The Balance of Payments and
International Linkages
• An accounting statement which measures all
financial and economic transactions between
domestic and foreign residents over a specified
period of time.
 National Level
 Corporate Level
• Forecasting international competitiveness
• Judging pressure placed on exchange rate
• Signaling possible imposition of capital controls
• Fundamentals of BOP Accounting
 Measures flows rather than stocks.
 Is based on a double-entry bookkeeping system.
 Always balances; i.e., it must be equal to zero.
• THE BALANCE OF PAYMENTS (B-O-P)
 PURPOSE:
• Measures all financial and economic transactions
over a specified period of time
 Double-entry bookkeeping
• Currency inflows = credits earn foreign exchange
• Currency outflows = debits expend foreign exchange
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Balance of Payments Accounts
•
Three Major Accounts:



•
Current
Capital
Official Reserves
Current Account

records net flow of goods, services, and unilateral
transfers.

In other words current account can be classified as
• Trade Balance (BOT)
• Service Balance
• Income Balance
• Unilateral Transfers
•
Capital Account




Function: records public and private investment and
lending.
Inflows = credits
Outflows = debits
Transactions classified as
• Direct Investments
• Portfolio Investments
• Other Financial Items
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Balance of Payments Accounts
contd.
•
•
•
Official Reserves Account

Function: measures changes in international
reserves owned by central banks.

reflects surplus/deficit of
•
current account
•
capital account
 Reserves consist of
•
gold
•
convertible securities
Net Effects:

Sum of all transactions must be zero:
1.
current account
2.
capital account
3.
official reserves
The Balance-of-payment measures

Some Definitions:
1.
2.
3.
Basic Balance
a) consists of current account and long-term capital
flows.
b) emphasizes long-term trends
c) excludes short-term capital flows that heavily depend
on temporary factors
Net Liquidity Balance:
measures the change in private domestic borrowing or
lending required to keep payments equal without adjusting
official reserves.
Official Reserve Transactions Balance
measures adjustments needed by official reserves.
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Generic Balance of Payments
Current Account
1. Trade Balance
2. Service Balance
3. Income Balance
4. Net Transfers
A (1 through 4) = Current Account Balance
____________________________________________________
B. Capital Account
____________________________________________________
C. Financial Account
1. Net Foreign Direct Investment
2. Net Portfolio Investment
3. Other Financial Items
A + B + C = Basic Balance
____________________________________________________
D. Net Errors and Omissions
A + B + C + D = Overall Balance
____________________________________________________
E. Official Reserves and Related Items
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Links from international to
domestic flows
A.
B.
c.
d.
e.
Global Linkages
set of basic macroeconomic identities which link:
domestic spending and production to current and
capital accounts
Domestic Savings and Investment and the Capital Account
1.
National Income Accounting
a.
National Income (NI) is
either spent (C) or saved (S)
NI = C + S
(5.1)
b.
National spending (NS) is
divided into personal spending (C)
and investment (I)
NS = C + I
(5.2)
Subtracting (5.2) - (5.1)
NI - NS = S - I
(5.3)
If NI >NS, S > I which implies
that surplus capital spent overseas.
In a freely-floating system,
excess saving = the capital account balance
Implications:
1. A nation which produces more than it spends will save more
than it invests domestically with a net capital outflow producing
a capital account deficit.
2.
A nation which spends more than it produces has a net capital
inflow producing a capital account surplus.
3.
A healthy economy will tend to run a current account deficit.
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The Link between Capital and
Current Accounts
1.
Beginning identity
NI - NS = X - M
(5.4)
where X = exports
M = imports
X-M=current account balance (CA)
2. Combining (5.3) + (5.4)
S - I = X - M
(5.5)
3. If S - I = Net Foreign Investment (NFI)
NFI = X - M
(5.6)
4. Implications:
a. If CA is in surplus, the nation must be a net
exporter of capital.
b. If CA is a deficit, the nation is a major capital
importer.
c. When NS > NI, the excess must be acquired through
foreign trade.
•
Solutions for Improving CA deficits:
1.) Raise national income (output) relative to domestic
investment (I).
2.) Increase (S) relative to domestic investment (I).
•
Government budgets and current account deficits
 CURRENT ACCOUNT BALANCE
CA = Saving Surplus - Gov’t. budget deficit
 CA Deficit means the nation is not saving enough to finance (I)
and the deficit
 CA Surplus means the nation is saving more than needed to
finance its (I) and deficit.
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COPING WITH THE CURRENT ACCOUNT
DEFICIT
• Possible solutions unlikely to work:
 Currency Depreciation
 Protectionism
• Currency depreciation
 U.S. Experience:
Does not improve the trade deficit.
 Depreciations are ineffective
because
• It takes time to affect trade.
• J-Curve Effect states that a decline in currency
value will initially worsen the deficit before
improvement.
• Protectionism
 Trade Barriers used:
• Tariffs
• Quotas
 Results:
• Most likely will reduce both X and M.
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COPING WITH THE CURRENT ACCOUNT
DEFICIT contd.
• Foreign ownership
 one protectionist solution would place limits on
or eliminate foreign ownership leading to
capital inflows.
• Stimulate national saving
 change the tax regulations and rates.
• Summary: current-account Deficits
 neither bad nor good inherently
• Since one country’s exports are another’s
imports, it is not possible for all to run a surplus
• Deficits may be a solution to the problem of
different national propensities to save and
invest.
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