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The Balance of
Payments
1
Learning Outcomes
1. Definition of the balance of payments
(BOP) and its accounts
2. Some macroeconomic relations
3. The link between BOP and exchange
rates
4. Comments on current account deficit
© 2002 by Stefano Mazzotta
1. Definition of the Balance
of Payments and its Accounts
3
The definition of BOP
• It is a statistical statement of all
economic and financial transactions
between the home country and the rest
of the world during a certain time period.
• The net of all transactions affects the
country’s international monetary
reserves.
© 2002 by Stefano Mazzotta
What are the types of
transactions?
•
•
•
•
•
Exports of goods and services
Imports of goods and services
Gifts and other “one-sided” payments
Income flows
Capital flows
© 2002 by Stefano Mazzotta
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The importance of the BOP
• Helps forecast a country’s economic
potential, especially in the short run,
and its competitiveness on the world
markets.
• Indicates the pressure on a country’s
foreign reserves and its currency.
© 2002 by Stefano Mazzotta
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BOP accounts
• They are records of different transactions.
– Any payment out is recorded as a debit (“-”)
– Any payment in is recorded as a credit (“+”)
• Types of accounts
– Current account (CA)
– Capital account (KA)
– Official reserves account (ORA)
© 2002 by Stefano Mazzotta
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Current account (CA)
• It is the net flow of goods, services, and
unilateral transactions (gifts) between
countries.
• Example:
Debits
Gift to a foreigner
Import of coffee
abroad
Tourists in Germany
Credits
Export of wheat
Profits from a US firm
Leasing a ship to India
© 2002 by Stefano Mazzotta
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Capital account (KA)
• It is the net result of public and private
international investment and lending
activities.
• Example:
Debits
Purchase of JPY
Receipt of CHF
.
Credits
Sale of JPY (Yen)
Payment for shares
© 2002 by Stefano Mazzotta
Official reserves account
(ORA)
• It is the net holdings of gold and foreign
currencies by official monetary institutions.
• Example:
Debits
Purchase of EUR
Credits
Sale of gold
© 2002 by Stefano Mazzotta
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Deficit vs. surplus
• A country incurs a deficit (of one of its accounts),
if it spends abroad more than what it earns or
receives from other countries.
Debits > Credits
• A country incurs a surplus, if it spends abroad
less than what it earns or receives from other
countries.
Debits < Credits
© 2002 by Stefano Mazzotta
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Relations among BOP accounts
• Since each account is a net supply or
demand for a currency,
CA + KA + ORA = 0
CA + KA = BOP
• Therefore,
BOP = -ORA
© 2002 by Stefano Mazzotta
2. Some Macroeconomic
Relations
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Notations
Y - national income
I - investment
X - exports
S - savings
C - private consumption
G - government expenditure
M - imports
T - taxes
RF - net transfers from foreigners
RI - net investment income (the difference between
the income of citizens of a given country abroad
and foreign citizens in that country)
© 2002 by Stefano Mazzotta
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GNP vs. GDP
• GNP - gross national product produced
by citizens of a given country
• GDP - gross domestic product produced
within the borders of a given country
A question:
What is larger: GDP or GNP?
© 2002 by Stefano Mazzotta
Major macroeconomic
relations
Y = GNP + RF
GNP = C + I + G + X - M
GDP = GNP - RI
© 2002 by Stefano Mazzotta
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More relations
Y = C + I + G + X - M + RF = C + S + T
E=
C+I+G
=C+I+G
Y - E = X - M + RF = (S - I) + (T - G)
CA = X - M + RF
© 2002 by Stefano Mazzotta
How to understand these
relations
• If a country’s expenditure is more than its
income, that is, Y - E < 0, then that country:
– Imports more than exports
– Invests more than saves
– Runs a government budget deficit
• If a country’s expenditure is less than its
income, that is, Y - E > 0, then that country:
– Exports more than imports
– Saves more than invests
– Runs a government budget surplus
© 2002 by Stefano Mazzotta
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3. The Link between BOP
and Exchange Rates
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Relation of BOP to exchange
rates: Floating exchange rates
• Under floating exchange rate regime (“free
float”), the exchange rate is determined by
the laws of supply and demand.
• This means no government intervention.
• Therefore,
ORA = 0
or
CA = - KA
© 2002 by Stefano Mazzotta
Determinants of home currency
supply and demand: floating
rates
• What does increase the demand for home
currency?
– Exports
– Foreign investment in the home country
• What does increase the supply for home
currency?
– Imports
– Home country investment abroad
© 2002 by Stefano Mazzotta
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Economic intuition behind
CA < 0
• The current account deficit implies that
– imports > exports
– the current supply of home currency > the
current demand for home currency
– there exists a net demand for
“investments” in home currency
– there is more investments by foreigners in
a country than by country’s citizens abroad
– KA is in surplus
© 2002 by Stefano Mazzotta
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Economic intuition behind
CA > 0
• Current account surplus implies that
– imports < exports
– the current supply of home currency < the
current demand for home currency
– there exists a net supply for “investments”
in home currency
– there is less investments by foreigners in a
country than by country’s citizens abroad
– KA is in deficit
© 2002 by Stefano Mazzotta
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Relation of BP to exchange
rates: Fixed exchange rates
• Under fixed exchange rates the exchange rate
is fixed or varies within a narrow band.
• Any excess market demand for a home
currency is supplied by the government.
• Any excess market supply for a home currency
is adsorbed by the government.
• Therefore,
CA = - (KA + ORA)
© 2002 by Stefano Mazzotta
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Determinants of home currency
supply and demand: fixed rates
• What does increase the demand for home
currency?
– Exports
– Foreign investment in the home country
– Government’s purchase of the home currency
• What does increase the supply for home
currency?
– Imports
– Home country investment abroad
– Government’s sell of the home currency
© 2002 by Stefano Mazzotta
4. Comments on Current
Account deficit
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How to “cure” the CA deficit:
Argument 1
• Make home currency depreciate:
– Increase the demand for home products
abroad
– Decrease the demand for foreign products
at home
– Decrease the amount of foreign
investments
© 2002 by Stefano Mazzotta
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The U.S. evidence
• In the mid 1980s, the U.S. dollar was
very strong
• Foreign investment in the U.S.
decreased
• The demand for and, as a result, the
value of the U.S. dollar declined
• There was some increase in exports
© 2002 by Stefano Mazzotta
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Did it work? - No!
• The CA deficit did not decline
Why?
• The U.S. continued to spend in excess
of its national income (Y - E < 0)
© 2002 by Stefano Mazzotta
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How to “cure” the CA deficit:
Argument 2
• Introduce import restrictions:
– Prohibit import of particular products
– Increase the price of imports
– Introduce quotas on foreign goods
© 2002 by Stefano Mazzotta
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Will it work? – Not sure
• Restriction of foreign goods decrease
domestic demand for foreign currency
• Home currency appreciates
• Exports become more expensive for
foreigners
• The volume of exports decrease
• There is less trade between home country
and outside world
• Everyone has lost
© 2002 by Stefano Mazzotta
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Conclusions
• With floating exchange rates, any given value
of the home currency can neither cause
problems in the balance of payments nor
solve them.
• While there is a fundamental linkage between
exchange rates and the balance of payments,
things sometimes work differently.
• Current account deficit is not necessarily a
bad thing.
© 2002 by Stefano Mazzotta