Primer on International Economics

The Central Dilemma:

In order to conduct economic relations with one another, countries must have a way to conduct exchange with one another. For most situations with two countries with two different currencies, one of two conditions must be true: (1) Exchange is conducted through a third currency (such as the dollar, euro or gold) ( ) !uyers and sellers in the two countries have access to each others" currency #therwise the two countries would be unable to actually do business with each other$ In order for either of these conditions to hold, there has to be a balance between money flowing into and out of that economy. %his can ta&e the form of: (1) 'eci(rocal trade. %hat is, the countries sell goods bac& and forth, so (arties in both countries have access to the other country"s currency ( ) Financial flows. )ountries which want to buy (but don"t ex(ort anything of their own) can acce(t financial inflows (essentially a loan of currency) from the selling country, then use the money they *borrowed+ to ma&e (urchases. In both cases, there is a balance of money in and money out. ,nder situation (1), both countries would have a more-or-less balanced current account. ,nder situation ( ), countries with current account deficits would run matching financial account sur(luses.

The Balance of Payments

%hese external balances are summari.ed in the I/F"s !alance of 0ayments document. %he !#0 encom(asses several accounts (which I have sim(lified and summari.ed below): )urrent 1ccount: 2oods and 3ervices !alance Investment Income (i.e., dividends) )urrent %ransfers (i.e., remittances) -------------------------------------------------------4 )urrent 1ccount !alance Foreign 5irect Investment 0ortfolio Investment -------------------------------------------------------4 Financial 1ccount !alance

Financial 1ccount

%hese two accounts ((lus the tiny ca(ital account) must balance each other to .ero for countries which have floating exchange rates. 3o F1 6 )1 4 7 (money in is balanced by money out). 3o the ,3, for instance, im(orts more than it ex(orts but receives the money to run this deficit through large financial inflows (i.e., (eo(le buying ,3 stoc&s and bonds). For countries li&e )hina, with fixed exchange rates, the central ban& also conducts official reserve transactions (#'%) which maintain the balance of money in 4 money out. In )hina"s case, the central ban& has to run a large deficit (through buying ,3 treasury bills) in order to balance the country"s large current account sur(lus. 3o for these countries, F1 6 )1 6 #'% 4 7.