BALANCE OF PAYMENTS

WHY DO COUNTRIES TRADE?

Trade is simply buying and selling goods and services from other countries.

Imports: The purchase of goods and services from foreign countries leading to outflow of currency.

Export: The sale of goods and services leading to inflow of foreign currencies.

But what really prompts countries to do these trades?

WHY DO COUNTRIES TRADE?

Different countries according to various factors have different levels of efficiency in producing different goods.

Comparative Advantage When a country can produce goods at lower

opportunity cost i.e. it sacrifices less resources in production.

Absolute Advantage When a country can produce goods with fewer

resources than another country.

WHY DO COUNTRIES TRADE?

Countries Good 1 Good 2

Country A 5 2.5

Country B 10 20

Total 15 22.5

A unit of labour can produce either 10 Good1 or 5 Good2 in country A, and a unit of labour in country B can produce either 20 Good1 or 40 Good2.

Thus opportunity cost of producing additional Good2 is high in country A, and opportunity cost for producing Good1 is higher in country B.

WHY DO COUNTRIES TRADE?

Countries Good 1 Good 2

Country A 10 0

Country B 5 30

Total 15 30

Now suppose the countries produce the goods in which they have minimum opportunity cost i.e. they achieve specialisation in the suitable good and then trade.

Larger quantities will be produced and they will have mutual benefits.

Below is Table for such production.(Lets suppose still Country B produces good 1 due to fear of shortage)

WHY DO COUNTRIES TRADE?

Countries Good 1 Good 2

Country A 5 5

Country B 10 25

Total 15 30

The tables below compare outputs before and after trading, showing benefits.

Countries Good 1 Good 2

Country A 5 2.5

Country B 10 20

Total 15 22.5

BALANCE OF PAYMENTS

A country’s balance of payments accounts keep track of both its payments to and its receipts from foreigners.

Any transaction resulting in a payment to foreigners is entered in the balance of payments accounts as a debit and is given a negative (—) sign.

Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive (+) sign.

BALANCE OF PAYMENTS

Three types of International Transactions are recorded in Balance of Payments: Transactions that involve the export or import of

goods or services. They enter directly into the current account.

The financial account records all international purchases or sales of financial assets.

Certain other activities resulting in transfers of wealth between countries are recorded in the capital account.

BALANCE OF PAYMENTS

BALANCE OF PAYMENTS:CURRENT ACCOUNT

The balance of payments accounts divide exports and imports into three categories: Merchandise trade

Exports or imports of goods. Services

Payments for legal assistance, tourists’ expenditures, and shipping fees.

Income International interest and dividend payments and the

earnings of domestically owned firms operating abroad.

It also includes unilateral current transfers (like gifts and foreign aids).

It measures the difference between sales of assets to foreigners and purchases of assets located abroad.

Financial inflow (capital inflow) A loan from the foreigners with a promise that they will

be repaid. Financial outflow (capital outflow)

A transaction involving the purchase of an asset from foreigners.

Example: When an American company buys a French factory,

the transaction enters the U.S. balance of payments as a debit in the financial account.

BALANCE OF PAYMENTS:FINANCIAL ACCOUNT

These international asset movements differ from those recorded in the financial account.

For the most part they result from nonmarket activities, or represent the acquisition or disposal of non-produced, nonfinancial, and possibly intangible assets (such as copyrights and trademarks).

Examples: If U.S. government forgives $1 billion in debt owed to

it by Pakistan, U.S. wealth declines by $1 billion, or the $1 billion is recorded as debt in U.S. capital account.

If wealthy British citizen immigrates to U.S. and brings along $5billion in British asset, result would be a $5 billion credit in U.S. capital account.

BALANCE OF PAYMENTS:CAPITAL ACCOUNT

BALANCE OF PAYMENTS

Simple rule of double-entry book keeping: “Every international transaction automatically

enters the balance of payments twice, once as a credit and once as a debit.”

It holds true as every transaction has two sides: If you buy something from foreigner, you must

pay him/her in someway.

EXAMPLES

A U.S. citizen buys a $1000 typewriter from an Italian company, and the Italian company deposits the $1000 in its account at Citibank in New York.

That is, the U.S. trades assets for goods. This transaction creates the following two

offsetting entries in the U.S. balance of payments: It enters the U.S. CA with a negative sign (-$1000). It shows up as a $1000 credit in the U.S. financial

account.

EXAMPLES

A U.S. citizen pays $200 for dinner at a French restaurant in France by charging his Visa credit card.

That is, the U.S. trades assets for services. This transaction creates the following two

offsetting entries in the U.S. balance of payments: It enters the U.S. CA with a negative sign (-$200). It shows up as a $200 credit in the U.S. financial

account.

EXAMPLES

A U.S. citizen buys a $95 newly issued share of stock in the United Kingdom oil giant British Petroleum (BP) by using a check drawn on his stockbroker money market account. BP deposits the $95 in its own U.S. bank account at Second Bank of Chicago.

That is, the U.S. trades assets for assets. This transaction creates the following two

offsetting entries in the U.S. balance of payments: It enters the U.S. financial account with a negative

sign (-$95). It shows up as a $95 credit in the U.S. financial

account.

EXAMPLES

A U.S. bank forgives $5000 in debt owed to it by the government of Pakistan.

This transaction creates the following two offsetting entries in the U.S. balance of payments:

It enters the U.S. capital account with a negative sign (-$5000).

It shows up as a $5000 credit in the U.S. financial account.

BALANCE OF PAYMENTS

Any international transaction automatically gives rise to two offsetting entries in the balance of payments resulting in a fundamental identity:

Current account + financial account + capital account = 0

BALANCE OF PAYMENTS:STATISTICAL DISCREPANCY

Data associated with a given transaction may come from different sources that differ in coverage, accuracy, and timing.

This makes the balance of payments accounts seldom balance in practice.

Account keepers force the two sides to balance by adding to the accounts a statistical discrepancy.

It is very difficult to allocate this discrepancy among the current, capital, and financial accounts.

BALANCE OF PAYMENTS

Official Reserve Transactions Central bank

The institution responsible for managing the supply of money.

Official international reserves Foreign assets held by central banks as a cushion

against national economic misfortune. Official foreign exchange intervention

Central banks often buy or sell international reserves in private asset markets to affect macroeconomic conditions in their economies.

CURRENT ACCOUNT BALANCE AS % OFGDP IN SELECTED COUNTRIES: 1970–2003

BALANCE OF PAYMENTS

Case Study: Is the United States the World’s Biggest Debtor?At the end of 1999, the United States had

a negative net foreign wealth position far greater than that of any other single country.

The United States is the world’s biggest debtor.

However, the United States has the world’s largest GNP.

EXCHANGE RATES AND TRADE

When individuals, businesses and governments in one country want to trade, borrow or lend in another country, they must convert their currency into the other country currency for the transaction.

Exchange rates are important because they enable us to translate different counties’ prices into comparable terms.

Exchange rates are determined in the same way as other asset prices i.e. supply and demand.

EXCHANGE RATES

An exchange rate can be quoted in two ways:Direct:

The price of the foreign currency in terms of domestic currency.

Example: $0.01 per yen.Indirect:

The price of domestic currency in terms of the foreign currency.

Example: 0.68 euro per dollar.

EXCHANGE RATES

Nominal exchange rate or the exchange rate is the price of one country’s currency in terms of another country’s currency. Example: Japan’s yen per U.S. dollar, India’s

rupees per euro. When a U.S. consumer wants to buy a

Japanese camera it has two parts: Price of camera in yen. Price of yen in dollars.

If camera is worth 25,000 yen and yen is worth $0.01, then dollar price for camera is $250.

EXCHANGE RATES

Two types of changes in exchange rates: Depreciation of home country’s currency

A rise in the home currency prices of a foreign currency.

It makes home goods cheaper for foreigners and foreign goods more expensive for domestic residents.

Appreciation of home country’s currency A fall in the home price of a foreign currency. It makes home goods more expensive for

foreigners and foreign goods cheaper for domestic residents.