The Balance of Payments: Linking the United States to the International Economy

1. The Balance of Payments: Linking theUnited States to the International Economy Open economy An economy that has interactions in trade or finance with other countries. Balance of payments The record of a country’s trade with other countries in goods, services, and assets. Current account The part of the balance of payments that records a country’s net exports, net investment income, and net transfers. Balance of trade The difference between the value of the goods a country exports and the value of the goods a country imports.

2. The Balance of Payments: Linking theUnited States to the International Economy The Current Account Trade Flows for the United States and Japan, 2006

3. The Balance of Payments of the United States, 2006 (billions of dollars) Don’t forget net compensation of nationals working abroad (= Labor Services) The Balance of Payments balances: Current Account + Financial Account + Capital Account + Statistical Discrepancy = ZERO

4. The International Sector and NationalSaving and Investment U.S. Imports and Exports, 1970–2006

5. Current account Records payments for currently produced goods and services, including capital and labor services. • Mostly exports and imports of goods and services. • Also includes net int’l earnings of country’s labor and capital resources. • Unilateral transfers (exports and imports not paid for) are netted out. Financial account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. Net foreign investment The difference between capital outflows from a country and capital inflows. Also equal to net foreign direct investment (fdi) plus net foreign portfolio investment. Capital account The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers, and sales and purchases of nonproduced, nonfinancial assets.

6. Nominal exchangerateThe value of one country’s currency in terms of another country’s currency. The Foreign Exchange Market and Exchange Rates Currency appreciation An increase in the market value of one currency relative to another currency. Currency depreciation A decrease in the market value of one currency relative to another currency. Some currencies have fixed exchange rates that do not change over long periods. The country’s central bank buys and sells the currency at the fixed rate of exchange.

7. The Foreign Exchange Market and Exchange Rates: The Operation of Supply and Demand for a Currency Equilibrium in the Market for Foreign Exchange • Foreign demand for US dollar: • Buy US stuff • Currently produced goods • and services • Buy US assets • Stocks • Bonds • Real estate • Hotels and factories (fdi) • Hold $ in US banks • Transactions demand • Speculative demand

8. 12 Month Average Unemployment by Categoryhttp://www.nytimes.com/interactive/2009/11/06/business/economy/unemployment-lines.html?hp State and local rates: http://www.bls.gov/Lau/

9. The Foreign Exchange Market and Exchange Rates: Shifts in Demands and Supplies An Increase in Supply of Dollars on Foreign Exchange Market…Americans buy more Japanese cars…. … and An Increase in Demand for Dollars: Japanese buy a lot more US bonds & hotels • An increase in the supply of dollars in exchange for yen: • Americans buying more Toyota cars • Americans buying more Toyota stock • Americans fearing dollar depreciation buy yen now. $ Depreciates (Get fewer yen/dollar) • But a bigger • Increase in the • Demand for Dollars: • Japanese buying more US bonds • Japanese buying more US factories Dollar Appreciates on net

10. How Movements in the Exchange Rate Affect Exports and Imports If the economy is currently below potential GDP, then, holding all other factors constant including prices at home and abroad, depreciation of the domestic currency should increase net exports, aggregate demand, and real GDP. An appreciation in the domestic currency should have the opposite effect: Exports should fall, and imports should rise, which will reduce net exports, aggregate demand, and real GDP. It’s the real exchange rate, the nominal rate adjusted for prices, that matters: Real exchange rate The price of domestic goods in terms of foreign goods. Real exchange rate = [Yen/$] x [$/Bourbon]/[Yen/Suntory] = Suntory/Bourbon

11. The International Sector and NationalSaving and Investment U.S. Imports and Exports, 1970–2006

12. Balance of Payment Arithmetic Current Account Balance + Financial Account Balance = 0 Current Account Balance = -Financial Account Balance or: Net Exports = Net Foreign Investment … NX = NFI • Private Saving = National Income – Consumption - Taxes • Sprivate = Y – C – T = (C + I + G + NX) - C - T = I + (G - T) + NFI • Private saving finances domestic and foreign investment and the government’s deficit • Public Saving = Taxes – Gov’t Spending = Spublic = T – G • National Saving = Private Saving + Public SavingS = Sprivate + Spublic • S = [I + (G - T) + NX] + (T - G) = I + NFI • A country that saves a lot has positive NX and invests abroad • NFI = I - S = I - Sprivate - (T - G) = (I - Sprivate) + (G - T) = - NX • Twin Deficit: G-T up  NX down

13. The Effect of a Government Budget Deficit on Investment The Twin Deficits, 1978–2006

14. Why Is the United States the “World’s Largest Debtor”? Large current account deficits have resulted in foreign investors purchasing large amounts of U.S. assets.

15. Can the U.S. Current Account Deficit Be Sustained? Sustaining the Unsustainable U.S. trade-weighted exchange index: Major currencies.

16. K e y T e r m s Net foreign investment Nominal exchange rate Open economy Real exchange rate Saving and investment equation Speculators Balance of payments Balance of trade Capital account Closed economy Currency appreciation Currency depreciation Current account Financial account