan with dollar
denominated assets when the demand for the Yuan decreases. Recently the central bank has
intervened very heavily in the markets to prevent the Yuan from appreciating. Since the end of
2001, Dollar buying has been so great that the foreign reserves held by the Chinese
government have risen by $153 billion to over $360 billion. This accumulation of foreign
exchange reserves would tend to expand China's money supply, although in recent months the
Chinese central bank has moved to reign in monetary expansion. Among other measures to
sterilize reserve accumulation, the central bank has - for the first time - begun issuing central
bank paper to restrict growth of the monetary base. Nevertheless, the broader money supply
continues to grow very rapidly: M2 climbed 22 percent over the 12 months ending in August
2003. It is also important to recognize that China still has significant capital controls. China's
capital controls allow for more inflows than outflows, thus bolstering foreign exchange reserves.
China is gradually loosening some controls (on securities rather than debt), and outflows are
likely to grow as new channels develop for Chinese to seek diversification and better returns
than those offered by low domestic interest rates. Indeed, there is already significant leakage of
capital. A relaxation of controls on outflows would reduce upward pressure on the yuan.
Source: (Dep. of the Treasury, press rel. Oct. 1, 2003)
http://www.ustreas.gov/press/releases/js774.htm