The Balance of Payments and International Economic Linkages

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CHAPTER 5

• The Balance of Payments and International
  Economic Linkages

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PART I. BALANCE-OF-PAYMENTCATEGORIES

• A. THE BALANCE OF PAYMENTS (B-O-P)
• 1. PURPOSE
• Measures all financial and economic
  transactions over a specified period of time.

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BALANCE-OF-PAYMENTCATEGORIES

• 2. Double-entry bookkeeping
• a. Currency inflows credits earn foreign
  exchange
• b. Currency outflows debits expend
  foreign exchange

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BALANCE-OF-PAYMENTCATEGORIES

• 3. Three Major Accounts
• a. Current
• b. Capital
• c. Official Reserves
• 4. Current Account
• records net flow of goods, services, and
  unilateral transfers.

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BALANCE-OF-PAYMENTCATEGORIES

• 5. Capital Account
• a. Function records public and private
  investment and lending.
• b. Inflows credits
• c. Outflows debits
• d. Transactions classified as
• 1.) portfolio
• 2.) direct
• 3.) short term

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BALANCE-OF-PAYMENTCATEGORIES

• 6. Official Reserves Account
• a. Function
• 1.) measures changes in international
  reserves owned by central banks.
• 2.) reflects surplus/deficit of
• a.) current account
• b.) capital account

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BALANCE-OF-PAYMENTCATEGORIES

• 6. Official Reserves Account (cont) b.
  Reserves consist of
• 1.) gold
• 2.) convertible securities

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BALANCE-OF-PAYMENTCATEGORIES

• 7. Net Effects
• a. Sum of all transactions must be zero
• 1.) current account
• 2.) capital account
• 3.) official reserves

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BALANCE-OF-PAYMENTCATEGORIES

• 8. The Balance-of-payment measures
• a. Some Definitions
• 1.) Basic Balance
• a.) consists of current account and
  long-term capital flows.
• b.) emphasizes long-term trends
• c.) excludes short-term capital flows
  that heavily depend on temporary factors.

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BALANCE-OF-PAYMENT CATEGORIES

• 2.) Net Liquidity Balance
• measures the change in private domestic
  borrowing or lending require to keep payments
  equal without adjusting official reserves.

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BALANCE-OF-PAYMENTCATEGORIES

• 3.) Official Reserve Transactions Balance
• - measures adjustments needed by official
  reserves.

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PART II. THE INTERNATIONAL FLOW OF GOODS,
SERVICES, AND CAPITAL

• II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWS
• A. Global Linkages
• set of basic macroeconomic identities which
  link domestic spending and production to
  current and capital accounts

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• B. Domestic Savings and Investment
• and the Capital Account
• 1. 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 I (5.2)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• c. Subtracting (4.2) - (4.1)
• NI - NS S - I (5.3)
• If NI gtNS, S gt I which implies that surplus
  capital spent overseas.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• d. In a freely-floating system,
• excess saving the capital account
  balance
• e. Implications
• 1. A nation which produces more than it
  spends will save more than it invests
  domestically with a net capital outflow
  producing a capital account deficit.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• 2. A nation which spends more than it produces
  has a net capital inflow producing a capital
  account surplus.
• 3. A healthy economy will tend to
• run a current account deficit.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• C. 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)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• 2. Combining (5.3) (5.4)
• S - I X - M (5.5)
• 3. If S - I Net Foreign Investment
  (NFI)
• NFI X - M (5.6)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• 4. Implications
• a. If CA is in surplus, the nation must be a
  net exporter of capital.
• b. If CA is a deficit, the nation is a major
  capital importer.
• c. When NS gt NI, the excess must be acquired
  through foreign trade.

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• d. Solutions for Improving CA deficits
• 1.) Raise national income (output)
• relative to domestic investment (I).
• 2.) Increase (S) relative to domestic
  investment (I).

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• D. GOVERNMENT BUDGETS AND CURRENT ACCOUNT
  DEFICITS
• 1. CURRENT ACCOUNT BALANCE
• CA Saving Surplus - Govt budget
  deficit

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND
CAPITAL

• 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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PART III. COPING WITH THE CURRENT ACCOUNT
DEFICIT

• I. POSSIBLE SOLUTIONS UNLIKELY TO WORK
• A. Currency Depreciation
• B. Protectionism

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COPING WITH THE CURRENT ACCOUNT DEFICIT

• II.CURRENCY DEPRECIATION
• A. U.S. Experience
• Does not improve the trade deficit.
• B. 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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THE J - CURVE

Trade balance improves
Net change in trade balance
Currency depreciation
TIME
0
Trade balance initially deteriorates
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COPING WITH THE CURRENT ACCOUNT DEFICIT

• III. PROTECTIONISM
• A. Trade Barriers used
• 1. Tariffs
• 2. Quotas
• B. Results
• Most likely will reduce both X and M.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

• C. FOREIGN OWNERSHIP
• one protectionist solution would place limits
  on or eliminate foreign ownership leading to
  capital inflows.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

• D. STIMULATE NATIONAL SAVING
• change the tax regulations and rates.

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COPING WITH THE CURRENT ACCOUNT DEFICIT

• III. SUMMARY CURRENT-ACCOUNT
• DEFICITS
• - neither bad nor good inherently
• 1. Since one countrys exports are anothers
  imports, it is not possible for all to run a
  surplus

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COPING WITH THE CURRENT ACCOUNT DEFICIT

• Deficits may be a solution to the problem of
  different national propensities to save and
  invest.
• Homework Q 1,2, 7
• Problems 11, 12