MAN 441: International FinanceMAN 441: International Finance

The Balance of Payments and International The Balance of Payments and International LinkagesLinkages

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CHAPTER OVERVIEWCHAPTER OVERVIEW

I.I. BALANCE-OF-PAYMENT CATEGORIESBALANCE-OF-PAYMENT CATEGORIES

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

III.III. COPING WITH CURRENT ACCOUNT COPING WITH CURRENT ACCOUNT DEFICITSDEFICITS

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PART I. BALANCE-OF-PAYMENTCATEGORIESPART I. BALANCE-OF-PAYMENTCATEGORIES

A.A. THE BALANCE OF PAYMENTS (B-O-P)THE BALANCE OF PAYMENTS (B-O-P)

1.1. PURPOSE:PURPOSE:

Measures all financial and economic Measures all financial and economic transactions over a specified period transactions over a specified period of time.of time.

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2.2. Double-entry bookkeepingDouble-entry bookkeeping

a. a. Currency inflows = credits Currency inflows = credits

earn foreign exchangeearn foreign exchange

b. b. Currency outflows = debits Currency outflows = debits

expend foreign exchangeexpend foreign exchange

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3.3. Three Major Accounts:Three Major Accounts:

a.a. CurrentCurrent

b.b. CapitalCapital

c.c. Official ReservesOfficial Reserves

4.4. Current AccountCurrent Account

records net flow of goods, services, records net flow of goods, services, and unilateral transfers. and unilateral transfers.

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5.5. Capital AccountCapital Account

a. a. Function: records public and Function: records public and private investment and lending.private investment and lending.

b. Inflows = creditsb. Inflows = credits

c. Outflows = debitsc. Outflows = debits

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BALANCE-OF-PAYMENTCATEGORIESBALANCE-OF-PAYMENTCATEGORIES

5.5. Capital Account (con’t)Capital Account (con’t)

d. Transactions classified asd. Transactions classified as

1.) Portfolio1.) Portfolio

2.) Direct2.) Direct

3.) Short term3.) Short term

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6.6. Official Reserves AccountOfficial Reserves Account

a. Function:a. Function:

1.) Measures changes in international 1.) Measures changes in international reserves owned by central banks. reserves owned by central banks.

2.) Reflects surplus/deficit of2.) Reflects surplus/deficit of

a.) Current accounta.) Current account

b.) Capital accountb.) Capital account

b. Reserves consist of b. Reserves consist of

1.) Gold1.) Gold

2.) Convertible securities2.) Convertible securities

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BALANCE-OF-PAYMENTCATEGORIESBALANCE-OF-PAYMENTCATEGORIES

7. Net Effects:7. Net Effects:

a. a. Sum of all transactions must be Sum of all transactions must be zero:zero:

1.) Current account1.) Current account

2.) Capital account2.) Capital account

3.) Official reserves3.) Official reserves

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8.8. The Balance-of-payment measuresThe Balance-of-payment measures

a. Some Definitions:a. Some Definitions:

1.) Basic Balance1.) Basic Balance

a.) Consists of current account a.) Consists of current account and long-term capital flows.and long-term capital flows.

b.) Emphasizes long-term trends.b.) Emphasizes long-term trends.

c.) Excludes short-term capital flows that c.) Excludes short-term capital flows that heavily depend on temporary factors.heavily depend on temporary factors.

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BALANCE-OF-PAYMENT CATEGORIESBALANCE-OF-PAYMENT CATEGORIES

2.) Net Liquidity Balance:2.) Net Liquidity Balance:

Measures the change in private domestic Measures the change in private domestic borrowing or lending require to keep payments borrowing or lending require to keep payments equal equal without adjusting official reserves.without adjusting official reserves.

3.)3.) Official Reserve Transactions BalanceOfficial Reserve Transactions Balance

Measures adjustments needed by official reserves.Measures adjustments needed by official reserves.

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

II.II. LINKS FROM INTERNATIONAL TO DOMESTIC FLOWSLINKS FROM INTERNATIONAL TO DOMESTIC FLOWS

A.A. Global LinkagesGlobal Linkages

set of basic macroeconomic identities which link:set of basic macroeconomic identities which link:

--Domestic spending and production to current and capital accounts.Domestic spending and production to current and capital accounts.

B.B. Domestic Savings and InvestmentDomestic Savings and Investment and the Capital and the Capital AccountAccount

1.1. National Income AccountingNational Income Accounting

a.a. National Income (NI) is either National Income (NI) is either spent (C) or saved (S)spent (C) or saved (S)

NI = C + SNI = C + S (5.1)(5.1)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALTHE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

b. b. National spending (NS) is National spending (NS) is

divided into personal spending (C)divided into personal spending (C) and investment (I)and investment (I)

NS = C + INS = C + I (5.2)(5.2)

c. c. Subtracting (Subtracting (55.2) - (.2) - (55.1).1)

NI - NS = S - INI - NS = S - I (5.3)(5.3)

If NI >NS, S > I which implies that surplus If NI >NS, S > I which implies that surplus capital spent overseas.capital spent overseas.

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d.d. In a freely-floating system,In a freely-floating system,

excess saving = the capital excess saving = the capital account balanceaccount balance

e.e. Implications:Implications:

1.1. A nation which produces more than it spends A nation which produces more than it spends will save more than it invests domestically with a will save more than it invests domestically with a net capital outflow producing a capital account net capital outflow producing a capital account deficit.deficit.

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2.2. A nation which spends more A nation which spends more than it produces has a net than it produces has a net

capital inflow producing a capital capital inflow producing a capital account surplus.account surplus.

3.3. A healthy economy will tend toA healthy economy will tend to

run a current account deficit.run a current account deficit.

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CC.. THE LINK BETWEEN THE CURRENT AND CAPITAL THE LINK BETWEEN THE CURRENT AND CAPITAL ACCOUNTSACCOUNTS

1.1. Beginning identityBeginning identity

NI - NS = X - MNI - NS = X - M (5.4)(5.4)

where where X = exportsX = exports, , M = importsM = imports

X-M=current account balance (CA)X-M=current account balance (CA)

2.2. Combining (5.3) + (5.4)Combining (5.3) + (5.4)

S - I = X - MS - I = X - M (5.5)(5.5)

3. 3. If S - I = Net Foreign Investment (NFI)If S - I = Net Foreign Investment (NFI)

NFI = X - MNFI = X - M (5.6)(5.6)

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THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITALTHE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

4.4. Implications:Implications:

a.a. If CA is in surplus, the nation must be a If CA is in surplus, the nation must be a net exporter of capital.net exporter of capital.

b.b. If CA is a deficit, the nation is a major If CA is a deficit, the nation is a major capital importer.capital importer.

c.c. When NS > NI, the excess must be When NS > NI, the excess must be acquired through foreign trade.acquired through foreign trade.

d.d. Solutions for Improving CA deficits:Solutions for Improving CA deficits:1.)1.) Raise national income (output)Raise national income (output) relative to relative to nationalnational spendingspending . .

2.)2.) Increase (S) relative to domestic investment (I).Increase (S) relative to domestic investment (I).

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PART III. COPING WITH THE CURRENT ACCOUNT DEFICITPART III. COPING WITH THE CURRENT ACCOUNT DEFICIT

I.I. POSSIBLE SOLUTIONS POSSIBLE SOLUTIONS UNLIKELYUNLIKELY TO TOWORK:WORK:

A.A. Currency DepreciationCurrency Depreciation

B. B. ProtectionismProtectionism

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COPING WITH THE CURRENT ACCOUNT DEFICITCOPING WITH THE CURRENT ACCOUNT DEFICIT

II.CURRENCY DEPRECIATIONII.CURRENCY DEPRECIATION

A. A. U.S. Experience: U.S. Experience:

Does not improve the trade deficit.Does not improve the trade deficit.

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COPING WITH THE CURRENT ACCOUNT DEFICITCOPING WITH THE CURRENT ACCOUNT DEFICIT

B.B. Depreciations are ineffective becauseDepreciations are ineffective because

1.1. It takes time to affect trade.It takes time to affect trade.

2.2. J-Curve EffectJ-Curve Effect

States that a decline in currency value States that a decline in currency value will initially worsen the deficit before will initially worsen the deficit before

improvement.improvement.

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THE J - CURVETHE J - CURVE

TIME

Net changein trade balance

0

Currency depreciation

Trade balance initially deteriorates

Trade balanceimproves

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COPING WITH THE CURRENT ACCOUNT DEFICITCOPING WITH THE CURRENT ACCOUNT DEFICIT

III.III. PROTECTIONISMPROTECTIONISM

A.A. Trade Barriers used:Trade Barriers used:

1.1. TariffsTariffs

2.2. QuotasQuotas

B.B. Results:Results:

Most likely will reduce Most likely will reduce both both X and M.X and M.

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III.III. SUMMARY: CURRENT-ACCOUNTSUMMARY: CURRENT-ACCOUNT

DEFICITSDEFICITS

- neither bad nor good inherently- neither bad nor good inherently

1.1. Since one country’s exports are Since one country’s exports are another’s imports, it is not possible another’s imports, it is not possible

for all to run a surplusfor all to run a surplus

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2.2. Deficits may be a solution to the problem of Deficits may be a solution to the problem of different national propensities to save different national propensities to save and invest.and invest.