Balance of Payments: a record of all the transactions of a country with the rest of the world over period of time, usually a year
Credit item: leads to money entering the country from abroad; has a positive value
Debit item: leads to money leaving the country to go abroad; has a negative value
Current account: includes visible and invisible goods; measure of the follow of funds from trade in goods and services plus other income flow
Current account balance: sum of visible and invisible goods; if it's negative, there is a current account deficit; if it's positive, there is a current account surplus
Includes: balance of trade in goods, balance of trade in services, income, and current transfers
Visible goods: goods
Invisible goods: services
Capital account: changes in short-term and long-term external assets and liabilities of a country
Capital transfers: net monetary movements gained or lost through actions like transferring goods and financial assets by migrants entering/leaving the country, debt forgiveness, transfers relating to the sale of fixed assets, gift taxes, inheritance taxes, and death duties
Transactions in non-produced, non-financial assets: net international sales and purchase of non-produced assets like land or the rights to natural resources, along with the net international sales and purchases of intangible assets like patents, copyrights, brand names, or franchises
Capital account deficit: when a country acquires more foreign assets than foreigners acquired domestic assets
Capital account surplus: when a country has less foreign assets than the foreigners acquired of domestic assets
Financial account: net change in foreign ownership of domestic financial assets
Direct investment: measure of the purchase of long-term assets, so the purchaser is trying to gain a lasting interest in a company in another economy; expected to have a positive return in the future; most of it is foreign direct investment (FDI- investment by multinational corporations into another country)
Portfolio investment: measure of stock and bond purchases, consists of buying and selling of things like treasury bills and government bonds; the investor is putting the money forward to purchase the asset, and in return, they expect that interest will be paid on the investment, so the money will be repaid; borrowing and lending on the international market
Reserve assets: reserves of gold and foreign currencies which all countries hold and are itemized in the official reserve account
Assumptions:
The balance of payments is divided into two accounts: the current account and the capital account
The sum of the current and capital accounts equals zero, so there is a balance
The balance of payments accounts will not actually balance because there are too many individual transactions, so the measurement isn't exact; always some transactions that haven't been recorded
It is called "net errors and omissions" to make sure the accounts actually balance
Effects on the Exchange Rate with the Current Account
A current account deficit could cause downward pressure on the exchange rate of the currency
Short-run: deficit may be covered by increasing the capital and financial accounts or by the government using their reserve assets to help balance the accounts
Long-run: this will not work forever because the reserve assets will eventually run out, so the exchange rate has to be depreciated
Floating system: deficit means that there is excess supply of the currency in the foreign exchange markets; caused by the demand for exports decreasing, along with the demand for the currency, or the demand for imports increased, so there would be more demand for foreign currencies, meaning there would be a greater supply of the domestic currency in the foreign exchange market; the exchange rate should fall
Fixed exchange rate system: is much more of a problem for a fixed exchange rate system than a floating system; this means that the exchange rate has been set at too high of a value
A current account surplus could cause upward pressure on the exchange rate
In a fixed exchange rate system, this implies that the exchange rate has been set a too low a value
Short-run: could be offset by deficits of the capital and financial accounts or by increasing reserve assets
Long-run: likely that other countries become unhappy with the artificially low exchange rate, thus demanding higher exchange rates, or they will threaten with protectionist measures against the country's exports
Floating system: surplus means there’s an excess demand for the currency on the foreign exchange markets; caused by increased demand for exports, along with the demand for the currency, or the demand for imports feel, so there was less demand for foreign currencies, thus a lower supply of the domestic currency on the foreign market; exchange rate should rise, which decreases the competitiveness of the country’s exports and also it lowers the domestic price of imports
Consequences of current account and capital account imbalances: Current account deficit:
Foreign exchange reserves could increase the capital account; if reserves are taken from the official reserve account, then there’s a positive entry into the capital account; eventually the reserves would run out though
The high level of buying the assets for ownership could be causing the current account deficit; the inflow into the capital account is helping fund the current account deficit; confidence is very important because foreign investors would not be as willing to take the risk of investing in a country if they believed they weren’t getting a return
Could come from high levels of lending from abroad; high interest rates will have to be paid, so there would be short-term issues with the economy, causing an increase in the current account deficit in the future
Current and capital accounts surpluses:
Allows a country to have a deficit on the capital account by building up their official reserve account or by purchasing assets abroad- could lead to protectionism because one country’s surplus is another country’s deficit
Causes appreciation of the currency in the foreign exchange market because there’s an increased demand for their currency; makes imports cheaper
Capital account surplus is positive, except this means there are high levels of borrowing from abroad
Measuring the current account deficit or surplus:
Consider the value of the total (example from balance of payments packet: if Germany has a current account surplus of US$ 109.8 billion which the current account deficit in the US is US$380.1 billion)
The country’s GDP
To correct the current account deficit: Expenditure-switching policies: policies implemented by the government to switch expenditure of domestic consumers away from imports towards domestically produced goods and services
Government policies to depreciate or devalue the value of the currency: will reduce the level of the exchange rates, causing exports to be less expensive and imports more expensive
Protectionist measures: restrict the imports of products by reducing their availability through embargoes, quotas, voluntary export restraints, and administrative, health, and safety, and environmental barriers, or by using tariffs to increase prices.
Expenditure-reducing policies: policies implemented by the government that attempt to reduce overall expenditure in the economy, shifting AD in to the left; expenditure on all goods and services should fall
Deflationary fiscal policies: increase direct tax rates and/or reducing government expenditure
Deflationary monetary policies: increase the rate of interest and/or reducing the money supply; increasing interest rates would increase the capital flows from abroad; leads to a capital account surplus, which offsets the current account deficit
*To avoid the economic costs of a large current account deficit: actively pursue export promotion policies, could be government-run trade missions, hoping to develop new markets, and government-sponsored advertising campaigns
Diagrams:
Current Account Deficit Affects on the Exchange Rate: Depreciation
Current Account Surplus Affects on the Exchange Rate: Appreciation
Example:
With the graphs shown above, in Australia, if they are having a current account deficit, shown in the first graphs, with there being a decrease in demand for the Australian dollar, it causes the exchange rate to decrease, causing the supply of the Australian dollar to increase
On the other hand, with a current account surplus, there is an excess demand for the Australian dollar, causing the demand to shift out from D to D1, which then causes the supply to shift in from S to S1 because the exchange rate appreciate
Definitions:
- Balance of Payments: a record of all the transactions of a country with the rest of the world over period of time, usually a year
- Credit item: leads to money entering the country from abroad; has a positive value
- Debit item: leads to money leaving the country to go abroad; has a negative value
- Current account: includes visible and invisible goods; measure of the follow of funds from trade in goods and services plus other income flow
- Current account balance: sum of visible and invisible goods; if it's negative, there is a current account deficit; if it's positive, there is a current account surplus
- Includes: balance of trade in goods, balance of trade in services, income, and current transfers
- Visible goods: goods
- Invisible goods: services
- Capital account: changes in short-term and long-term external assets and liabilities of a country
- Capital transfers: net monetary movements gained or lost through actions like transferring goods and financial assets by migrants entering/leaving the country, debt forgiveness, transfers relating to the sale of fixed assets, gift taxes, inheritance taxes, and death duties
- Transactions in non-produced, non-financial assets: net international sales and purchase of non-produced assets like land or the rights to natural resources, along with the net international sales and purchases of intangible assets like patents, copyrights, brand names, or franchises
- Capital account deficit: when a country acquires more foreign assets than foreigners acquired domestic assets
- Capital account surplus: when a country has less foreign assets than the foreigners acquired of domestic assets
- Financial account: net change in foreign ownership of domestic financial assets
- Direct investment: measure of the purchase of long-term assets, so the purchaser is trying to gain a lasting interest in a company in another economy; expected to have a positive return in the future; most of it is foreign direct investment (FDI- investment by multinational corporations into another country)
- Portfolio investment: measure of stock and bond purchases, consists of buying and selling of things like treasury bills and government bonds; the investor is putting the money forward to purchase the asset, and in return, they expect that interest will be paid on the investment, so the money will be repaid; borrowing and lending on the international market
- Reserve assets: reserves of gold and foreign currencies which all countries hold and are itemized in the official reserve account
Assumptions:- The balance of payments is divided into two accounts: the current account and the capital account
- The sum of the current and capital accounts equals zero, so there is a balance
- The balance of payments accounts will not actually balance because there are too many individual transactions, so the measurement isn't exact; always some transactions that haven't been recorded
- It is called "net errors and omissions" to make sure the accounts actually balance
Effects on the Exchange Rate with the Current AccountConsequences of current account and capital account imbalances:
Current account deficit:
Current and capital accounts surpluses:
Measuring the current account deficit or surplus:
To correct the current account deficit:
Expenditure-switching policies: policies implemented by the government to switch expenditure of domestic consumers away from imports towards domestically produced goods and services
Expenditure-reducing policies: policies implemented by the government that attempt to reduce overall expenditure in the economy, shifting AD in to the left; expenditure on all goods and services should fall
- Deflationary fiscal policies: increase direct tax rates and/or reducing government expenditure
- Deflationary monetary policies: increase the rate of interest and/or reducing the money supply; increasing interest rates would increase the capital flows from abroad; leads to a capital account surplus, which offsets the current account deficit
*To avoid the economic costs of a large current account deficit: actively pursue export promotion policies, could be government-run trade missions, hoping to develop new markets, and government-sponsored advertising campaignsDiagrams:
Example: