Unit VII

Unit 7 

Balance of Payments

Measures of money inflows and outflows between the U.S. and the rest of the world

• Inflow = credit
• Outflow = debit

Divided into 3 accounts

• Current Account
• Capital/Financial Account
• Official/Reserve Account

Double Entry Bookkeeping

 

Every transaction in the balance of payments is recorded twice with standard accounting practice

Current Account 

•  Balance of trade/Net exports

• Exports of goods/services - import of goods/services
• Exports = credit
• Import = debit

•  Net Foreign Income

• Income earned by U.S. owned foreign assets - income paid to foreign held U.S. assets

• Net Transfers

• Foreign aid  - debit to the current account

Capital/Financial Account

 Balance of capital ownership

 Includes the purchase of both real and financial assets

 Direct investment in the U.S. is a credit to the capital account

 Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account

 Purchase of foreign financial assets represents a debit to the capital account

 Purchase of domestic financial assets by foreigner represents a credit

 What causes these flows?

• Differences in rates of return on investment
• Ceteris Paribus, savings will flow toward higher returns
  

Relationship between Capital and Current Account

Double entry bookkeeping

Zero each other out

Official Reserves

• Foreign currency holding of the U.S. Fed

• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments

• When there is a balance of payments deficit there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments

Credit vs. Debit

·                     Credit - addition to a nation's account

·                     Debit - subtractions to a nation's account

How to Calculate

1.             Balance on trade

• Merchandise and service exports - merchandise and service imports

2.             Trade deficit occurs when the balance on trade is negative

• imports > exports

3.             Trade surplus when bot is positive

• exports > imports

4.             Balance on current account

• Balance on trade + net investment income + transfer payments

5.             Official Reserves

• Nationally change in CA + change in FA + change in official reserves = non zero

Foreign Exchange (FOREX)

Buying and selling of currency

The exchange rate is determined in the foreign currency markets

Exchange rate is price of currency

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand for currency

• An increase in the supply of a currency will decrease the exchange rate of a currency
• Decrease in supply of currency will increase exchange rate
• Increase in demand for currency, increase in e
• Decrease in demand for currency, decrease in e

Appreciation and Depreciation

Appreciation - when e of currency increases

Depreciation - when e of currency decreases

Exchange Rate Determinants

• Consumer's Taste

• Relative Income

• Relative Price level

• Speculation

• Flexible Exchange Rate

• Set by market forces with little or no government intervention

• Fixed Exchange Rate

•  Determined by government policies

Absolute Advantage - Faster, more efficient

Comparative Advantage - Lower opportunity cost

• Same country can have absolute advantage in 2 products

• Can only have one comparative advantage in 1