International economics

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8 lecture
Balance of payment
 The Balance of Payment (BOP)
• A country’s balance of payments is commonly defined as the record of
transactions between its residents and foreign residents over a
specified period. These transactions include exports and imports of
goods and services, cash receipts and payments, gifts, loans, and
investments. Residents may include business firms, individuals, and
government agencies.
• In standard accounting, double entry book-keeping, each transaction
will result in a debit and a credit entry of equal size or amount.
• Thus in that sense, a country’s balance of payments accounts for any
given year always balances.
The balance of payments helps business managers and government
officials to analyze a country’s competitive position and to forecast the
direction of pressure on exchange rates. The ability of multinational
companies (MNCs) to move money across national boundaries is critical.
MNCs depend on this ability for exports, imports, payment of foreign
debts, and dividend remittances. Many factors affect a firm’s ability to
move funds from one country to another. In particular, a country’s balance
of payments affects the value of its currency, its ability to obtain
currencies of other countries, and its policy toward foreign investment.
• A resident institutional unit is an institutional unit that is resident
because it has a centre of economic interest in the economic territory of
a country.
• The sectors of an economy are composed of two main types of
institutional units:
1- Households and individuals who make up a household.
2- legal and social entities, such as corporations (e.g. branches of
foreign direct investors), non-profit institutions, and the government of
that economy. All these sectors are known to be resident according to
their relationship with the economic regional lands. Regional lands
include in addition to the land the regional and the international water that
is controlled by this country.
 An Overview of the Balance of
Payments
Sources and uses of funds
The balance of payments is a sources-and-uses-of-funds statement
reflecting changes in assets, liabilities, and net worth during a specified
period. Transactions between domestic and foreign residents are entered
in the balance of payments either as debits or credits. In dealing with the
rest of the world, a country earns foreign exchange on some transactions
and expends foreign exchange on others. Transactions that earn foreign
exchange are often called credit transactions and represent sources of
funds.
These transactions are recorded in the balance of payments as credits
and are marked by plus signs (+). The following transactions represent
credit transactions:
1 Exports of goods and services.
2 Investment and interest earnings.
3 Transfer receipts from foreign residents.
4 Investments and loans from foreign residents.
Transactions that expend foreign exchange are sometimes called debit
transactions and represent uses of funds. These transactions are
recorded in the balance of payments as debits and are marked by minus
signs (-). The following transactions represent debit transactions:
1 Imports of goods and services.
2 Dividends and interest paid to foreign residents.
3 Transfer payments abroad.
4 Investments and loans to foreigners.
 Example 3.1
(a) An American company sells $30,000 worth of machinery to a British
company (earn foreign exchange); (b) an American woman visits her
husband in Japan. She cashes $5,000 worth of US traveler’s checks at a
Japanese hotel and spends the $5,000 in Japan before returning to the
United States (expend foreign exchange); (c) the US Red Cross sends
$20,000 worth of flood-relief goods to Chile (expend foreign exchange);
(d) an American purchases $5,000 worth of French bonds (expend
foreign exchange); and (e) a US bank lends $10,000 to a Canadian firm
for 90 days (expend foreign exchange).
 The balance of payments as a whole
A country incurs a “surplus” in its balance of payments if credit transactions exceed
debit transactions or if it earns more abroad than it spends. On the other hand, a
country incurs a “deficit” in its balance of payments if debit transactions are greater
than credit transactions or if it spends more abroad than it earns.
Autonomous transactions in Balance of payments of an economy are those
transactions which are undertaken for some economic motive (profits). Autonomous
transactions include exports, imports, unilateral transfers, and investments. The
arithmetic sum of these autonomous transactions, sometimes called “above-the-line
items,” represents the balance-of-payments surplus or deficit. A balance-of payments
surplus occurs when autonomous receipts exceed autonomous payments.
• By the same token, a balance-of-payments deficit takes place when autonomous
payments exceed autonomous receipts. On the other hand, compensating
transactions occur to account or compensate for differences between international
payments and receipts. These compensating items or accommodating transactions,
called “below-the-line items,” are used to eliminate international disequilibrium.
Accommodating transactions on the other hand, are determined by the net
consequences of the autonomous items, that is, whether the BoP is in surplus or
deficit. The official reserve transactions are seen as the accommodating item in
the BoP (all others being autonomous).
Surpluses and deficits in the balance of payments are of considerable interest to
banks, companies, portfolio managers, and governments. They are used to:
1 Predict pressures on foreign-exchange rates.
2 Anticipate government policy actions.
3 Assess a country’s credit and political risks.
4 Evaluate a country’s economic health.
The transactions of cases (a)–(e) in example 3.1 represent autonomous
transactions. In case (a), the export of US machinery earns a foreign
exchange of $30,000 and is thus a credit. Transactions of cases (b)–(e)
cause the USA to expend a foreign exchange of $40,000 and are
therefore debits. Consequently, the USA has an overall deficit of $10,000
in its balance of payments and must undertake $10,000 worth of
compensating transactions to make up the difference. In this case, the
compensating transactions of the USA involve sales of its gold,
reductions in its balance of convertible foreign currencies, or increases in
the balance of the US dollars held by other nations.
Now, for a moment, suppose that the USA has a surplus in its balance of
payments rather than a deficit. To account for this surplus in the US
balance of payments, US reserves, such as gold and convertible foreign
currencies, would increase by $10,000, or the balance of the US dollars
held by other nations would decrease by $10,000. These transactions,
designed to account for the surplus in the balance of payments, are also
called compensating transactions.
 Balance of Payments Accounts
• The balance of payments accounts of any country focus exclusively on
the relationship of the country with the Rest of the World
• We consider summary accounts for Mexico in 2017 presented in Table
14.2
• The balance of payments has five parts
• Current account
• Capital/financial account
• Official reserve transactions
• Errors and omissions
• Overall balance
 Balance of Payments Accounts
• The current account The current account shows flows of goods, services,
primary income, and secondary income between residents and non-residents.
• The capital account The capital account shows credit and debit entries for non-
produced non-financial assets and capital transfers between residents and non-
residents. It records acquisitions and disposals of non-produced nonfinancial
assets, such as land sold to embassies and sales of leases and licenses, as well
as capital transfers.
• The official reserve transactions record governmental transactions
involving the exchange of assets
Table 14.2: Mexican Balance of Payments, 2017
(billions of US dollars) Current Account

The overall balance must be zero: things add up

• Current Account + Capital/Financial Account + Official Reserves
Transactions + Errors and Omissions = 0
Balance of Payments: Overall Balance

• The overall balance must be zero: things add up

Current Account
+ Capital/Financial Account
+ Official Reserves Transactions
+ Errors and Omissions
=0
• This can be seen in item 16 in Table 14.2
Table 14.2: Mexican Balance of Payments, 2017
(billions of US dollars) Current Account
Item Gross Net Major Balance
Current Account
1. Goods exports 409.8
2. Goods imports -420.8
3. Goods trade balance -11.0 =item1+item2
4. Service exports 27.6
5. Service imports -37.5
6. Goods and services trade balance -20.9 =item3+item4+item5
a.k.a. primary income. Net of income
7. Net income receipts and income payments -28.3
8. Net transfers 30.5
9. Current account balance -18.7 =item6+
a.k.a. secondary income. Includes foreign aid, foreign remittances, and item7+
international pension flows. item8
Table 14.2: Mexican Balance of Payments, 2017
(billions of US dollars) Other Accounts
Item Gross Net Major Balance
Capital/Financial Account
10. Direct investment FDI 26.9
11. Portfolio investment Equities and bonds 8.2
12.Other investment Commercial bank lending -8.0
13. Capital/financial account balance 27.1 =item10+
Official Reserve Transactions item11+item12

14. Official reserves balance Reflects the actions of treasuries 4.8

Errors and Omissions and central banks
15. Errors and omissions -13.2
Overall Balance
16. Overall balance 0
 Official Reserve Balance
• When Mexico’s central bank sells foreign exchange holdings (cash and reserve assets
such as gold held by a central bank or other monetary authority), this generates an
inward flow of funds and income or receipts on Mexico’s official reserve balance (positive
entries)
• When Mexico’s central bank buys foreign exchange holdings, this generates outlays or
expenditures on the official reserve balance (negative entries)
• When foreign central banks sell their reserves of Mexico’s currency, this generates an
outward flow of funds and an outlay or expenditure on Mexico’s official reserves balance
(negative entries)
• Finally, when foreign central banks buy reserves of Mexico’s currency, this generates an
income or receipts on Mexico’s official reserve balance (positive entries)
 Analyzing the Balance of Payments Accounts
• For ease of analysis, we remove the errors and omissions major
balance
 Current Account + Capital/Financial Account + Official Reserves Transactions
= 0. (14.7a)

• If two of the items in this equation have the same sign (positive or
negative), then the third must have the opposite sign (negative or
positive)
 Analyzing the Balance of Payments Accounts
 Current Account + Capital/Financial Account + Official Reserves Transactions = 0
(14.7a)
• If the current and capital/financial accounts are both positive (negative), then
official reserve transactions must be negative (positive) as the central bank must
buy additional assets to generate an offsetting expenditure with a negative entry
and bring the over all balance back to zero.
• If the current and official reserve transaction accounts are both positive
(negative), then the capital/financial account must by negative (positive), as the
central bank must sell assets to generate an offsetting receipt with a positive
entry and bring the over all balance back to zero.
• If the capital/financial and official reserve transaction accounts are both positive
(negative), then the current account must be negative (positive)
• Current account + Capital/financial account = Change in official reserves (14.7b)
 The Exchange Rate and the Balance of Payments
 In Figure 14.2, suppose that the demand for euros increases.
 Under a flexible exchange rate system, the dollar would depreciate to R =
1.50.
 Under a managed floating exchange rate system, monetary authorities
might intervene, letting the dollar depreciate (to R=1.25 in the figure), but
not by the full amount that would occur otherwise.

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FIGURE 14-2 Disequilibrium Under a Fixed and Flexible Exchange Rate System.

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• Disequilibrium under a Fixed and a Flexible Exchange Rate System. With D€ and S
€, equilibrium is at point E at the exchange rate of R = $/ € = 1, at which the
quantities of euros demanded and supplied are equal at € 200 million per day. If D €
shifted up to D €, the United States could maintain the exchange rate at R = 1 by
satisfying (out of its official euro reserves) the excess demand of € 250 million per
day (TE in the figure). With a freely flexible exchange rate system, the dollar would
depreciate until R = 1.50 (point E in the figure). If, on the other hand, the United
States wanted to limit the depreciation of the dollar to R = 1.25 under a managed
float, it would have to satisfy the excess €demand of ¤100 million per day (WZ in the
figure) out of its official euro reserves.

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• When the BOP shows surplus:
• Demand > Supply for that currency.
• Allow currency value to increase (currency appreciation).
• Or accumulate foreign reserves.
• When the BOP shows deficit:
• Supply > Demand for that currency.
• Currency may depreciate.
• Or use official reserves to support currency

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 Problems
1- Assume that a country has a current-account deficit of $10,000 and a financial-
account surplus of $12,000. Assume that the capital account and net errors and
omissions are negligible.
(a) Does the country have a balance-of-payments deficit or surplus?
(b) What will happen to the country’s official reserve account?
Current
2- A country has a merchandise trade surplus of $5,000, an income balance of zero, a
current transfer surplus of $3,000, and a current-account deficit of $4,000. What is the
service trade balance?
3- Assume that: (a) a country has a current-account surplus of $10,000; (b) its
financial account has a deficit of $15,000; and (3) its other two accounts – the capital
account and net errors and omissions – are negligible. What is the balance of the
country’s reserve account? How can the country eliminate the $5,000 imbalance on
its balance of payments?
Thank You