Download Chapter 12

Chapter 12
The Balance
of Payments
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Topics to be Covered
• Balance of Payments
• Components of the Balance of Payments:
– Current Account
– Financial Account
• Financing the Current Account
• Saving, Investment, and Current Account
• Other Balance of Payments Measures
• Balance of Payments Equilibrium
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-2
Why Study the Balance of
Payments?
• Balance of payments issues such as trade deficits
and foreign indebtedness are controversial topics.
• Balance of payments accounts provide insights into
the country’s economic performance relative to the
rest of the world.
• The study of the economics of balance of payments
allows proper evaluation of the various arguments
and government policies recommended to eliminate
trade imbalances.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-3
IMF BOP Importance
• Balance of payments and international investment position
data are most important, of course, for national and
international policy formulation. External aspects (such as
payments imbalances and inward and outward foreign
investment) play a leading role in economic and other policy
decisions in the increasingly interdependent world economy.
Such data are also used for analytical studies; that is, to
determine the causes of payments imbalances and the
necessity for implementing adjustment measures;
relationships between merchandise trade and direct
investment; aspects of international trade in services;
international banking flows and stocks; and external debt
problems, income payments, and growth; and links between
exchange rates and current account and financial account
flows.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-4
Balance of Payments
• Balance of Payments (BOP) - an
accounting record of a country’s trade in
goods, services, and financial assets with
the rest of the world during a particular time
period (year or quarter).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-5
IMF Definition
• The balance of payments is a statistical statement that
systematically summarizes, for a specific time period, the
economic transactions of an economy with the rest of the
world. Transactions, for the most part between residents and
nonresidents,
• 1 consist of those involving goods, services, and income; those
involving financial claims on, and liabilities to, the rest of the
world; and those (such as gifts) classified as transfers, which
involve offsetting entries to balance—in an accounting sense—
one-sided transactions.
• 2 A transaction itself is defined as an economic flow that
reflects the creation, transformation, exchange, transfer, of
economic value and involves changes in ownership of goods
and/or financial assets, the provision of services, or the
provision of labor and capital.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-6
Double-entry System
• The basic convention applied in constructing a balance of
payments statement is that every recorded transaction is
represented by two entries with equal values. One of these
entries is a credit with a positive sign; the other is a debit with
a negative sign. In principle, the sum of all credit entries is
identical to the sum of all debit entries, and the net balance of
all entries in the statement is zero.
• keep in mind the following the rule of double-entry
bookkeeping: Every international transaction automatically
enters the balance of payments twice, once as a credit and
• once as a debit. This principle of balance of payments
accounting holds true because every transaction has two
sides: If you buy something from a foreigner, you must pay
him in some way, and the foreigner must then somehow spend
or store your payment.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-7
Features of the BOP
• BOP follows the accounting procedure of
double-entry bookkeeping (debits and
credits).
– A credit entry records an item or transaction that
brings foreign exchange into the country.
– A debit entry represents a loss of foreign
exchange.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-8
Features of the BOP (cont.)
• BOP will always balance.
• A BOP deficit (surplus) means that the debit
entries exceed (are less than) the credits.
This imbalance applies only to a particular
account or component of the BOP.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-9
Balance of Payments Accounts
(cont.)
• The balance of payments accounts are
separated into 3 broad accounts:
– current account: accounts for flows of goods
and services (imports and exports).
– financial account: accounts for flows of
financial assets (financial capital).
– capital account: flows of special categories of
assets (capital): typically non-market, nonproduced, or intangible assets like debt
forgiveness, copyrights and trademarks.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-10
Example of Balance of
Payments Accounting
• You import a DVD of Japanese anime by using your debit
card.
• The Japanese producer of anime deposits the money in
its bank account in San Francisco. The bank credits the
account by the amount of the deposit.
DVD purchase
–$30
(current account)
Credit (“sale”) of deposit in account by bank
+$30
(financial account)
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-11
Example of Balance of
Payments Accounting (cont.)
• You invest in the Japanese stock market by
buying $500 in Sony stock.
• Sony deposits the money in its Los Angeles
bank account. The bank credits the account by
the amount of the deposit.
Purchase of stock
(financial account)
Credit (“sale”) of deposit in account by bank
–$500
+$500
(financial account)
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-12
Example of Balance of
Payments Accounting (cont.)
• U.S. banks forgive a $100 M debt owed by the
government of Argentina through debt restructuring.
• U.S. banks who hold the debt thereby reduce the debt by
crediting Argentina's bank accounts.
Debt forgiveness: non-market transfer
(capital account)
Credit (“sale”) of account by bank
(financial account)
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
–$100 M
+$100 M
12-13
Components of the BOP
• Current Account
• Capital Account
• Financial Account
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-14
Current Account
• The current account includes the value of trade in
merchandise, services, income from investments,
and unilateral transfers.
• Covered in the current account are all
transactions (other than those in financial items)
that involve economic values and occur between
resident and nonresident entities. Specifically, the
major classifications are
• goods and services, income, and current
transfers.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-15
Goods and services
a. Goods
1. General merchandise
2. Goods for processing
3. Repairs on goods
4. Nonmonetary gold
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-16
Goods
• General merchandise covers most movable goods that residents
export to, or import from, nonresidents.
• Goods for processing covers exports of goods crossing the frontier
for processing abroad and re-import of the goods, which are valued
on a gross basis before and after processing.
• Repairs on goods covers repair activity on goods provided to or
received from nonresidents on ships, aircraft, etc. The repairs are
valued at the prices (fees paid or received) of the repairs and not at
the gross values of the goods before and after repairs are made.
• Nonmonetary gold covers exports and imports of all gold not held
as reserve assets (monetary gold) by the authorities. Nonmonetary
gold is treated the same as any other commodity and, when feasible,
is subdivided into gold held as a store of value and other (industrial)
gold.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-17
Services
•
Transportation
•
1.1 Sea transport 1.2 Air transport
Passenger, Freight ,Other.
•
1.3.3 Other
•
1. A. b. 2. Travel
•
1. A. b. 3. Communications services
•
1. A. b. 4. Construction services
•
1. A. b. 5. Insurance services**
•
1. A. b. 6. Financial services
•
1. A. b. 7. Computer and information services
•
1. A. b. 8. Royalties and license fees
•
1. A. b. 9. Other business services
•
9.3 Miscellaneous business, professional, and technical services*
•
1. A. b. 10. Personal, cultural, and recreational services
•
10.1 Audiovisual and related services
•
10.2 Other personal, cultural, and recreational services
•
1. A. b. 11. Government services
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-18
Income
• Compensation of employees covers wages, salaries, and other
benefits, in cash or in other kind……
• Investment income
• covers receipts and payments of income associated, respectively,
with residents’ holdings of external financial assets and with
residents’ liabilities to nonresidents. Investment income consists of
direct investment income, portfolio investment income, and other
investment income. The direct investment component is divided into
income on equity (dividends, branch profits, and reinvested earnings)
and income on debt (interest); portfolio investment income is divided
into income on equity (dividends) and income on debt (interest);
other investment income covers interest earned on other capital
(loans, etc.).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-19
Current transfers
• Current transfers are distinguished from capital
transfers, which are included in the capital and financial
account.
• Current transfers include those of general government
(e.g., current international cooperation between different
governments, payments of current taxes on income and
wealth, etc.), and other transfers (e.g., workers’ remittances,
and claims on non-life insurance).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-20
Capital Account
• Certain other activities resulting in transfers of wealth between
countries are recorded in the capital account. These
international asset movements-which are generally very small
for the United States-differ from those recorded in the financial
account. For the most part they result from nonmarket
activities or represent the acquisition or disposal of
nonproduced, nonfinancial, and possibly intangible assets
(such as copyrights and trademarks). For example, if the U.S.
government forgives $ 1 billion in debt owed to it by the
government of Pakistan, U.S. wealth declines by $1 billion and
a $ 1 billion debit is recorded in the U.S. capital account. As
another example, if a Swede immigrates to the United States
and brings with him title to $ 1 00,000 in Swedish assets, the
result would be a $ 100,000 credit in the U.S. capital account
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-21
Financial account
• The classification of standard components in the financial account
is based on these criteria: All components are classified according
to type of investment or by functional subdivision (direct investment,
portfolio investment, other investment, reserve assets).
• Financial account: the difference between sales of domestic assets
to foreigners and purchases of foreign assets by domestic citizens.
• Financial inflow
– Foreigners loan to domestic citizens by buying domestic assets
– Domestic assets sold to foreigners are a credit (+) because the
domestic economy acquires money during the transaction
• Financial outflow
– Domestic citizens loan to foreigners by buying foreign assets
– Foreign assets purchased by domestic citizens are a debit (-)
because the domestic economy gives up money during the
transaction
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-22
Financial account
•
Financial account has at least
3 subcategories:
1. Official (international) reserve assets
2. All other assets
3. Statistical discrepancy
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-23
Financial account
• Official (international) reserve assets: foreign
assets held by central banks to cushion against
financial instability.
– Assets include government bonds, currency, gold and
accounts at the International Monetary Fund.
– Official reserve assets owned by (sold to) foreign central
banks are a credit (+) because the domestic central bank
can spend more money to cushion against instability.
– Official reserve assets owned by (purchased by) the
domestic central bank are a debit (-) because the domestic
central bank can spend less money to cushion against
instability.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-24
Financial account
• The negative value of the official reserve
assets is called the official settlements
balance or “balance of payments.”
– It is the sum of the current account, the capital
account, the non-reserve portion of the financial
account, and the statistical discrepancy.
– A negative official settlements balance may
indicate that a country
• is depleting its official international reserve assets or
• may be incurring large debts to foreign central banks so
that the domestic central bank can spend a lot to protect
against financial instability.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-25
Statistical discrepancy
– Data from a transaction may come from different
sources that differ in coverage, accuracy, and
timing.
– The balance of payments accounts therefore
seldom balance in practice.
– The statistical discrepancy is the account added
to or subtracted from the financial account to
make it balance with the current account and
capital account.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-26
THE BALANCE OF
PAYMENTS ACCOUNTS
Table 12.4(a) U.S. International Transactions, 2006 ($
billions)
Current Account transactions
Exports of Merchandise
$1,023.1
Imports of Merchandise
–1,861.4
–838.3
Balance of Trade (Goods)
Exports of Services
422.6
Imports of Services
–342.8
Balance on Services
79.7
–758.5
Balance on Goods & Services
Income Receipts on U.S. Assets Abroad
Income Payments on Foreign Assets in the U.S.
650.5
–613.8
Balance on Investment Income
36.6
–721.9
Balance on Goods, Service, and Income
Unilateral Transfers, Net
Balance of Current Account
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
–89.6
–811.5
12-27
THE BALANCE OF
PAYMENTS ACCOUNTS
Table 12.4(b) U.S. International Transactions, 2006 ($
billions)
Current Account transactions
–3.9
Capital Account transactions, net
–1,055.2
Financial Account Transactions
Change in U.S. Owned Assets Abroad
U.S. Official Reserve Assets
2.4
U.S. Government Assets, Other than Official Reserve
5.3
U.S. Private Assets
–1,062.9
Change in Foreign Owned Assets in the U.S.
1,859.6
Foreign Official Assets
440.3
Foreign Private Assets
1,419.3
Balance on Financial Account
804.4
Statistical Discrepancy
–17.8
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-28
TABLE 12.2 Simplified U.S. Balance of
Payments for 2007 (millions $)
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-29
Drawing a Line in the BOP
•
If we draw a line at the current account
balance, then:
1. Items “above the line” refer to the current
account trade in goods, services, income, and
unilateral transfers.
2. Items “below the line” are the capital and
financial account transactions (purchases and
sales of financial assets).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-30
Drawing a Line in the BOP
(cont.)
• Since the BOP always balances, then a
current account deficit (above the line)
implies that the country is running a net
surplus below the line, so that the country is
a net borrower from the rest of the world.
• The U.S. became a net borrower in 1985 for
the first time since World War I because of
the huge current account deficits in the
1980s (refer to Global Insight 12.1).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-31
Imbalances
• While the BOP has to balance overall,
surpluses or deficits on its individual
elements can lead to imbalances between
countries. In general there is concern over
deficits in the current account. Countries
with deficits in their current accounts will
build up increasing debt and/or see
increased foreign ownership of their assets.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-32
Causes of Disequilibrium
• The balance of payments of a country is said to be in
equilibrium when the demand for foreign exchange is exactly
equivalent to the supply of it. The balance of payments is in
disequilibrium when there is either a surplus or a deficit in the
balance of payments. When there is a deficit in the balance of
payments, the demand for foreign exchange exceeds the
demand for it local currency.
• A number of factors may cause disequilibrium in the balance of
payments. These various causes may be broadly categorized
into:
• (i) Economic factors ;
• (ii) Political factors; and
• (iii) Sociological factors.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-33
Causes of Disequilibrium
• Economic Factors:
• A number of economic factors may cause
disequilibrium in the balance of payments. These
are: Development Disequilibrium:
• Large-scale development expenditures usually
increase the purchasing power, aggregate demand
and prices, resulting in substantially large imports.
The development disequilibrium is common in
developing countries, because the above factors,
and large-scale capital goods imports needed for
carrying out the various development programs,
give rise to a deficit in the balance of payments.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-34
Causes of Disequilibrium
Capital Disequilibrium:
• Cyclical fluctuations in general business activity are one of the
prominent reasons for the balance of payments disequilibrium.
As Lawrance W. Towle points out, depression always brings
about a drastic shrinkage in world trade, while prosperity
stimulates it. A country enjoying a boom experiences more
rapid growth in its imports than its exports, while the opposite
is true of other countries. But production in the other countries
will be activated as a result of the increased exports to the
boom country.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-35
Causes of Disequilibrium
•
•
•
•
•
Secular Disequilibrium:
Sometimes, the balance of payments diequilibrium persists for
a long time because of certain secular trends in the economy.
For instance, in a developed country, the disposable income is
generally very high and, therefore, the aggregate demand,
too, is very high. At the same time, production costs are very
high because of the higher wages. This naturally results in
higher prices. These two factors - high aggregate demand and
higher domestic prices may result in the imports being much
higher than the exports. This could be one of the reasons for
the persistent balance of payments deficits of the USA.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-36
Causes of Disequilibrium
• Structural Disequilibrium:
• Structual changes in the economy may also cause balance of
payments disequilibrium. Such structural changes include the
development of alternative sources of supply, the development of
better substitutes, the exhaustion of productive resources, the
changes in transport routes and costs, etc.
• Political Factors:
• Certain political factors may also produce a balance of payment
disequilibrium. For instance, a country plagued with political
instability may experience large capital outflows, inadequacy of
domestic investment and production, etc. These factors may,
sometimes, cause disequilibrium in the balance of payments. Further,
factors like war, changes in world trade routes, etc., may
also produce balance of payments difficulties.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-37
Causes of Disequilibrium
• Social Factors:
• Certain social factors influence the balance
of payments. For instance, changes in
tastes, preferences, fashions, etc. may affect
imports and exports and thereby affect the
balance of payments
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-38
Causes of Disequilibrium
• There are conflicting views as to the
primary cause of BOP imbalances, with
much attention on the US which currently
has by far the biggest deficit. The
conventional view is that current account
factors are the primary cause - these include
the exchange rate, the government's fiscal
deficit, business competitiveness , and
private behaviour such as the willingness of
consumers to go into debt to finance extra
consumption.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-39
Causes of Disequilibrium
• In the context of BOP and international monetary systems, the
reserve asset is the currency or other store of value that is
primarily used by nations for their foreign reserves. BOP
imbalances tend to manifest/very clear as hoards/saved of the
reserve asset being amassed/collected by surplus countries,
with deficit countries building debts denominated in the
reserve asset or at least depleting their supply. Under a gold
standard, the reserve asset for all members of the standard is
gold. In the Bretton Woods system , either gold or the US
Dollar could serve as the reserve asset, though its smooth
operation depended on countries apart from the US choosing
to keep most of their holdings in dollars.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-40
Causes of Disequilibrium
• Global reserves rose sharply in the first decade of the
21st century, partly as a result of the 1997 Asian
Financial Crisis, where several nations ran out of
foreign currency needed for essential imports and thus
had to accept deals on unfavourable terms. The IMF
estimates that between 2000 to mid-2009, official
reserves rose from $1,900bn to $6,800bn. Global
reserves had peaked at about $7,500bn in mid 2008,
then declined by about $500 as countries without their
own reserve currency used them to shield themselves
from the worst effects of the financial crisis. From Feb
2009 global reserves began increasing again to reach
approximately $8,400bn by May 2010.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-41
Causes of Disequilibrium
•
•
As of 2009 approximately 65% of the world's $6,800bn total is held in US
dollars and approximately 25% in Euros. The UK Pound, Japanese yen, IMF
SDRs, and precious metals also play a role. In 2009 Zhou Xiaochuan,
governor of the People's Bank of China, proposed a gradual move towards
increased use of SDRs, and also for the national currencies backing SDRs to
be expanded to include the currencies of all major economies. Dr Zhou's
proposal has been described as one of the most significant ideas expressed in
2009.
While the current central role of the dollar does give the US some advantages
such as lower cost of borrowings, it also contributes to the pressure causing
the US to run a current account deficit, due to the Triffin dilemma . In a
November 2009 article published in Foreign Affairs magazine, economist C.
Fred Bergsten argued that Dr Zhou's suggestion or a similar change to the
international monetary system would be in the United States' best interests as
well as the rest of the world's. Since 2009 there has been a notable increase
in the number of new bilateral agreements which enable international trades
to be transacted using a currency that isn't a traditional reserve asset, such as
the renminbi, as the Settlement currency.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-42
Economic Implications of the
BOP
• It is impossible for every country in the
world to have a trade surplus.
• If international trade is voluntary, then it is
difficult to argue that deficit countries are
harmed and surplus countries benefit.
• Deficits are not inherently bad, nor are
surpluses necessarily good.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-43
Balance of Payments
Equilibrium
• BOP equilibrium is the situation where
credit items equal debit items for a
particular sub-account, such as the current
account or official settlements account, of a
country’s balance of payments.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-44
Balance of payments crisis
• A BOP crisis, also called a currency crisis, occurs when a nation
is unable to pay for essential imports and/or service its debt
repayments. Typically, this is accompanied by a rapid decline
in the value of the affected nation's currency. Crises are
generally preceded by large capital inflows, which are
associated at first with rapid economic growth. However a
point is reached where overseas investors become concerned
about the level of debt their inbound capital is generating, and
decide to pull out their funds. The resulting outbound capital
flows are associated with a rapid drop in the value of the
affected nation's currency.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-45
Movement Towards BOP
Equilibrium
• What happens if the country has a current
account deficit?
– The country must borrow from (or sell domestic
securities to) the rest of the world to finance the
current account deficit.
– As foreigners accumulate domestic securities, the
domestic currency value falls which, in turn,
raises net exports and consequently income.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-46
Movement Towards BOP
Equilibrium (cont.)
• What happens if the country has a current
account deficit? (cont.)
– In addition, domestic interest rates rise which, in
turn, lowers consumption and investment
spending.
– The increase in national income relative to
spending will reduce the current account deficit.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-47
Chapter 17
Basic Theories
of the Balance
of Payments
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
Topics to be Covered
•
•
•
•
•
•
•
•
Elasticities Approach to the Balance of Trade
Price Elasticity of Demand
J Curve Effect
Currency Contract Period
Pass-through Analysis
Evidence from Devaluations
Absorption Approach to the Balance of Trade
Monetary Approach to the Balance of
Payments
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-49
Basic Theories
• Theories of the Balance of Trade (No Capital
Flows)
– Elasticities Approach
– Absorption Approach
• Monetary Approach to the Balance of
Payments
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-50
The Elasticities Approach
• The elasticities approach examines how changing
relative prices of domestic goods and foreign
goods resulting from a change in the exchange rate
will affect the balance of trade of a country.
• For example, the relative price effect of a Japanese
yen devaluation should increase U.S. demand for
Japanese goods (as the $ price of Japanese goods
fall) and decrease Japanese demand for U.S. goods
(as the yen price of U.S. goods rise).
• How much quantity demanded changes in response
to the relative price change is determined by the
elasticity of demand.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-51
Price Elasticity of Demand
• The price elasticity of demand measures
the responsiveness of quantity demanded to
a change in the product’s price.
• The coefficient of elasticity of demand is
equal to the percentage change in quantity
demanded divided by the percentage change
in price, that is:
Similarly, we can compute a price elasticity
of supply.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-52
Elasticity of Demand (cont.)
• If the % change in quantity demanded
exceeds (is less than) the % change in price,
then demand is said to be elastic (inelastic).
• With an elastic (inelastic) demand, total
revenue (or price times quantity) will move
in the opposite (same) direction as the price
change.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-53
Supply and Demand for British
Pounds
• Refer to Figure 17.1
• Downward-sloping demand curve for pounds
• Upward-sloping supply curve of pounds
• Given that the market is in equilibrium,
suppose there is an increase in the demand
for pounds (i.e., demand curve shifts to the
right).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-54
FIGURE 17.1 Supply and Demand
in the Foreign-Exchange Market
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-55
Possible Responses to an
Increase in Demand for Pounds
• With flexible or freely floating exchange
rates, the pound will appreciate.
• A central bank can fix or peg the exchange
rate at the original level by supplying more
pounds from its foreign reserves.
• Foreign exchange controls or quotas can be
used to restrict the demand and supply of
pounds.
• Quotas or tariffs can be imposed on trade to
maintain the original demand and supply
curves.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-56
Balancing mechanisms
• Rebalancing by changing the exchange rate
• An upwards shift in the value of a nation's currency
relative to others will make a nation's exports less
competitive and make imports cheaper and so will
tend to correct a current account surplus.
Conversely a downward shift in the value of a
nation's currency makes it more expensive for its
citizens to buy imports and increases the
competitiveness of their exports, thus helping to
correct a deficit (though the solution often doesn't
have a positive impact immediately due to the
Marshall–Lerner condition.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-57
Marshall-Lerner Condition
• The Marshall-Lerner Condition states that
a $ devaluation will improve the U.S. trade
balance and provide a stable foreign
exchange market if the sum of the elasticity
of demand for U.S. imports and the elasticity
of demand for U.S. exports is greater than
one.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-58
TRADE FLOW ADJUSTMENT AND CURRENT ACCOUNT
DYNAMICS
• However, the response of trade flows to changes in
exchange rates may not always happen quickly.
• The price of imports and exports may not change
instantly as the exchange rate changes
• International trade may respond slowly to changes
in prices compared to the response of financial
markets
• The time it takes for the exchange rate to affect a
country’s exports and imports and the current
account balance could be six months to a year
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-59
TRADE FLOW ADJUSTMENT AND CURRENT ACCOUNT
DYNAMICS
• In the long run, as a country’s currency
depreciates, its exports expand and imports
contract (and vice versa)
• In the short run, as a country’s exchange
rate changes, the response of exports and
imports and current account balance could
very easily be in the opposite direction
• In part this is because international trade is
often conducted between parties on a
contract basis
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-60
TRADE FLOW ADJUSTMENT AND CURRENT ACCOUNT
DYNAMICS
• Importers agree to purchase a certain
amount of a good at an agreed upon price
• If currency depreciates, cost of goods in
domestic currency rises
• This causes the value of imports to rise, but
the value of exports in domestic currency
does not change as the price was
predetermined by the contract
• The net effect is that the current account
may initially worsen after a depreciation and
only improve after a lag
12-61
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
TRADE FLOW ADJUSTMENT AND CURRENT ACCOUNT
DYNAMICS
• The effect on the current account balance
has been called the J-curve
• This reflects the tendency for the current
account balance to initially worsen when a
currency depreciates
• Only after contracts are renewed to reflect
the new exchange rate will the current
account begin to improve
• It is important for policy makers to take the
lag effect into account
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-62
TRADE FLOW ADJUSTMENT AND CURRENT
ACCOUNT DYNAMICS
The J Curve
Current Account
Balance
Current Account Surplus
0
t0
t1
Time
Current Account Deficit
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-63
Evidence from Devaluations
• Effects of devaluation differ across countries
and time.
• One reason is that producers in different
countries (e.g., Japan and Germany) adjust
their profit margins on exports to offset the
effect of exchange rate changes. This
behavior is called pricing to market.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-64
Evidence (cont.)
• Studies show that in countries where the
capital-labor ratio is low, devaluations tend
to result in export expansion and economic
growth.
• Evidence from studies also indicate that the
adjustment of goods prices to changes in
exchange rates takes a long time (as much
as three years).
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-65
The Absorption Approach
• The absorption approach is a theory of the
balance of trade in goods and services that
emphasizes how domestic spending changes
relative to domestic production. The balance of
trade is the difference between what the economy
produces and what it consumes or absorbs.
• The absorption approach assumes, BT equilibrium
requires that, country consumption of goods and
services must equal country production of goods
and services Y+M =C+I+G+X
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-66
Absorption Approach (cont.)
• Thus,
• If total output exceeds absorption, then the
country will export its surplus and the
current account will be in surplus.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-67
Absorption Approach (cont.)
• Suppose the country devalues its currency,
then there are two possibilities:
– With unemployed resources, devaluation will
increase exports and output without inflation.
– With full employment, devaluation will raise
exports and lead to inflation as domestic prices
are bid up.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-68
Monetary Approach to the
Balance of Payments (MABP)
• Unlike the elasticities and absorption approaches,
the MABP incorporates both the current account
(trade in goods and services) and financial account
(trade in financial assets).
• The basic premise is that any balance of payments
disequilibrium is based on monetary disequilibrium,
or the difference between the amount of money
people want to hold Md=f(y.p.r) and the amount
supplied by monetary authorities Ms= A(d+R).
• Ms= money base* money nultiplier
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-69
MABP vs. MAER
• The monetary approach to the balance of
payments (MABP) applies to countries with fixed
exchange rates.
• The monetary approach to the exchange rate
(MAER) applies to countries with flexible or freely
floating exchange rates.
• The adjustment mechanism, or the process by
which disequilibrium is eliminated, depends on the
exchange rate system. With fixed exchange rates,
adjustment is through international money flows,
while with floating rates, adjustment is via changes
in the exchange rate.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-70
National Saving, Investment,
and the Current Account
• Given the national income accounting identity:
where Y is national income or GDP, C is consumption
spending, I investment, G government spending, and X
is net exports or the current account, we can rearrange
this identity as:
where Y – C – G is national income less consumption less
government spending, which we can call national saving
S. Thus, saving equals the sum of investment and the
current account.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-71
National Saving, Investment,
and the Current Account (cont.)
• Rearranging further, we get:
This states that if domestic saving exceeds
investment, there will be a current account
surplus.
• A country that spends more than its income
(I > S) will experience a current account deficit.
This overspending must be financed by foreign
investment, so there will be a financial account
surplus to match the current account deficit.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-72
More on the Link between
Saving and the Current Account
• Given two kinds of saving (private and
government):
where private saving equals income less
taxes (T) less consumption, and government
saving equals taxes less government
spending.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-73
Saving and Current Account
(cont.)
• If government spends more than its tax
revenues (i.e., budget deficit or government
dissaving) and private saving stays
constant, then the current account will run a
deficit. This was the twin-deficit problem of
the 1980s and early 1990s.
• When the U.S. budget turned surpluses in
late 1990s, the current account deficit
continued to grow. This was due to a
substantial drop in private saving along with
a rise in investment.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-74
Saving and Current Account
(cont.)
• Lesson: Reducing the current account deficit
requires increasing private saving relative to
investment, and expanding domestic output
or income relative to domestic spending.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-75
DETERMINANTS OF
THE CURRENT ACCOUNT
• Changes in aggregate demand and
aggregate supply influence output
• We will focus on one component of
aggregate demand and supply – the
current account
• We want to examine how a change in the
current account (exports minus imports)
impacts the equilibrium level of output
• Changes in other determinants of AD and
AS will be ignored
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-76
DETERMINANTS OF
THE CURRENT ACCOUNT
• Exports
– In the short run, a country’s exports are a
function of two major determinants
– The first is the level of income in foreign
countries (Yf)
– A country’s exports depend on foreigner's
ability to pay for the goods and services
– As foreign incomes change, the level of a
country’s exports will also change
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-77
DETERMINANTS OF
THE CURRENT ACCOUNT
• The size of he foreign-income effect
depends on two factors
• The most obvious is the size of the
change in foreign income
• Larger income changes have larger
effects on exports
• Changes in foreign income that affect a
country’s exports are weighted
averages of changes in income among
the countries trading partners
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-78
DETERMINANTS OF
THE CURRENT ACCOUNT
• Income elasticity of demand for the country’s exports
also affects the size of the foreign-income effect
• An income elasticity of demand measures the
percentage change in a country’s exports relative to the
percentage change in foreign income
• The income elasticity of demand for exports is
( Yf )  %Δ in X/%Δ in Yf 
• The size of country’s foreign income elasticity
depends on product mix of a country’s exports
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-79
DETERMINANTS OF
THE CURRENT ACCOUNT
• The second determinant of a country’s exports
is the real exchange rate (RXR)
• As real value of country’s currency appreciates
(depreciates), the level of a country’s exports
declines (increases)
• Size of the effect depends on the size of
change in real exchange rate
• Since bilateral exchange rates change by
different magnitudes, changes in a country’s
real exchange rate are a weighted average of
changes in bilateral exchange rates
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-80
DETERMINANTS OF
THE CURRENT ACCOUNT
• The second factor is the sensitivity of exports
to changes in the real exchange rate, the price
elasticity
• The price elasticity of demand for exports is
( RXR )  %Δ in X/%Δ in RXR 
• The sensitivity of a country’s exports is inversely related
to changes in the real exchange rate
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-81
DETERMINANTS OF
THE CURRENT ACCOUNT
• Imports
– The first determinant is the level of domestic
income (Yd)
– As domestic income rises, the level of imports
rises
– Size of effect depends on two factors, the size
of change in domestic income and the income
elasticity of demand for imports
– The income elasticity of the demand for
imports is
( Yd )  %Δ in M/%Δ in Yd 
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-82
DETERMINANTS OF
THE CURRENT ACCOUNT
• The second determinant is the real exchange
rate
• As currency appreciates, imports become
cheaper and usually increase
• Magnitude of effect depends on two factors,
the size of change in the real exchange rate
and the price elasticity of demand
• The price elasticity of the demand for
imports is ( RMR )  %Δ in M/%Δ in RXR 
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-83
DETERMINANTS OF
THE CURRENT ACCOUNT
Table 17.4
Factors Determining the Current Account
Factor
Effect on
Foreign Income Increases
Exports Increase
Current Account Increases
Foreign Income Decreases
Exports Decrease
Current Account Decreases
Real Exchange Rate Increases
Exports Increase
Current Account Increases
Exports Decrease
Real Exchange Rate Decreases
Exports Decrease
Current Account Decreases
Exports Increase
Domestic Income Increases
Exports Increase
Current Account Decreases
Domestic Income Decreases
Exports Decrease
Current Account Increases
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-84
Case Reading Answers
•
•
•
•
Viewing the Current Account Deficit as a Capital Inflow
The President of the United States has a controversy in his administration regarding the
appropriate policy response to a large and growing Japanese trade surplus. Some
important U.S. business leaders are calling for U.S. tariffs on Japanese products to lower
Japanese exports. Some U.S. labor leaders are complaining that Japanese exports are
reducing employment in the United States. The Presidents' Trade Representative wants to
use U.S. political power to convince Japan to cut domestic taxes and follow expansionary
fiscal and monetary policy aimed at stimulating domestic demand in Japan. As members
of the Presidents' Council of Economic Advisers, you have been asked to explain the
economics of the situation to help him decide on the correct policy. He specifically wants
you to address the following:
1. How do current account deficits occur?
Current account = domestic saving (S) - domestic investment (I)
If S>I, you get net outflow of capital and are a net creditor
If I>S, you get net inflow of capital and are a net debtor
Since the current account equals the capital or financial account, if you are borrowing
more from the rest of the world than you are lending, you will have a current account
deficit.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-85
Case Reading Answers
•
•
•
2. Does a growing trade deficit necessarily lower U.S. employment?
No. Foreign investment brings new jobs and lowers interest rates at home below what
they would otherwise be. Some export-oriented jobs will be lost, but they are replaced by
other jobs.
3. Is it "bad" for the U.S. to have a current account deficit?
Not necessarily. It depends upon what is done with the money borrowed from abroad.
If it makes for a richer country, then the burden of this debt is low as future generations
will be wealthier. Also consider the special condition of the U.S. as a producer of dollars—
the money that people and governments all over the world want. As long as there is a
foreign demand for U.S. financial assets, the U.S. may be expected to run current
account deficits. This is how a net outflow of dollar assets to other countries occurs.
4. What do you advise the President to do about the large Japanese current account
surplus?
The Japanese current account surplus is partly a result of slow growth in Japan. So the
President could pressure the Japanese government to stimulate growth to increase the
demand for foreign goods and decrease the S & I imbalance.
Copyright © 2010 Pearson Addison-Wesley. All rights reserved.
12-86