Understanding Balance-of-Payments Accounts

1. Chapter Thirteen The Balance-of-Payments Accounts

2. Introduction What’s in the Balance-of-Payments Accounts? What Are the Balance-of-Payments Surpluses and Deficits? What’s the Connection? The Balance-of-Payments and Foreign Exchange Market Chapter Thirteen Outline

3. Introduction • Countries vary in their degree of openness, or the extent to which they engage in economic activity across global boundaries. • Merchandise exports: exports of physical goods. • Services: banking, insurance, travel, transportation, consulting, and other activities on which the item traded is not a physical good. • Balance-of-payments (BOP) accounts: summarizes all the transactions by individuals, firms, and governments of one country with their counterparts in the rest of the world.

4. What’s in the Balance-of-Payments Accounts? • Three basic accounts: • Current account • The (nonofficial) capital account • The official settlement account • BOP accounts consist of double-entry bookkeeping system. • Each international transaction appears twice, because every transaction has 2 sides.

5. What’s in the Balance-of-Payments Accounts? • What goes into the current account? • Merchandise exports and imports; • Imports and exports of military services, travel, and transportation; • Current income received and paid on international investments; and • Unilateral transfers, including worker remittances and pension payments.

6. What’s in the Balance-of-Payments Accounts? • Each category of current-account transactions includes both exports by the U.S. (entered as credits[+]) and imports by the U.S. (entered as debits[-]). • Current-account balance: equals the sum of all the other entries and represents the difference between total exports by U.S. residents and total imports by U.S. residents.

7. What’s in the Balance-of-Payments Accounts? • Merchandise Trade • The largest source of credits in the U.S. current account is merchandise exports. • Merchandise exports equal the sum of the value of all goods exported by U.S. individuals, firms, and government agencies (excluding the military). • Merchandise trade deficit: when merchandise imports exceed merchandise exports. • Merchandise trade surplus: when merchandise exports exceed merchandise imports.

8. What’s in the Balance-of-Payments Accounts? • Services • Includes military transactions, travel and transportation, royalties, education, accounting, banking, insurance, and consulting. • Net merchandise trade and net services trade often are combined to report the balance on goods and services. • Equals the value of U.S. exports of goods and services minus the value of U.S. imports of goods and services.

9. What’s in the Balance-of-Payments Accounts? • Investment income • The third category in the current account includes interest, dividends, and other forms of income Americans receive from investments they own abroad and payments by Americans to foreigners as income earned on foreign-owned investments in the U.S. • Does not include new investments, but merely the current income from those made previously.

10. What’s in the Balance-of-Payments Accounts? • Unilateral transfers • Final category includes transactions that are not purchases or sales of either goods or services. • U.S. non-military aid to foreign countries (government aid or private charity), worker remittances, or funds sent back to the home country by individuals working in the U.S., and pensions paid to former U.S. residents now living abroad. • The U.S. consistently runs a deficit in unilateral transfers.

11. What’s in the Capital Account? • The capital account records international borrowing and lending and purchases and sales of assets. • Capital outflow: U.S. resident (individual, firm, or government agency) purchases a foreign asset or makes a foreign loan, the asset or IOU is imported into the U.S. and enters as a debit in the U.S. capital account. • Capital inflows: Foreign residents buy assets (bonds, stocks, or land) in the U.S., U.S. exports titles to the assets or IOUs for the loans – they become credits to U.S. balance-of-payments accounts.

12. What’s in the Official Settlements Balance? • Reports the net change in a country’s stock of foreign exchange reserves and official government borrowing. • Increases in the level of U.S. reserves or decreases in the level of reserves held by foreign central banks in the U.S. enter as debits in the U.S. official settlements account. • Decreases in the level of U.S. reserves or increases in the level of reserves held by foreign central banks in the U.S. enter as creditsin the U.S. official settlements account.

13. What’s in the Official Settlements Balance? • Statistical discrepancy: imperfections in data collection by U.S. Department of Commerce • Equals the amount by which the sum of the current, capital, and official settlements balances as actually calculated fail to sum to zero. Current-account balance + Capital-account balance + Official settlements balance + Statistical discrepancy = 0 • Many transactions are missed or unreported. • U.S. does not closely monitor tourism and imports brought into the U.S. by travelers. • Tax avoidance provides incentive for some types of capital flows to go undisclosed.

14. Balance-of-Payments Surpluses and Deficits • Autonomous or independently motivated, transactions: transactions that individuals, firms, or government agencies undertake for their own purposes (utility maximization by individuals, asset portfolio decisions, profit maximization by firms, and foreign-policy goals by government) and whose goals are unrelated to the balance of payments. • Examples: A U.S. resident buying pair of Italian shoes, U.S. firms selling bonds to a German resident, and U.S. government sending foreign aid to Israel.

15. Balance-of-Payments Surpluses and Deficits • Sum of autonomous transactions is a country’s balance-of-payments with the rest of the world: Current-account balance + Capital-account balance + Statistical discrepancy = Balance of payments • If total autonomous credits exceed total autonomous debits, then a balance-of-payments surplus (BOP > 0) exists. • Similarly, an excess of total autonomous debits over credits is a balance-of-payments deficit (BOP < 0).

16. Balance-of-Payments Surpluses and Deficits • Accommodating, or compensatory, transactions: Official government actions taken for BOP purposes: • Example: changes in central banks’ stocks of foreign exchange reserves. Current-account balance + Capital-account balance + Statistical discrepancy = - Official settlements balance • Therefore, the BOP just equals the negative of the official settlements balance. • Relationship between autonomous and accommodating transaction: Balance on autonomous transactions + Balance on accommodating transactions = 0

17. Balance-of-Payments and Foreign Exchange Market • Overall, or multilateral, BOP accounts: • They record all transactions between U.S. residents and the rest of the world as a whole. • Bilateral BOP accounts: • Report receipts and payments between the U.S. and one other country. • The multilateral BOP accounts =  all bilateral BOP accounts.

18. Figure 13.1: Equilibrium in the Foreign Exchange Market under a Flexible Exchange Regime e = $/£ S£ e 1 e 3 _ e ( ) 2 + + + $ e f D i ,i ,e ,e 0 Quantity of £ -Denominated Deposits

19. Balance-of-Payments and Foreign Exchange Market • The BOP, FX markets, and a flexible exchange rate. • Figure 13.2 illustrates a balance-of-payments equilibrium under a flexible exchange rate. • At e = $2/£1, individuals willingly hold the pound-denominated deposits they receive in payment for merchandise exports and other transactions. • Autonomous debits match autonomous credits in the balance-of-payments account (BOP = 0).

20. Figure 13.2: Balance-of-Payments Equilibrium under a Flexible Exchange Rate e = $/£ S£ BOP = 0 e = $2/ £ 1 D£ 0 Quantity of £ -Denominated Deposits

21. Balance-of-Payments and Foreign Exchange Market • The BOP, FX markets, and a flexible exchange rate. • Figure 13.3 shows a domestic currency appreciation. • The dollar appreciates from $2/£1 to $1.80/£1 to encourage individuals to hold more pound-denominated deposits in their asset portfolios. • The BOP is in equilibrium at e = $1.80/£1, where autonomous debits equal autonomous credits.

22. Figure 13.3: Domestic Currency Appreciation e = $/£ S £ e = $2.00/ £ 1 BOP = 0 e = $1.80/ £ 1 D£ 0 Quantity of £ -Denominated Deposits

23. Balance-of-Payments and Foreign Exchange Market • The BOP, FX markets, and a flexible exchange rate. • Figure 13.4 shows a domestic currency depreciation. • The dollar depreciates from $2/£1 to $2.20/£1 to discourage individuals from holding pound-denominated deposits in their asset portfolios. • At e = $2.20/£1, autonomous debits equal autonomous credits and the BOP is in equilibrium.

24. Figure 13.4: Domestic Currency Depreciation e = $/£ S £ BOP = 0 e = $2.20/ £ 1 e = $2.00/ £ 1 D£ 0 Quantity of £ -Denominated Deposits

25. Balance-of-Payments and Foreign Exchange Market • The BOP, FX markets, and a fixed exchange rate. • Figure 13.5 reproduces Fig. 12.9, which shows an exchange rate pegged above the equilibrium rate. • At eP1, individuals are unwilling to hold the existing supply of pounds. To maintain the exchange rate at eP1, a central bank must absorb the excess supply of pounds.

26. Figure 13.5: Fixed Exchange Rate Above the Equilibrium Rate e = $/£ S £ Intervention p e 1 BOP > 0 D£ 0 Quantity of £ -Denominated Deposits

27. Balance-of-Payments and Foreign Exchange Market • The BOP, FX markets, and a fixed exchange rate. • Bretton Woods system: the international monetary system and its fixed exchange rate regime devised after WWII. • Each central bank was responsible for intervening to maintain the value of the currency relative to the U.S. dollar. • Figure 13.6 shows a fixed exchange rate below the equilibrium rate. • In order to maintain a certain exchange rate, a central bank must supply pounds to the market through intervention. See Figure 13.6

28. Figure 13.6: Fixed Exchange Rate Below the Equilibrium Rate e = $/£ S£ BOP < 0 p e 2 Intervention D£ 0 Quantity of £ -Denominated Deposits

29. Notes on Case Two: The U.S. as a Debtor • A country’s net foreign wealth, or net international investment position, equals the difference between the value of foreign assets the country’s residents own and the value of domestic assets owned by foreigners. • At least three ways of valuing assets: • Until recently, the U.S. valued assets at historical cost (their original purchase price); • Assets’ current cost (the cost of purchasing them now); or • Assets’ market value (the price at which each asset could be sold now).

30. Key Terms in Chapter 13 • Merchandise exports • Services • Balance-of-payments accounts • Double-entry bookkeeping system • Current account • Credit • Debit

31. Key Terms in Chapter 13 • Current-account balance • Deficit • Merchandise trade balance • Surplus • Balance on goods and services • Capital account • Capital outflow • Capital inflow

32. Key Terms in Chapter 13 • Official settlements balance • Statistical discrepancy • Autonomous (independently motivated) transactions • Balance-of-payments surplus • Balance-of-payments deficit • Accommodating(compensatory)transactions

33. Key Terms in Chapter 13 • Bilateral balance-of-payments accounts • Bretton Woods system • Net foreign wealth (net international investment position)