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8/14/2019 BOP & INTERNATIONAL ECONOMICS LINKAGES
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AJAFIN 6605-04
BOP & INTERNATIONAL ECONOMICS LINKAGES
3
This chapter presents financial and real linkagesbetween domestic and global economies and analyzes
how these linkages affect business activities.
3 It examines the basic forces underlying the flow ofgoods, services and capital between countries and how
these flows are impacted by economic, political and
cultural factors.3 BOP statistics are closely followed by economists,
bankers, investors, foreign exchange traders, and
policy makers.
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An Outline:
The BOP definition.
Credits & Debits as Sources & Uses of Funds Three Major BOP Categories.
3 The Current Account: Is
the balance on current spending.
Records flow of goods, services, factors, and
transfers.
Balance on Trade
Balance on Goods, Services and Factor Incomes
Transfer Payments --- Gifts and Grants
The Current Account Balance
Current account transactions are income-related flows.
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3 The Capital Account: Records public and privatesinvestment and lending activities.Long-term Capital Trade in paper e.g. deeds, corporate
securities, and various debt instruments.Short-term Capital Short-term financial instruments e.g.
Demand Deposits, T-Bills, CD's, Bankers Acceptance (BAs),Commercial Papers (CP), and Repurchase Agreements (Repos).
Capital account transactions are asset related flows.
3 Official Reserve Account: Measures changes in
holding of gold and convertible currencies by Centralbank or monetary authorities.
Reserve assets consist of gold, convertible currencies,SDR, and reserve position in the IMF.
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Other Components of the BOP Include:
3 The Basic Balance - is the sum of the balance on current
account and the long-term capital account.It indicates the extent to which long-term capital flows
(autonomous) are affecting the balance of payments.
3
The Performance Balance -provides a summary of allautonomous flows plus some accommodating flows. It
is computed by adding short-term capital account to the
basic balance.
It shows the extent to which short-term investments areaffecting the pressure on domestic currency.
3 Errors and Omissions (Statistical Discrepancies)
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3 The SDR - is an artificial currency or a unit of
account, computed as:
A five currency composite since 1980
(16 currency composite, 1974-1980).
(With Euro, SDR is a 4 currency composite)
SDR = W C
i=1
5
i i
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BOP and International Economic Linkages
Definition:
The balance of payment is a systematic record of all
economic transactions between the residents of the
reporting country and the residents of foreign
countries (the rest of the world) during a given periodof time - usually 1 year.
An international economic transaction involves
the transfer of title or rendering of service from
residents of one country to residents of another
country.
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The BOP is based on the rule of double-entry
bookkeeping in which every credit entry brings about
an equal and offsetting debit entry so that debits equal
credits and the sum of all transactions equal zero.
In practice many transactions are only partly recorded,
estimated on the basis of surveys, or missedaltogether.
A credit transaction is one that leads to the receipt of a
payment from foreign entities.
A debit transaction leads to a payment being made to
foreign entities.
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Alternatively, viewed as "sources" and "uses offunds, the BOP is a form of flow of funds statementshowing changes in assets, liabilities, and net-worth
overtime.
In this framework, exports, investment income fromabroad, gifts received from abroad, borrowing from
abroad, and other credits (e.g., allocation of SDR) aresources of funds.
Imports, investment income paid to foreign residents,
gifts sent abroad, lending and investing abroad, andacquisition of international reserve assets (acceptablefor final settlement of international debt) are uses of
funds.
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The Current Account:
Includes trade in goods and services and transfer
payments.Transfer payments are gifts made by private and
public entities to foreigners, and gifts received from
foreign private and public entities.
Exports of goods and services and the receipt of
transfer payments are entered as credits because they
lead to receipt of payments from foreigners.
Imports of goods and services and the granting of
transfer payments are entered as debits because they
lead to payments to foreigners.
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The Capital Account:
Shows flows of international investments and loans,
both long-term and short-term. Long-term refers to a maturity of one-year or more
and include direct investments (building of foreign
plants) portfolio investments (purchase of foreign
stocks and bonds) and international loans for one-year
or more.
International capital movements (both L-T & S-T) are
further subdivided into private and official (i.e., of
monetary authorities) and non-liquid (such as foreign
bank loans to finance trade) and liquid (such as
foreign bank deposits).
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On Services and Investment Incomes: Exports and imports of services are treated analogously to
those of merchandise.
For example, when a foreign airline (e.g., British Airways)pays for baggage handling and aircraft maintenance at aU.S. airport (e.g., NY, Chicago, Atlanta) it is doing muchthe same thing as a foreign firm that buys computers in theU.S.
It is using the services of American factors of productionand incurring an obligation that must be discharged bypayment to the U.S. owners.
Also when an American tourist buys tickets from a foreignairline, he/she is doing much the same thing as anAmerican firm that buys oil from Saudi Arabia, Nigeria,
or Kuwait.
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Exports and imports of services are sometimes
described as Invisible Trade because they
cannot be seen to cross the border but they havethe same effect as visible merchandise trade.
Inflows and outflows of investment income
(factor income) are recorded in the currentaccount because they share two characteristics
with exports and imports of goods and services:
(a) They give rise to claims that must bedischarged by payments.
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(b) They reflect the use, by one country, of another
country's capital, a factor of production, and the
rent, compensation, interest, or reward paymentthereof adds to the national income of the country
that owns it.
Interest paid to Japan which holds U.S. T-bills isan outflow of investment income.
It represents compensation for the use, in the U.S.,
of Japanese capital and such payment adds to thenational income of Japan.
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In general, therefore, inflows of investment
income into the U.S. represent additions to U.S.
national income earned by U.S. capital "working"abroad and outflows from the U.S. represent
additions to the national income of other countries
earned by foreign capital "working" in the U.S.
Every transaction in the current account is an
income related flow.
Every transaction in the capital account is an asset
related flow.
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Capital transaction can be viewed in terms of
trade in paper, deeds to real property, corporate
securities, and various debt instruments. When an American company acquires a plant in
the UK, it is importing the deed to the plant.
When an American pension fund buys bonds in
Tokyo, it is importing securities.
In each case the importer must make payments to
the foreigner just like merchandise imports.
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The Official Settlement Account
Measures the change in a nation's (liquid and non-
liquid) liabilities to foreign official holders and thechange in a nation's official reserve assets during
the year.
A nation's official reserve asset refers to its gold,
convertible currencies, special drawing rights
(SDR), and reserve position in the IMF.
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An increase in a nation's liabilities to foreign
official holders and a decrease in a nation's official
reserve assets are credits (inflows) while adecrease in a nation's liabilities to foreign official
holders and a increase in its official reserve assets
are debts (outflows).
The change in official reserves measures a nation's
surplus or deficit on its current and capital account
transactions by netting reserve liabilities fromreserve assets.
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Errors and Omissions (Statistical Discrepancy)
Theoretically, double entry bookkeeping should cause
total credits to equal total debts when all accounts aretaken together.
However, because of recording errors and omissions
this equality does not always hold.
A special entry to make a nation's BOP "balance" is
necessary, hence the statistical discrepancy.
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Special Drawing Rights (SDR)
Is an "artificial" currency or a unit of account.
It is aninternational reserve asset created by the IMF and
allocated to member countries to supplement their
foreign currency reserves.
The SDR became a five currency composite in
1980, i.e., a weighted average of 5 major
currencies (U.S. Dollar, German Mark, French
Franc, Japanese Yen, British Pound).
(it was a 16 currency composite in 1974-1980)
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3 With the introduction of the euro, the SDR is now
essentially a four currency composite.
The SDR is primarily a means of payment onlyamong governments and/or central banks.
3 The current account transaction include all
transactions which give rise to earnings, expenses,
or distribution of earnings.
3 The capital account is the record of changes in anation's claims on foreigners and of changes in
liabilities to foreigners resulting from current
account transactions.
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Other Adjustments:
These include counterpart items, exceptional
financing, and liabilities constituting foreignauthorities' reserves.
3 Counterpart items are transactions that create or
reduce official reserves.3 The monetization of gold (or demonetization)
arises because gold is a commodity when held by
private parties, but a monetary reserve item whenheld central authorities.
3 Monetization of gold means gold has moved from
private hands to official accounts.
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3 Allocation or cancellation of SDR represents a
change in official holdings.
3 Exceptional financing refers to financing
mobilized by authorities outside of reserve
transaction, e.g., postponing debt payment, or
drawing on loans to finance transactions thatwould otherwise deplete the country's reserve
assets.
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The BOP account identifies transactions along
functional lines. One useful classification is:
3 (a) Current Account: include Merchandise; Services;Investment Income: (factor income): e.g. royalties,
licensing fees, education, telecom, legal, computer and
data processing, management, medical, insurance etc, and
Unilateral Transfers (gifts and grants)
3 (b) Capital Account: L-T capital & S-T capital.
3 (c) Statistical Discrepancy: Errors and omissions.
3 (d) Official Reserve Account: Official reserve assetsand foreign official assets.
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3 Services include such invisible items as military
expenditures, interests and dividends, travel and
transportation, fees and royalties, insurancepremiums.
3 Unilateral Transfers: Gifts and Grants both private
and official.Private: Personal gifts, philanthropic activities,
shipments by relief organizations.
Official: Money, goods, services to othercountries.
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Capital Account: Recordsloans, investments and other transfer of financial assets
and creation of liabilities.
Long-term Capital: Maturities > 1 year, e.g., Foreign
Direct Investment (FDI) , Portfolio Investments, and
Loans.
Private flows are usually in the form of FDI and portfolio
investments.
Government (official) flows are usually loans, financial
support in economic development projects overseas, andsubscription to various regional development banks.
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3 Short-term Capital: Maturity of < 1 year, e.g.,
demand deposits, short-term loans, and short-term
securities.
3 Short-term capital may be:
3
An accommodating adjustment induced bymerchandise trade, service trade, unilateral
transfer, investments (to finance other items in BOP).
3 An autonomous adjustment attributable to interestrate differences among nations and expected
changes in exchange rates (purely economic reasons).
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Account Balances:
3 The Trade Balance:
Records the balance on merchandise trade.3 The Balance on Current Account:
Indicates the balance on current spending.
It tells whether we are spending more abroad thanforeigners are spending in our country (ignoring
investment flows and accommodating flows).
The most important types of transactions included areimports and exports of goods and services, receipt and
payment of interests, dividends, and investment
incomes and net transfer payments.
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The Basic Balance:Is the sum of the balance on current account
and the long-term investment account.3 It indicates the extent to which autonomous long-term
investments are affecting the balance of payments.
3 When a country is a net recipient of long-term
investment funds, the basic balance should be more
positive than the current account balance.
Thus, long-term investment (net) may alleviate oraggravate the pressure on the domestic currency.
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The Performance Balance
3 Provides a summary of all autonomous flows
plus some accommodating transactions.
It is computed by
adding short-term capital account to the basic
balance.
3 It therefore provides insights into the extent to
which short-term investment flows are affectingthe pressure on domestic currency.
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3 A negative performance balance means that
additional accommodating transaction will be
needed to meet payment requirements.3 A country's ability to execute accommodating
transaction is limited to the availability of reserves.
3 In the absence of reserves, governments may
resort to restrictive measures on current and
capital account activities
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Accommodating transactions have two characteristics:
(a) They are undertaken by a government
(b) Their purpose is to finance a deficit or surplus in
the BOP.
However, not all international transactions conducted
by the government are accommodating.
Foreign aid is given for political or humanitarian
purposes, not to finance BOP surplus or deficit, henceit is not accommodating.
h i
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3 The Net Liquidity Balance: Measures changes inprivate domestic borrowing or lending required to keeppayments in balance without adjusting official
reserves.3 It includes the basic balance plus short-term private
non-liquid capital balance, the allocation of SDR anderrors and omissions.
3 The Official Reserve Transactions Balance: Measuresthe adjustment required in official reserves to achievebalance of payments equilibrium.
Because double-entry bookkeeping ensures that debitsequal credits the sum of all transactions equal zero, i.e.
Current Account Balance + Capital Account Balance +
Official Reserve Balance = Balance of Payments.
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3 A drawing down of official reserves (credit entry)
measures a nations BOP deficit
3 A building up of official reserves (debit entry)measures a BOP surplus
3 Deficits, while not necessarily bad, cannot be
sustained indefinitely because official reserves arelimited.
3 E h f h b l h i h i i l
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3 Each of these balances has its shortcomings mainlybecause of the increasing complexity of internationalfinancial transactions.
For example:
3 Changes in official reserves may now reflectinvestment flows as well as central bank interventions
3 The distinction between short-term and long-termcapital flows has become blurred.
3
While FDI is still determined by longer-tern factors,portfolio investment can now be just as speculative asbank deposits and liquidated just as quickly.
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Relative to GDP, U.S. Imports have Topped ExportsSince 1976, and the Trade Deficit has Widened
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U.S. Trade Deficits in 2003 by Country or Region
U S B l f P t 2003 ($B)
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U.S. Balance of Payments 2003 ($B)
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Some Typical Transactions (simplified form):
1. A U.S. firm exports $1000 worth of goods to UK and is paid with:(a) A deposit of $1000 worth of sterling into its account at a
London bank.
Debit(-) Credit(+)
Short-term private liquid capital: $1000 Exports: $1000
( U.S. claims on foreigners) - An outflow
If payment is made for U.S. exports in dollars against foreign
owned U.S. deposits then,
(b) Th "d bit" i d i b k d it f f i if
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(b) The "debit" is a decrease in bank deposits of foreigners if
payment is made for U.S. exports in dollars against their U.S.
deposits, so that
Debit(-) Credit(+)Short-term liquid liability (capital): $1000 Exports: $1000
( in U.S. liabilities to foreigners)
(c) Merchandise Imports:
U.S. residents import $50m worth of merchandise. Payment
made by transferring,
$20m (equivalent) from balance they hold in foreign banks, and
$30m from balance held in U.S. banks
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Debit(-) Credit(+)
Merchandise Imports: $50m U.S. private short-term claims: $20m
( in U.S. claims on foreigners)
Foreign private short-term claims: $30m
( in U.S. liability to foreigners)
2. U.S. tourists in London spend $30m for hotel and meals.
When U.S. tourists cash dollar traveler's checks at hotels in the
U.K., the hotels deposit the checks in their U.K. banks and the
banks send them for deposit credits in U.S.
The resulting increase in U.K. banks' deposits in the U.S.
shows additions to U.S. short-term liquid liabilities.
Debit(-) Credit(+)
Service category (travel): $30m Short-term liquid liability: $30m
(or tourist expenditure) (an increase in U.S. liability to
foreigners)
3 A E li h l d b $5 A i t k d ( ) b d i
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3. An English lady buys $5m American stocks, and pays: (a) by drawing
down her dollar deposits in a New York bank OR (b) by increasing
U.S. firms' demand deposit in U.K.
Debit(-) Credit(+)
Short-term liquid liabilities: $5m Portfolio investment: $5m
(a) ( in U.S. liabilities to foreigners)
(b) ( in U.S. claims on foreigners)
OR(c) A receipt of a $5m of investment income by U.S. firms from their
foreign investments. Checks sent to U.S. firms are drawn on U.S.
account holdings of foreign firms.
Debit(-) Credit(+)
Short-term liquid liabilities: $5m Income from investment abroad:
( in U.S. liabilities to foreigners) $5m
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5. The IMF allocates $50m of SDR to the U.S.
Debit(-) Credit(+)
Acquisition of official reserves: $50m Allocation of SDR: $50m
The debit shows additions to U.S. reserve assets, the credit
indicates its source.
NOTE
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NOTE:
3 Often one entry for a transaction is either a credit or a
debit to short-term liquid liabilities (capital) because in
U.S. transactions, most payments are made by
increasing or decreasing foreign deposits in U.S. banks.
3 It is possible to have entries for short-term liquid assets.
When dollar traveler checks are spent in England,
British banks increase their dollar deposits in U.S.
banks.
This is a debit (an outflow) to short-term liquid assets inthe British BOP or a credit in U.S. BOP to record an
increase in U.S. liability to foreigners (the British) - a
capital inflow to the U.S.
3 A current account surplus is not necessarily a sign of
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3 A current account surplus is not necessarily a sign ofeconomic strength, nor is a current account deficit a signof economic weakness or lack of competitiveness.
3 Economically healthy nations that provide goodinvestment opportunities tend to run trade deficits andcapital account surpluses.
3
Nations that are growing rapidly will import more goodsand services while weak economies will reduce theirimports because imports are positively related to income.Therefore, the faster a nation grows relative to other
economies, the larger its current account deficit tends tobe or the smaller its surplus.
3 Conversely, the slower a nation grows the smaller will beits current account deficit or the larger its current account
surplus.
3 Current account deficits may therefore reflect strong
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3 Current account deficits may, therefore reflect strongeconomic growth or a low level of savings and currentaccount surplus may signify a high level of savings or
slow rate of growth.3 Since current account deficits are financed by capital
inflows, the cumulative effect of these deficits is toincrease net foreign claims against the deficit nation and
reduce the nations international wealth.3 On the other hand, a nation that consistently runs current
account surpluses will increase its net international wealth.
3 A deficit country like the U.S. becomes net international
debtor and a surplus country like Japan or China becomesnet international creditor. In 2006, the U.S. net international investment position = - $2.8 T In 2006, Japans net international investment position = Y 215 T
In 2006, Chinas net international investment position = $662 B
H h US b d h if / di l i ? Di !
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Has the US become a spendthrift/prodigal nation? Discuss!
Recall that:
Private gross investment = savings (personal, business,
public sector) + borrowing from abroad.
In complete and frictionless markets, capital flows
towards the most productive uses, raising the standard ofliving for both recipients and owners.
In reality international capital markets are segmented and
far from frictionless.Therefore there are limits to the current account deficit
that a nation may incur/sustain.
The current US situation calls for (sustainability) concern.49
Factors Affecting Bop Components Economic Factors
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Factors Affecting Bop Components Economic Factors
3 Inflation Rates(relative inflation rates): A higher
domestic inflation relative to a nation's tradingpartners, ceteris paribus, will result in current accountdeficit.
Foreign goods become more attractive (imports ) or
domestic goods become more expensive and foreigndemand drops (exports ).
3 Interest Rates: An increase in domestic interest
(real) rates compared with ROW attracts funds fromforeign investors, so that, ceteris paribus, increase indomestic interest rate leads to improvements in capitalaccount balance.
3 Income Le el: A relati el higher domestic
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3 Income Level: A relatively higher domestic
income level leads to increased domestic
consumption, part of the additional consumption
coming from higher imports.
This will tend to increase current account
deficits.
Domestic Currency Value
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Domestic Currency Value:
3 The higher the domestic currency value in terms of
foreign currencies, ceteris paribus, the worse the current
account balance.
3 This is because domestic goods become more expensive
to the importing countries. As a result, the demand for
such goods will decrease.3 On the other hand, an appreciating domestic currency
makes foreign goods (domestic imports) more attractive
to domestic residents who will increase their demand for
such goods.
3 A decrease in export demand increase in import demand
has a negative effect on the domestic current account
balance.
3 Government Restrictions
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3 Government Restrictions
Tariff:
Tax on imported goods.Quota:
Quantitative limit on amount of a particular
product imported.
3 If a government imposes restrictions, BOP,
especially the current account, may improve
provided no retaliatory measures are taken by
foreign governments (ROW).
3 Tax on Foreign Income:
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3 Tax on Foreign Income:
May reduce the amount of foreign investment
undertaken by domestic residents.3 Restrictions on International Capital Flows:
Dual exchange rates (multiple exchange rates)
For example:different rate for government payments.
different rate for importers etc.
3 These restrictions will tend to reduce domestic
currency outflows.
Government Monetary and Fiscal Policies:
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Government Monetary and Fiscal Policies:
May affect economic variables such as inflationand interest rates which in turn influence BOPcomponents.
Impact of BOP on the Economy:
3
A current account deficit is associated with higherdomestic inflation and often results in higherunemployment .
3 A capital account deficit may be associated withhigher domestic interest rates which discouragedomestic borrowing for investment and result in aslowdown of economic expansion.
Correcting BOP Problems
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Correcting BOP Problems
Current Account / Capital Account Deficit
3 Any policy which improves foreign demand for
domestic goods and services or for investment
securities, e.g., more attractive export prices
resulting from low inflation or depreciatingcurrency value.
3
Under a floating exchange rate regime, anyinternational trade imbalance should be corrected
automatically.
A Trade Account Deficit:
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A Trade Account Deficit:
3 Implies that we are selling our currency (supplying
our currency) to buy foreign goods than foreigndemand for our currency to buy domestic goods.
3 A depreciation of our currency should stimulate
foreign demand for domestic goods (ceteris
paribus). (See Marshall-Lerner conditions)
Restrictions on Imports:3 If domestic imports can be restricted while
domestic exports can be increased, the trade
balance should improve.
Question: Why are managers and investors vitally interested in the
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Question: Why are managers and investors vitally interested in theBOP of countries?
3 The balance of payments helps to forecast a country's market
potential, especially in the short run. A country experiencing aserious balance of payments deficit is not likely to import as much as
if it were running a surplus.
3 The balance of payments is an important indicator of pressure on a
country's foreign exchange rate, and thus on the potential for a firm
trading with or investing in that country to experience exchange gains
or losses.
3 Continuing deficits in a country's balance of payments may signal
future controls on outgoing capital movements, such as payments of
dividends, fees, and interest to foreign firms and investors.3 Continuing surpluses in a country's balance of payments may indicate
that country's strong international competitive position, and therefore
a potentially good location for an operating subsidiary, or portfolio
investment.
*** International Economic Linkages (59 72)
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*** International Economic Linkages(59-72)
Define:
Y = National Income (or National Product)
C = Consumption
S = Savings
National Income is either spent on consumption or saved, so
Y = C + S ........ (1)Similarly, the amount that a nation spends on goods and
services (National Expenditure), E, can be divided into
Consumption (C) and Real Investment, Id(Plant & Equipment,
R&D, etc). Hence:
E = C + Id
........ (2)
(1) - (2) gives
Y - E = S - Id
........ (3)
3 If a nation's income exceeds its spending, then
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p g,savings will exceed domestic investment resulting insurplus capital.Excess capital must be invested overseas: Thus:S - Id = If ........ (4)
3Net Foreign Investment (If) equals the nations' netpublic and private capital outflows plus increase inofficial reserves.
3 A nation that produces more than it spends, Y- E > 0,will save more than it invests domestically, S - Id > 0,
and will have a net capital outflow.
3 The capital outflow, If > 0, will appear as somecombination of a capital account deficit and an
increase in official reserves.
The Current & Capital Accounts
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The Current & Capital Accounts
Let D = spending on domestic goods and services:
X = exports, M = imports, E = national expenditure.
Then
Y - D = X ........ (5)
E - D = M ........ (6)
Combining (5) and (6) we have,
Y - E = X - M ........ (7)
National Income - National Expenditure= Exports - Imports
Equation (7) says that a Current Account Surplus, X - M > 0,
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Equation (7) says that a Current Account Surplus, X M 0,
arises when national output exceeds domestic expenditures.
A current account deficit, (X - M < 0), will be the reverse.
Combining (3) and (7) we have:
S - Id = X - M ........ (8)
(8) means that if a nation's saving exceed its investments, thenthe nation will run a Current Account Surplus.
Note that: S - Id = If = X - M.
So that:
If = X - M ........ (9)
Net Foreign Investment = Exports - Imports
3 For example, the Japanese have a high savings rate (= 15 %)
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p , p g g ( )
relative to their investment rate hence they have a Current
Account Surplus.
The US saves less (= 2%) than it invests and must run a currentaccount deficit.
3 Equation (9) means that funds earned by selling abroad must
be either spent on imports or exchanged for claims against
foreigners (foreign investment).3 Between the US and Japan, for example, any deficit in the
Current Account, (X- M < 0), is exactly equal to the surplus
in the capital account. Otherwise there would be imbalance in
the foreign exchange market and exchange rate would change.
Equation 9 can be re written as:
X - M - If = 0 ........ (10)
3 In (10), current account balance and capital account balance exactly
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( ), p y
offset each other under a freely floating exchange rate system.
Without intervention in exchange market, the sum of the
current account balance + capital account balance + balance on
official reserves account equals zero.
3 These identities allow us to assess the efficacy of proposed
solutions for improving the current account balance.
3 Therefore if a nation wants to reduce its current account deficit
or increase its current account surplus it must:
Raise national product relative to national spending, (Y- E) > 0
Increase savings relative to domestic investment, (S - Id) > 0
Budget Deficits & Current Account Deficits
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Budget Deficits & Current Account Deficits
By decomposing aggregate domestic spending and income
into government and private sectors we can relate
government deficits to current account deficits:
Let:
E = National Expenditure (or Spending)
Ch = Household SpendingId = Private Investment (Domestic)
G = Government Spending
T = Taxes; S = SavingsThen we have
E = Ch + Id + G
E = Y - (S + T) + Id + G ....... (11)
Rearranging (11) we get a new expression for
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Rearranging (11) we get a new expression forexcess spending:
E - Y = (Id- S) + (G - T) ........ (12)
3 A nation's excess spending equals its netborrowing from abroad.
3 Alternatively, a nations excess spending equals the
sum of its excess of private investment overprivate savings and total government deficit.
Combining (7) and (12) we get:
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g ( ) ( ) g
X - M = S - Id
- (G - T) ........ (13)
C/A Saving GovernmentBalance Surplus Budget Deficit
3 A nation's current account balance is identically equal
to its private savings minus investment balance lessgovernment budget deficit.
3 Therefore a nation running a current account deficit,X - M < 0, is not saving enough to finance its private
investment and its government budget deficit.
3 Conversely a nation running a current account surplus issaving more than is needed to finance its private
investment and government deficit.
Coping With Current Account Deficit:
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Coping With Current Account Deficit:
1 - Devaluation
2 - Protectionism
3 - Restriction on Foreign Ownership of Domestic Assets
4 - Boosting the National Savings Rate
On Currency Devaluation / Depreciation:
(A) Disequilibrium View:
3 Posits that nominal disturbances can cause changes in
real exchange rates because of sluggish / slow price
adjustment. It
proposes a systematic relationship between exchange
rate and the current account balance.
(B) Equilibrium Theory of Exchange Rate:
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3 Agues that no simple relation exists between exchange rates and thecurrent account balances.
3 Maintains that trade deficits do not "cause" currency depreciation,nor does currency depreciation by itself help reduce trade deficits.
The necessary conditions for devaluation to improve anation's current account can be analyzed in three contexts:
1. Elasticity Approach:3 Focuses on effects of relative price changes, brought about
by devaluation, on consumption and production.Devaluation will improve a nation's balance of trade ifMarshall Lerner Conditions (e
MD
+ eXD
> 1) are met, that is,change in quantity of import and export demand must besufficiently large to offset the lower foreign currency priceof a nation's exports and higher domestic currency price ofimports following devaluation.
Volume effect must dominate price effect.
2. The Absorption Approach:
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p pp3 Shifts attention to the whole economy.
Any improvement in the Balance on Current Account,
(X - M), must cause an increase in the difference betweenTotal Output and Total Domestic Expenditure, (Y- E).
3 Total absorption of goods and services, E + X, must equal theaggregate amount of goods and services available, Y+M, so that:
E + X = Y + Mor X - M = Y E
3 A trade surplus, X - M > 0, arises when national output is greaterthan domestic expenditures, (Y- E > 0).
3 When underemployed resources exist, output, Y, can increase
without inflation if there are no bottlenecks in the economy.
With full employment, domestic expenditures, E, must be reduced.
Devaluation will not succeed otherwise
3. The Monetary Approach:
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3. The Monetary Approach:3 Concentrates on demand for money balances.
An excess demand for goods and services (a tradedeficit) reflects excess supply of money.
3 Devaluation reduces the real value of the moneysupply because of price increases for traded goods and
services.
3 It works by causing the public to reduce its spendingin order to restore the real value of its money balances
and other financial assets.3 The reduction in expenditures will improve the
balance of payments as long as monetary expansion
does not follow the devaluation.
3 Protectionism:
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The use of Tariffs and Quotas
3 Restriction on Foreign Ownership of DomesticAssets.
3 Boosting the Savings Rate:
Social security benefits.
Tax changes.
IRA and other tax deferred savings ***
Other Issues:
3 Current Account Deficit and Unemployment
3 Current Account Deficits / Surpluses: Good or Bad?
3 Is the Trade Deficit a Subtraction from GDP?
3 Is the U.S. Spending too Much and Saving too Little?
3 The U.S. current account deficit can be viewed as an efficientd i diff i i i d i
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adaptation to different savings propensities and investmentopportunities in the US and the rest of the world.
The real problem, if any, may be either too much consumption and
too little savings or too much investment.The hard fact is that the situation confronting the US and ROWsince the early 90s is an expression of national preferences towhich trade flows have adjusted in a timely manner .
3
Long term consequences for a nation that runs a current accountdeficit:
3 (i) If the Current Account deficit and the resulting capital accountsurplus finances productive domestic investments, then the nationis better off as the returns from these added investments will help
to service the foreign debts with income left to improve domesticliving standards.
3 (ii) If the capital account surplus finances current consumption, itmerely increases a nation's well being today at the expense of
future well being.
3 In popular discussions, the U.S. trade deficit is often referred
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to as a subtraction from the GDP.Economic analysis suggests otherwise.
3 Some imported goods (e.g. agricultural products, oil)
cannot be produced in the U.S., while other imports providelow-cost products for consumers and firms.
3 Production at some firms might even decrease if importedproducts were not available.
3 Furthermore, in a tight labor market, some firms might find itdifficult to hire enough labor to expand output by the size ofthe trade deficit.
3 The basic economics of trade deficit suggests that with
floating exchange rates, a trade deficit can persist only if
foreigners willingly accumulate financial claims issued by
a countrys household and firms (if foreigners continue
to invest in the country).
3 Absent this, the value of domestic currency would fall and
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the trade gap would tend to close as import prices increaseand export prices decrease.
3 At the same time the yields available on domestic investmentsmust remain attractive especially to foreign investors.
3 Economists view the trade deficit as part of an overall
general equilibrium involving domestic demand,production, and investment opportunities, relative to
economic conditions in the rest of the world.
Therefore, the trade deficit is not a subtraction from GDP.
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The Case for Free Trade
3 The case for free trade is based on the theory of
comparative advantage.
When countries specialize and trade based on
comparative advantage, consumers pay less and
consume more, and resources are used moreefficiently.
3
When tariffs and quotas are imposed, many of thegains from trade are eliminated.
C f i
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The Case for Protection
3
Protection saves jobs.3 Some countries engage in unfair trade practices.
3 Cheap foreign labor makes competition unfair.
3 Protection safeguards national security.
3 Protection discourages dependency.
3 Protection safeguards infant industries.3 Protection fights neo-colonialism