Understanding Balance of Trade and Balance of Payments

1. Unit 5:International Trade and Foreign Exchange

2. Balance of Trade vs. Balance of Payments

3. Net Exports (XN) = Exports – Imports • Trade Surplus = Exporting more than is imported • Trade Deficit (aka. trade gap) = Exporting less than is imported Balance of Trade Trade Balance Trade Deficit Trade Surplus X < M X = M X > M Net Exports = Neg. Net Exports = Pos. Net Exports = 0

4. Balance of trade - includes only goods and services Balance of payments - considers ALL international transactions. Balance of Payments- Summary of a country’s international trade. - Summary is within a given year - Prepared in the domestic country’s currency The balance of payments is made up of two accounts. The current account and the financial account. Balance of Payments

5. Current Account The Current Account tracks the difference between a nation’s total exports and its total imports. These transactions don’t create liabilities that have to be paid back in the future.

6. Current Account • 1. Goods and Services Examples: - The U.S. exports cars to be sold in Canada. This is a payment FROM foreigners for goods and services. - The U.S. imports oil from Venezuela. This is a payment TO foreigners for goods and services. The MOST IMPORTANT PART of the Current Account!

7. Current Account • 2. Factor Income- payments for the use of factors of production owned by residents of other countries. (This can be interest on loans from overseas, profits of foreign-owned corporations, or labor income from native-born workers who work overseas.) Examples: - Walmart, an American company, earns profit from stores in Europe. This is a factor income payment FROM foreigners. - Honda, a Japanese company, produces and sells cars in Indiana and other U.S. states. This is a factor income payment TO foreigners.

8. Current Account • 3. Net Transfers- Funds sent by residents of one country to residents of another country. Ex: donations, aids and grants, official assistance, and remittance (money sent back to families in their country of origin).

9. Financial (Capital) Account The Financial Account tracks the ownership of U.S. assets held by foreigners and the ownership of foreign assets held by U.S. (ex. bonds, stocks, real estate) These transactions DO create liabilities that have to be paid back in the future. Examples: • A Korean company buys a factory in Ohio • An American buys a Japanese government bond • When a foreign company builds a factory in a different country that is Foreign Direct Investment

10. Financial (Capital) Account Net Capital Outflow- The difference between the purchase of foreign assets and domestic assets purchased by foreigners Financial Account Surplus = Inflow > Outflow Financial Account Deficit = Inflow < Outflow

11. Balance of Payments USA CHINA X = M X = M Current Account Trade Balance Trade Balance Inflow = Outflow Inflow = Outflow Financial Account Suppose the USA imports more Chinese goods and services than they export to China?

12. Balance of Payments USA CHINA X < M X > M Current Account Trade Deficit Trade Surplus Inflow = Outflow Inflow = Outflow Financial Account Suppose the USA imports more Chinese goods and services than they export to China?

13. Balance of Payments USA CHINA X < M X > M Current Account Trade Deficit Trade Surplus Inflow = Outflow Inflow = Outflow Financial Account If US has a Trade Deficit w/China, then China has a Trade Surplus w/US.

14. China now has all of these American dollars, that they can only spend on American items. If China has bought all of the goods and services that it wants from America, it can still put the extra money to good use by buying American financial assets. (At least the money will be earning interest, instead of sitting in a Chinese drawer somewhere.) So there will be an outflow of money from China and an inflow of money into the US when China buys American assets.

15. Balance of Payments USA CHINA X < M X > M Current Account Trade Deficit Trade Surplus Inflow>Outflow Inflow<Outflow Financial Account “Net Capital Inflow” or “Financial Account Surplus” “Net Capital Outflow” or “Financial Account Deficit”

16. So, if a country has a Trade Deficit in the Current account, they will have a Surplus (Net Capital Inflow) in the Financial Account. And, if a country has a Trade Surplus in the Current account, they will have a Deficit (Net Capital Outflow) in the Financial Account. Hence, the Balance of Payments. It is an identity that Current Account + Financial Account = 0

17. If a country has a deficit in the current account, they must have a surplus in the financial account

18. Current or Financial Account? Identify if the examples are counted in the current or capital account and determine if it is a credit or debit for the US. • Bill, an American, invests $20 million in a ski resort in Canada • A Korean company sells vests to the US Military • A US company, Boeing, sells twenty 747s to France • A Chinese company buys a shopping mall in San Diego • An illegal immigrant living in the US sends a portion of his earning to his family in Bora Bora • A German investor buys $50,000 US Treasury Bonds • Italian tourists spend 5 million in the US while American tourists spend 8 million in Italy.

19. Current or Financial Account? Identify if the examples are counted in the current or capital account and determine if it is a credit or debit for the US. • Financial Account (financial asset), Debit • Current Account (trade of goods/services), Debit • Current Account (trade of goods/services), Credit • Financial Account (financial asset), Credit • Current Account (net transfer), Debit • Financial Account (financial asset), Credit • Current Account (net transfer), Debit

20. Practice 1. U.S. income increases relative to other countries. Does the current account balance move toward a deficit or a surplus? • U.S. citizens have more disposable income • Americans import more • Net exports (Xn) decrease • The current account balance decreases and moves toward a deficit. 2. If the U.S. dollar depreciates relative to other countries does the current account balance move toward a deficit or a surplus? • U.S. exports become more desirable • America exports more • Net exports (Xn) increase • The current account balance increases and moves toward a surplus.