Transcript Lecture 16: The Balance of Payments and the Exchange rate

The International Balance of Payments
• The components of the balance of payments:
– Current account
– Capital account
– Official financing
• National income determination and foreign trade
Economies are becoming more “open” (in terms of trade as % of
GDP), but some countries are more open than others…
Exports and imports as % of GDP
1990
2003
Mauritius
153
121
Zambia
99
76
Chile
64
68
China
29
66
UK
51
54
Argentina
15
40
Bangladesh
20
37
India
17
31
Brazil
14
30
United States
20
23
Source: World Bank World Development Indicators
• Higher degree of openness => structure of production
and employment, and economic growth, are more likely
to be affected by external events
• The balance of payments provides and indication of how
international trade and external events feed back into
the macroeconomy
• This presentation describes how balance of payments
accounts are recorded and then explores the link
between the balance of payments and a country’s
exchange rate
The balance of payments (BoP) accounts
A country’s balance of payments accounts record its
international trading position and its lending and
borrowing
=> records transactions between countries
Each transaction is classified according to the payment
or receipts that it generates
– Transactions that generate a receipt of a payment from
foreigners are a credit item in the accounts with a + sign
These represent a supply of foreign exchange ($) and a
demand for the local currency (£)
– Transactions that comprise a payment to foreigners are
reported as a debit item with a - sign
=> These represent demand for foreign exchange ($) and a
supply of the local currency (£)
Three Balance of Payments (BoP) Accounts
a) The balance of payments on Current Account
b) The balance of payments on Capital Account
c) The balance for Official Financing
(International reserves account operated by central bank)
Let us consider two countries:
• the United Kingdom:
– local or domestic
– currency: British pounds (£)
• the United States:
– foreign
– currency: US follars ($)
a) The balance of payments on Current Account
Records transactions arising from trade in goods and
services
• The visible trade balance
– payments and receipts from the import/export of tangible
goods (cars, food, textiles,…)
• The invisibles trade balance
– payments and receipts for financial services, shipping and
tourism, interest and dividends payments on investments,
etc.…
b) The balance of payments on Capital Account
Records transactions related to international
movements in the ownership of financial assets
• The purchase of foreign investments by UK citizens
brings assets to the UK (in exchange for money) and are
referred to as a capital outflow
– to purchase these foreign assets, locals have to buy $
=> debit (negative) entry in the Capital Account
b) The balance of payments on Capital Account
(cont.)
• Foreign investment into the UK increases UK liabilities to
foreigners, and it is a capital inflow
– foreigners have to buy £ to undertake their investments
credit (positive) entry in the Capital Account
The Capital Account is further divided into short-term and
long-term capital flows
• The supply of £s reflects imports to the UK and UK
purchases of foreign assets
=> outflows in the UK balance of payments
• The demand for £s reflects UK exports and sales of UK
assets to foreigners
inflows in the UK balance of payments
• The exchange rate is the price of the £ in terms of other
currencies (e.g. $)
• If the exchange rate is freely floating then it will adjust
to ensure that the demand for £s = the supply of £s 
inflows = outflows in the BoP  BoP is exactly = zero
• Since BoP = Current Account + Capital Account:
– a Current Account surplus => a Capital Account deficit
– a Current Account deficit => a Capital Account surplus
c) The balance for Official Financing
• If the exchange rate is fixed, and there is a BoP deficit
 outflows > inflows  supply of £s > demand for £s
• The Central Bank must offset this excess supply of £s by
buying them with foreign currency ($); i.e. runs down
its reserves of foreign exchange
c) The balance for Official Financing (cont)
The balance for official financing shows the net increase
or decrease in a country’s holdings of foreign currency
reserves:
– A decrease in the official reserves is reported as a credit item
(+), since it involves the purchase of £s
– an increase is reported as a debit item (-)
=> If the exchange rate is freely floating, then the
balance for official financing is zero
• The balance of payments must always balance since the
accounts are constructed such that this must be true by
definition
– However, there can be measurement error and unreported
borrowing from abroad and other illegal activities
The discrepancy represents a combination of unrecorded
current and capital account transactions
• This requires the inclusion of what is referred to as a
balancing item, to ensure the accounts balance in
practice
National Income Identities
and the Current Account Balance
Recall the aggregate expenditure equation in
our study of macroeconomics:
AE (=AD) = C + I + G + X - M
• Leakages are:
S+T+M
• Injections are:
I+G+X
=> In equilibrium: injections = leakages
S+T+M=I+G+X
The balance of payments on Current Account could be
re-written as:
(X - M) = (T - G) + (S - I)
(M - X)
trade
deficit
or
= (G - T) +
(I - S)
= government + private sector
balance
balance
Trade deficit = government deficit + priv. sector deficit
An increase in govt. expenditure (G), or a reduction in
private saving (S) worsens the trade balance (i.e. raises
trade deficit)
Are trade deficits a problem?
• A trade deficit is not necessarily a bad thing (e.g. when
growing domestic industries attract foreign investments)
– if borrowing is financing investment (which generates
economic growth and income in future) then it is not a
problem
• However, if a country persistently runs a trade deficit
this is something to worry about (e.g. vulnerability to
loss of foreign investors’ confidence)
– excessive borrowing on capital account to finance
consumption on current account will incur higher interest
payments and eventually lead to reduction consumption