The Balance of Payments and International Economic Linkages

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• The Balance of Payments and International
  Economic Linkages
• (Shapiro Chapter 5)

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Balance of Payments

• Funds flow from one country to another due to
  transactions between
• Individuals
• Firms
• Government
• Measurement of all such transactions is done
  through a record keeping called the Balance of
  Payments (BOP)
• BOP is the statistical record of the countrys
  international transactions over a certain period
  of time presented in double-entry bookkeeping
• Double entry bookkeeping
• a. Currency inflows credits (earn foreign
  exchange)
• b. Currency outflows debits (expend foreign
  exchange)

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Example of double entry bookkeeping

• Example (text) Suppose Boeing Corporation
  exported aircraft to Japan worth 50 million.
  Suppose that Japan Airlines that purchased the
  aircraft paid for this using its dollar account
  at Chase Manhattan Bank in New York City. This
  would show up as
• Transaction Credit Debit
• Boeings export 50 million
• Withdraw from US bank -50 million

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• On the other hand if Boeing imported jet engines
  from Rolls Royce and paid for this by crediting
  the account of Rolls Royce at a major NY bank to
  the tune of 30 million, the transaction would
  show up as
• Transaction Credit Debit
• Boeings import -30 million
• Deposit at US bank 30 million

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Components of the BOP

• Three Major Accounts
• a. Current
• b. Capital
• c. Official Reserves
• Current account
• Balance on goods and services
• Balance on trade Exports - Imports of
  merchandise Net interest and dividend receipts
  receipts from international tourism, patents
  and royalties
• Balance on services
• Unilateral transfers
• Government aid or gifts to or from abroad

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• Capital account
• Long term investment between countries
• Short term investment (less than one year)
• Official reserves account measures changes in
  international reserves (gold, convertible
  securities, and foreign currency) owned by
  central banks.
• Sum of all transactions must be zero
• current account capital account official
  reserves
• BOP 0

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• Statistical discrepancy a positive figure
  reflects a mysterious inflow of funds a negative
  amount reflects an outflow.
• In 2000, that item was 0.7 billion.
• In 1990 it was 66.8 billion. This discrepancy
  coincided with such worrisome foreign events as
  the Iraqi invasion of Kuwait, turmoil in Iran,
  unrest in Central and Latin America, and .
• Many experts believe that the statistical
  discrepancy in that year was primarily the result
  of foreigners surreptitiously moving money into
  what they deemed to be a safe political haven-the
  United States.

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International Economic Linkages

• Domestic Savings and Investment and the Capital
  Account
• 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 Id (5.2)
• c. Subtracting (5.2) - (5.1)
• National income - National
  spending Savings-Investment
• NI - NS S - Id (5.3)
• If NI gtNS, S gt Id which implies that surplus
  capital spent overseas (net capital
  outflow--capital account deficit).

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• The Link Between the Current and Capital Accounts
• 1. Beginning identity
• NI - NS X - M (5.4)
• where X exports
• M imports
• X-Mcurrent account balance (CA)
• 2. Combining (5.3) (5.4)
• S - Id X - M (5.5)
• 3. If S - Id Net Foreign Investment
  (NFI)
• NFI X - M (5.6)

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• 4. Implications
• If CA is in surplus, the nation must be a net
  exporter of capital.
• If CA is a deficit, the nation is a major capital
  importer.
• Solutions for Improving CA deficits
• (1) Raise national income (output) relative to
• domestic investment (Id).
• (2) Increase (S) relative to domestic
  investment (Id).

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• Government Budgets and Current Account Deficits
• 1. Current Account Balance
• CA Saving Surplus - Govt budget
  deficit
• 2. CA Deficit means the nation is not saving
• enough to finance (I) and the deficit.
• 3. 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
• 1. U.S. Experience does not improve the trade
  deficit.
• 2. Example (1) Suppose a German tire
  manufacturer charged DM120 per tire and the
  exchange rate of the dollar vis-a-vis the DM was
  DM 1 0.5. Hence the dollar cost of the tire
  made in Germany would be 120 x 0.5 60. If the
  dollar depreciates as a result of a deficit in
  the BOP to DM 1 0.60, the dollar price of the
  tire should increase to 120 x 0.60 72 making
  the German tire more expensive leading to a
  decline in demand for exports and so on...

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• (2) However, if the decline in the value of the
  dollar is accompanied by a decline in the price
  charged by the German tire manufacturer, the
  dollar price could remain unchanged
• (3) For instance if the dollar depreciation was
  accompanied by a decline in the price of the tire
  to DM100 then the dollar price would be
• 100 x 0.60 60 which is the same as before
• (4) Often when the dollar depreciates, foreign
  firms also reduce prices so as to remain
  competitive with US firms

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• 3.Depreciations are ineffective because
• (1) It takes time to affect trade.
• (2) J-Curve Effect states that a decline in
  currency value will initially worsen the deficit
  before improvement.

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• Protectionism
• Trade Barriers used
• 1. Tariffs
• 2. Quotas
• Results Most likely will reduce both X and M
• Stimulate national saving change the tax
  regulations and rates.

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Summary Bottom Line on current account deficits
and surpluses

• Assume the US consistently ran a current account
  deficit because of a lower propensity to save and
  a capital account surplus because of favorable
  investment opportunities
• Capital flows into the US
• This may not be necessarily bad so long as the
  current account deficit and the accompanying
  inflow of capital finances productive investment
• If the capital account surplus finances current
  consumption, then we have a problem
• Conversely a capital account surplus that
  finances current consumption will affect future
  productivity and future consumption