The Balance of Payment

1. The Balance of Payment

2. National Income Account and BOP • Y = C + I + G + CA • Y = GDP • C = consumption • G = government spending • CA = current account balance This is called National Income Identity

3. Current Account • CA = X – M = net export of goods and services X = export; M = import • Strictly speaking CA = X – M +UT but, for a while, we ignore UT = unilateral transfer • In a closed economy, we do not have CA. (because X = M = 0)

4. National Income Account • Consumption = spending by households, including consumer spending on durable goods • Investment = Business sector’s adding to the physical stock of capital, including inventories. (individual household’s purchases of stocks, bonds or real estates are not included) • Government purchases = spending by federal, state, or local governments

5. National Income Account • 1999 • C 67.6% $6.3 trillion • I 17.5% $1.6 • G 17.6% $1.6 • CA -2.7% -$0.25

6. Current account balance • (Domestic spending on goods and services produced domestically) = C + I + G – M • (Foreign spending on goods and services produced domestically) = X

7. Current account balance (cont’d) • CA = X – M • When X > M or CA > 0, we say current account surplus. • When X < M or CA < 0, we say current account deficit. • CA = Y – (C + I + G) = Y – A where A = domestic absorption

8. Current account balance (cont’d) • A country with current account deficit is buying more from foreigners than it sells to them It has to increase net foreign debts. CA = net foreign wealth • US has been a net debtor since 1985. In 1998, debt = $5.5 trillion

9. Saving and Investment • Let S = national saving = Y – C – G. • Then S = I + CA (In a closed economy S = I) where I = domestic investment = capital stock accumulation CA = foreign wealth acquisition = net foreign investment • An open economy can increase investment by borrowing abroad.

10. Saving • S = SP + SG where SP = Yd – C = Y – T – C SG = T – G SP = private saving; SG = government saving; Yd = disposable income; T = net tax. • Then SP = (C + I + G + CA) – T – C = I + CA + (G - T) where G – T = government budget deficit. • So CA = SP – I – (G – T) A large gov’t budget deficit leads to a large current account deficit.

11. Balance of Payment Accounts • Double-entry bookkeeping each entry is recorded twice. • A debit entry  a payment to foreigners • A credit entry  a receipt from foreigners

12. Current Account (CA)the record of commodity and services transaction • A. Exports (credit) • B. Imports (debit) • 1. Merchandise: commodity transaction • 2. Services: travel, tourism, royalties, transportation costs, insurance premiums. • 3. Income • Income receipts on US assets abroad (credit) • Income payments on foreign assets in US (debit) • Direct investment receipts and payments • Interest, dividends.

13. Current Account (cont’d) • C. Unilateral Transfers (debit) • US foreign aid, gifts, retirement pensions, interest payments to foreigners on their US gov’t debt, workers’ remittances. • CA > 0: current account surplus  the country is a net lender to the rest of world • CA < 0: current account deficit  the country is a net borrower from the rest of world

14. Capital Account (KA)the record of financial assets transaction • A. US assets abroad • 1. US official reserve assets (Gold, SDR, reserve in IMF, foreign currencies) • 2. US gov’t assets • 3. US private assets (direct investment, foreign securities) • B. Foreign assets in US • 1. Foreign official assets in US (US gov’t securities, …) • 2. Other foreign assets in US (direct investment, US treasury securities)

15. Example (a) • An American buys a share of German stock, paying by writing a $10,000 check on his account with a Swiss Bank. • Debit: US asset held abroad $10,000 • Credit: US asset held abroad $10,000. For Germany • Credit: Foreign asset held in Germany • Debit: German asset held abroad

16. Example (b) • An American buys a share of German stock, paying the seller with a $10,000 check on an American bank. • Debit: US asset held abroad $10,000 • Credit: Foreign asset held in US $10,000

17. Example (c) • The French government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens. • Debit: Foreign asset held in US $1 million • Credit: Foreign asset held in US $1 million (US official reserve asset)

18. Example (d) • A tourist from Detroit buys a meal at an expensive restaurant in Lyons, France, paying with a VISA credit card. VISA uses a checking account in France to make payments. • Debit: Import, Services $300 • Credit: US assets held abroad $300

19. Example (e) • A California winegrower contributes a case of his best cabernet sauvignon for a London wine tasting. • No market transaction!

20. Statistical Discrepancy • Theoretically, current account and capital account should add up to zero. But in reality, there is a discrepancy due to errors, time lags, and so on.

21. Official Reserve Assets • Official reserve assets: • purchase or sale of foreign assets held by the central bank • Official international reserves: gold, SDR, foreign currencies, etc. • (current account) + (non-reserve capital account) + (statistical discrepancy) = Balance of Payment (official settlement)

22. Balance of Payment • Balance of Payment (official settlement) = current account deficit needed to be covered by the central bank’s official reserve transactions. • BOP deficit the country is running down its official reserves.