Balance of Payments

Unit 7: Open Economy: International Trade and Finance

What does it mean to have a “Balance of

Payments?”

● AKA, balance of international payments (BoP)

● The record of all economic transactions between the residents of the country and of the world in a particular period

BoP should always equal zero when the three accounts are

added together.

The reason being:

● that every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa. ○ If a country exports an

item, it effectively imports foreign capital when that item is paid for.

How a Nation Balances its Payments:1. Current Account

a. Measures transactions in goods, services, investment income and current transfers.

b. Records monetary gifts or grants that flow into or out of a country.2. Capital (Financial) Account

a. Measures net flow of funds for investment in real assets (factories, land, etc.) and financial assets (stocks, bonds, etc.) into a nation from the rest of the world.

3. Official Reservesa. To balance the two accounts, a country’s official foreign exchange reserves

measures the net effect of all the money flows from other accountsb. The OR determine whether there is a net buildup of foreign currency held

in a country over a period of time.

The Balance of PaymentsBoP will always equal zero when the three accounts are added together.

● If a country’s current account is in surplus (greater than zero), its capital account + official reserves will be in deficit (less than zero)

● If a country has a current account deficit (less than zero), then its capital account + official reserves will be positive, and the BoP taken as a whole will be zero.

*In practice, statistical discrepancies arise due to the difficulty of accurately counting every transaction between an economy and the rest of the world.

The Current Account● Measures the flow of goods, services, and income between the

residents of one nation and the residents of other nations. ● The current account balance is known as the balance of trade.

● Hot Tip: The current account is also Net Exports (Xn in AD!)

The current account is made up of Four Components:

1. Balance of trade in goods● This measures the spending by consumers and firms in one nation on

another nation’s goods○ Ex: everything you, I, and Barro’s buys from China

● Measures spending by consumers in the rest of the world on the recording nation’s goods. ○ Ex: All of the American products other people/countries purchase

Good Credits (+)● Goods exported count as a credit in the

current account○ They require that foreigners make

payments● Both consumer and capital goods count

as credits

Good Debits (-)● Spending by domestic consumers on

goods produced in foreign nations○ They require a payment to foreign

producers

2. Balance of trade in services● Non-tangible purchases

○ Ex: tourism, banking, consulting, legal services, transportation● Services can be “imported” and “exported” even though there is no

physical transportation of a product involved.

Service Credits (+)● Services bought by foreigners

within the nation or from abroad○ They require that foreigners

make payments to a domestic producer

Service Debits (-)● Services consumed by domestic

households that were purchase from foreigners○ They require a payment to

foreign producers

3. Income balance● The transfer of incomes earned by citizens of one country from activities

in another country back to the income earner’s country of origin.○ Ex: wages earned by a country’s citizen for employment by foreign

companies abroad.

Income Credits (+)● Wages earned by a country’s workers

employed abroad that are sent home● Interest on a residents’ savings and

investments in foreign banks/financial markets

● Dividends earned abroad from domestic investors in foreign firms○ They require that foreigners make

payments to the domestic resident

Income Debits (-)● Wages paid by firms in one country to

foreign workers that are sent abroad.● Interest paid to foreign investors in

domestic banks● Dividends paid to foreign shareholders

○ We pay foreigners. Commonly referred to as “leakages”

4. Current transfer balance● A gift; grant; payment made from one nation to another that does not

require the exchange of goods or services. ○ Official transfers: Gov’t foreign aid○ Private transfers: Citizen → foreign citizen

Transfer Credits (+)● Official transfers from foreign

governments to our government● Private transfers from households to

individuals in our country (or the gov’t)○ Foreign $ → domestic○ Increases disposable income at

home○ Reduces disposable income in the

foreign country

Transfer Debits (-)● Official transfers from foreign

governments to their government● Private transfers from households to

individuals in their country (or the gov’t)○ Domestic $ → Foreigners○ Decreases disposable income at

home○ Increases disposable income

abroad

Positive Current Account Balance: Trade Surplus

Negative Current Account Balance: Trade Deficit

When all of the credits and debits from each of those four components of the current account are added together, they will equal either a positive or a negative number.RECIPROCAL!

The Financial (Capital) Account● Measures exchanges between a nation and the rest of the world

involving ownership of financial and real assets● The purchasing of assets leads to ownership of assets, not the

purchase of a nation’s goods or services● Assets won’t be brought back to the purchaser’s home country, so it

stays in the foreign country

The financial account measures two types of investments:

1. Direct investment● Acquiring significant ownership in a foreign business.● Foreign direct investment: the buying and selling of a minimum

of 10% of a company’s shares by by a foreign investor in the domestic economy or by a domestic investor in another nation’s economy

Direct investment abroad: Investors from one country may buy or sell ownership stakes in foreign firms.

Credits (+)● Domestic investors selling shares in

foreign firms● There is an inflow of financial capital

Debits (-)● Domestic investors buy shares in

foreign firms, acquiring ownership● There is an outflow of financial capital

Direct investment at home: Foreign investors may buy or sell ownership stakes in domestic firms.

Credits (+)● Foreign investment in shares of

domestic firms increases● There is net inflow of financial capital

Debits (-)● Foreigners sell their ownership in

domestic firms to domestic investors● There is outflow of financial capital

2. Portfolio investmentPortfolio investment measures investments that result in less than 10% of a foreign firm, by ● the investments of foreigners in businesses in the domestic economy● Domestic investors investing in business and government debt abroad

Portfolio investment abroad: the money spent by domestic investors in foreign equity and debt. An asset to the investor’s home country, and a liability to the foreign country.

Credits (+)● When investors sell those assets,

foreigners make a payment to the domestic investor○ + to financial account

Debits (-)● When domestic investors buy foreign

assets○ - from financial account since the

money goes to a foreign stakeholder

Portfolio investment at home: The money spent by foreigners on domestic stocks, shares, and bonds.● Liability for the home country● Asset for the foreign country

Credits (+)● Foreign investor buying domestic

securities makes a payment to the home country○ + in financial account

Debits (-)● Foreigners investor sells his domestic

securities, domestic country makes a payment to him○ - from the financial account

3. Other investment Assets to home country:● Loans made by banks to foreign borrowers● Savings by domestic households in foreign banks

Credits (+)● Foreign borrower pays back a loan to a

domestic bank○ Inflow in financial account

Debits (-)● Domestic bank makes loan abroad

○ Outflow in financial account

Liabilities to home country:● Borrowing from foreign banks● Savings by foreign households in domestic banks

Credits (+)● Money borrowed from a foreign bank

○ Payment from abroad to a domestic interest

○ Inflow in financial account

Debits (-)● When a loan is repaid to a foreign bank● Outflow in financial account

The Official Reserves AccountForeign Exchange Reserves: the assets of other nations held by a country’s central bank. ● Reserves usually consist of government bonds and foreign currency

★ When the inflow of money into a country in a given year exceeds the outflow of money going to foreign countries, the difference is added to the central bank’s official reserves of foreign exchange.

↳ In America, the reserves are in U.S. Treasury, not the Federal Reserve

★ If there is a net outflow of money in a year, the difference is made up by a withdrawal from the central bank’s reserves of foreign exchange, and the reserves decrease.○ A net deficit in the current and financial accounts results in an

inflow in the official reserves account.■ Net deficit in CA and FA = X < M

○ If a country has a net balance of payment surplus (X > M), then the change in the foreign exchange reserves is recorded as a negative ■ More domestic money is placed into foreign assets

Hence this slide from the beginning:● If a country’s current account is in surplus (greater than zero), its

capital account + official reserves will be in deficit (less than zero)

● If a country has a current account deficit (less than zero), then its capital account + official reserves will be positive, and the BoP taken as a whole will be zero.

*In practice, statistical discrepancies arise due to the difficulty of accurately counting every transaction between an economy and the rest of the world.

#FBF

Purpose of Foreign Exchange Reserves★ The presence of foreign exchange reserves in a nation’s central bank

allows the government to draw on these reserves to intervene in the market for their nation’s currency to:○ Influence the exchange rate○ Balance out the financial account in years where the current and

financial accounts aren’t balanced