■ CHAPTER 4

■ THE BALANCE OF PAYMENTS AND INTERNATIONAL LINKAGES

■ CHAPTER OVERVIEW
I.
I. BALANCE-OF-PAYMENT CATEGORIES
II. THE INTERNATIONAL FLOW OF GOODS, SERVICES,
AND CAPITAL
III. COPING WITH CURRENT ACCOUNT DEFICITS

■
PART I. BALANCE-OF-PAYMENT
CATEGORIES
A. THE BALANCE OF PAYMENTS (B-O-P)
1. PURPOSE:
Measures all financial and economic transactions over
a specified period of time.

■ BALANCE-OF-PAYMENT
CATEGORIES
2. Double-entry bookkeeping
a. Currency inflows = credits
earn foreign exchange
b. Currency outflows = debits
expend foreign exchange

■ BALANCE-OF-PAYMENT
CATEGORIES
3. Three Major Accounts:
a. Current
b. Capital
c. Official Reserves
4. Current Account
records net flow of goods, services, and unilateral
transfers.

■ BALANCE-OF-PAYMENT
CATEGORIES
5. Capital Account
a. Function: records public and private investment and
lending.
b. Inflows = credits
c. Outflows = debits

■ BALANCE-OF-PAYMENT
CATEGORIES
5. Capital Account (con’t)
d. Transactions classified as
1.) portfolio
2.) direct
3.) short term
■ BALANCE-OF-PAYMENT
CATEGORIES
6. Official Reserves Account
a. Function:
1.) measures changes in
international reserves
owned by central banks.
2.) reflects surplus/deficit of
a.) current account
b.) capital account

■ BALANCE-OF-PAYMENT
CATEGORIES
6. Official Reserves Account (con’t) b. Reserves consist of
1.) gold
2.) convertible securities

■ BALANCE-OF-PAYMENT
CATEGORIES
7. Net Effects:
a. Sum of all transactions must be zero:

1.) current account

2.) capital account
3.) official reserves

■ BALANCE-OF-PAYMENT
CATEGORIES
8. The Balance-of-payment measures
a. Some Definitions:
1.) Basic Balance

a.) consists of current

account and long- term capital
flows.

■ BALANCE-OF-PAYMENT
CATEGORIES

1.) Basic Balance (con’t)

b.) emphasizes long- term trends.

■ BALANCE-OF-PAYMENT
CATEGORIES
1.) Basic Balance (con’t)
c.) excludes short-term capital flows that heavily depend on
temporary factors.
■ BALANCE-OF-PAYMENT
CATEGORIES
2.) Net Liquidity Balance:
measures the change in
private domestic borrowing
or lending require to keep
payments equal without
adjusting official reserves.

■ BALANCE-OF-PAYMENT
CATEGORIES
3.) Official Reserve Transactions
Balance
- measures adjustments
needed by official reserves.

■ PART II. THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

II. LINKS FROM INTERNATIONAL
A. Global Linkages
set of basic macroeconomic
domestic spending and
capital accounts
TO DOMESTIC FLOWS
identities which link:
production to current and

■
B.
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL
Domestic Savings and Investment
and the Capital Account
1. National Income Accounting
a. National Income (NI) is either spent (C) or
saved (S)

NI = C + S (4.1)

■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

b. National spending (NS) is
divided into personal spending (C) and
investment (I)

NS = C + I (4.2)

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c.
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL
Subtracting (4.2) - (4.1)
NI - NS = S - I (4.3)

If NI >NS, S > I which implies

that surplus capital spent overseas.
■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL
d. In a freely-floating system,
excess saving = the capital account balance
e. Implications:
1. A nation which produces more than it spends
will save more than it invests
domestically with a net capital outflow producing a
capital account deficit.

■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

2. A nation which spends more than it produces has a net capital inflow
producing a capital account surplus.
3. A healthy economy will tend to
run a current account deficit.

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C.
THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL
THE LINK BETWEEN THE CURRENT AND CAPITAL
ACCOUNTS
1. Beginning identity
NI - NS = X - M (4.4)
where X = exports
M = imports
X-M=current account balance (CA)

■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

2. Combining (4.3) + (4.4)
S - I = X - M (4.5)
3. If S - I = Net Foreign Investment (NFI)
NFI = X - M (4.6)

■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

4. Implications:
a. If CA is in surplus, the nation must be a net
exporter of capital.
b. If CA is a deficit, the nation is a major capital importer.
c. When NS > NI, the excess must be acquired through
foreign trade.

■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

d.Solutions
d.Solutions for Improving CA deficits:
1.) Raise national income (output)
relative to domestic investment (I).
2.) Increase (S) relative to domestic investment (I).

■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL

D. GOVERNMENT BUDGETS AND
CURRENT ACCOUNT DEFICITS
1. CURRENT ACCOUNT BALANCE
CA = Saving Surplus - Gov’t budget deficit
■ THE INTERNATIONAL FLOW OF GOODS, SERVICES, AND CAPITAL
2. CA Deficit means
the nation is not saving enough to finance (I) and the
deficit.

3. CA Surplus means
the nation is saving more than needed to finance its (I)
and deficit.

PART III. COPING WITH THE

CURRENT ACCOUNT DEFICIT
I. POSSIBLE SOLUTIONS UNLIKELY TO WORK:

A. Currency Depreciation

B. Protectionism

■ COPING WITH THE CURRENT ACCOUNT DEFICIT

II.
II. CURRENCY DEPRECIATION
A. U.S. Experience:
Does not improve the trade deficit.

■ COPING WITH THE CURRENT ACCOUNT DEFICIT

B. Depreciations are ineffective because
1. It takes time to affect trade.

2. J-Curve Effect
states that a decline in currency value will
initially worsen the deficit before improvement.

■ THE J - CURVE

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III.
COPING WITH THE CURRENT ACCOUNT DEFICIT
PROTECTIONISM
A. Trade Barriers used:
1. Tariffs
2. Quotas
B. Results:
Most likely will reduce both X and M.

■ COPING WITH THE CURRENT ACCOUNT DEFICIT

C. FOREIGN OWNERSHIP
one protectionist solution would place limits on or eliminate
foreign ownership leading to capital inflows.

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D.
COPING WITH THE CURRENT ACCOUNT DEFICIT
STIMULATE NATIONAL SAVING
change the tax regulations and rates.
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III.
COPING WITH THE CURRENT ACCOUNT DEFICIT
SUMMARY: CURRENT-ACCOUNT
DEFICITS
- neither bad nor good inherently
1. Since one country’s exports are another’s imports, it is
not possible for all to run a surplus

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2.
COPING WITH THE CURRENT ACCOUNT DEFICIT
Deficits may be a solution to the problem of different
national propensities to save and invest.