Balance of Payments

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CHAPTER 5

• Balance of Payments

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CHAPTER OVERVIEW

• Balance of Payments
• A model of foreign trade
• Reducing the current account deficit

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Balance of Payments

• Accounting statements that record all
  transactions between a nations residents and the
  rest of the world.

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Balance of Payments

• Current Account
• records net flow of goods, services, and
  unilateral transfers.
• Trade balance net merchandise balance.
• Services balance net services balance.
• Transfers payments/donations from
  industrialized to non-industrialized countries.

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Balance of Payments

• Capital Account
• records sales and purchases of capital, both
  financial and real
• Portfolio financial assets with maturities
  greater than one year.
• Direct investments in real assets.
• Short-term financial assets with maturities
  greater than one year.

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Balance of Payments

• Official Reserves Account
• measures changes in international reserves owned
  by central banks.
• ? Official Reserves
• ? current account ? capital account
• Reserves consist ofGold and convertible
  currencies

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A Model of Foreign Trade

• National income
• sum of all income in a nation.
• National spending
• sum of all products sold in a nation.

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A Model of Foreign Trade

• In any given year, income is either consumed (C)
  or saved (S)
• NI C S (5.1)
• Identically, money spent is either for
  consumption (C) or investment (I) NS C
  Id (5.2)

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A Model of Foreign Trade

• NI NS Id S
• NI - NS S Id (5.3)
• NI - NS Net foreign investment
• In a freely-floating system,
• excess saving the capital account surplus

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A Model of Foreign Trade

• Implications
• A nation that produces more than it spends will
  save more than it invests domestically has a net
  capital outflow producing a capital account
  deficit.
• A nation which spends more than it produces has a
  net capital inflow producing a capital account
  surplus.
• A healthy economy will tend to run a current
  account deficit.

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A Model of Foreign Trade

• Link between capital and current accounts
• NI National Product
• Goods for domestic use goods for export
• NS Goods from domestic producers goods from
  imports
• NI NS Exports Imports (5.4)

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A Model of Foreign Trade

• Combine (5.3) (5.4)
• S - Id X - M (5.5)
• If S - Id Net Foreign Investment (NFI)
• NFI X - M (5.6)

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A Model of Foreign Trade

• Implications
• If X gt M, the surplus must be invested in
  foreign assets.
• If X lt M, foreigners must make up the
  difference.
• When NS gt NI, the excess must be acquired
  through foreign trade.

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A Model of Foreign Trade

• The Government
• NS Private Private Govt
• spending investment Spending
• (NI Private taxes) PI GS
• Saving
• NS NI (PI PS) (GS taxes)

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A Model of Foreign Trade

• NS NI (PI PS) (GS taxes)
• Excess Excess Budget
• spending Investment Deficit
• NI NS X M ? NS NI M X
• So,
• CA PS PI Budget deficit

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A Model of Foreign Trade

• CA Deficit means
• the nation is not saving enough to finance Id
  and the deficit.
• CA Surplus means
• the nation is saving more than needed to
  finance its Id and deficit.

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A Model of Foreign Trade

• Solutions for Improving CA deficits
• NI NS S Id X M NFI
• PS ( PI Budget Deficit)
• 1.) Raise national income (output) relative to
  domestic investment (Id).
• 2.) Increase (S) relative to domestic
  investment (Id). How?
• 3.) ???

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Reducing the Current Account Deficit

• Solutions UNLIKELY to work
• Currency Depreciation
• Protectionism

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Reducing the Current Account Deficit

• 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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Reducing the Current Account Deficit

• Protectionist trade
• The use of trade barriers such as tariffs and
  quotas to limit imports.
• Most likely results
• A reduction in both X and M, not just M.

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Reducing the Current Account Deficit

• Foreign Ownership
• one protectionist solution would place limits on
  or eliminate foreign ownership leading to capital
  inflows.
• Would this be advisable?

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Reducing the Current Account Deficit

• Summary current account deficits are
• neither bad nor good inherently
• Since one countrys exports are anothers
  imports, it is not possible for all countries to
  run a surplus
• Deficits may be a solution to the problem of
  different national propensities to save and
  invest.