bop & international economics linkages

8/14/2019 BOP & INTERNATIONAL ECONOMICS LINKAGES

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AJAFIN 6605-04

BOP & INTERNATIONAL ECONOMICS LINKAGES

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This chapter presents financial and real linkagesbetween domestic and global economies and analyzes

how these linkages affect business activities.

3 It examines the basic forces underlying the flow ofgoods, services and capital between countries and how

these flows are impacted by economic, political and

cultural factors.3 BOP statistics are closely followed by economists,

bankers, investors, foreign exchange traders, and

policy makers.


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An Outline:

The BOP definition.

Credits & Debits as Sources & Uses of Funds Three Major BOP Categories.

3 The Current Account: Is

the balance on current spending.

Records flow of goods, services, factors, and

transfers.

Balance on Trade

Balance on Goods, Services and Factor Incomes

Transfer Payments --- Gifts and Grants

The Current Account Balance

Current account transactions are income-related flows.


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3 The Capital Account: Records public and privatesinvestment and lending activities.Long-term Capital Trade in paper e.g. deeds, corporate

securities, and various debt instruments.Short-term Capital Short-term financial instruments e.g.

Demand Deposits, T-Bills, CD's, Bankers Acceptance (BAs),Commercial Papers (CP), and Repurchase Agreements (Repos).

Capital account transactions are asset related flows.

3 Official Reserve Account: Measures changes in

holding of gold and convertible currencies by Centralbank or monetary authorities.

Reserve assets consist of gold, convertible currencies,SDR, and reserve position in the IMF.


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Other Components of the BOP Include:

3 The Basic Balance - is the sum of the balance on current

account and the long-term capital account.It indicates the extent to which long-term capital flows

(autonomous) are affecting the balance of payments.

3

The Performance Balance -provides a summary of allautonomous flows plus some accommodating flows. It

is computed by adding short-term capital account to the

basic balance.

It shows the extent to which short-term investments areaffecting the pressure on domestic currency.

3 Errors and Omissions (Statistical Discrepancies)


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3 The SDR - is an artificial currency or a unit of

account, computed as:

A five currency composite since 1980

(16 currency composite, 1974-1980).

(With Euro, SDR is a 4 currency composite)

SDR = W C

i=1

5

i i


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BOP and International Economic Linkages

Definition:

The balance of payment is a systematic record of all

economic transactions between the residents of the

reporting country and the residents of foreign

countries (the rest of the world) during a given periodof time - usually 1 year.

An international economic transaction involves

the transfer of title or rendering of service from

residents of one country to residents of another

country.


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The BOP is based on the rule of double-entry

bookkeeping in which every credit entry brings about

an equal and offsetting debit entry so that debits equal

credits and the sum of all transactions equal zero.

In practice many transactions are only partly recorded,

estimated on the basis of surveys, or missedaltogether.

A credit transaction is one that leads to the receipt of a

payment from foreign entities.

A debit transaction leads to a payment being made to

foreign entities.


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Alternatively, viewed as "sources" and "uses offunds, the BOP is a form of flow of funds statementshowing changes in assets, liabilities, and net-worth

overtime.

In this framework, exports, investment income fromabroad, gifts received from abroad, borrowing from

abroad, and other credits (e.g., allocation of SDR) aresources of funds.

Imports, investment income paid to foreign residents,

gifts sent abroad, lending and investing abroad, andacquisition of international reserve assets (acceptablefor final settlement of international debt) are uses of

funds.


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The Current Account:

Includes trade in goods and services and transfer

payments.Transfer payments are gifts made by private and

public entities to foreigners, and gifts received from

foreign private and public entities.

Exports of goods and services and the receipt of

transfer payments are entered as credits because they

lead to receipt of payments from foreigners.

Imports of goods and services and the granting of

transfer payments are entered as debits because they

lead to payments to foreigners.


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The Capital Account:

Shows flows of international investments and loans,

both long-term and short-term. Long-term refers to a maturity of one-year or more

and include direct investments (building of foreign

plants) portfolio investments (purchase of foreign

stocks and bonds) and international loans for one-year

or more.

International capital movements (both L-T & S-T) are

further subdivided into private and official (i.e., of

monetary authorities) and non-liquid (such as foreign

bank loans to finance trade) and liquid (such as

foreign bank deposits).


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On Services and Investment Incomes: Exports and imports of services are treated analogously to

those of merchandise.

For example, when a foreign airline (e.g., British Airways)pays for baggage handling and aircraft maintenance at aU.S. airport (e.g., NY, Chicago, Atlanta) it is doing muchthe same thing as a foreign firm that buys computers in theU.S.

It is using the services of American factors of productionand incurring an obligation that must be discharged bypayment to the U.S. owners.

Also when an American tourist buys tickets from a foreignairline, he/she is doing much the same thing as anAmerican firm that buys oil from Saudi Arabia, Nigeria,

or Kuwait.


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Exports and imports of services are sometimes

described as Invisible Trade because they

cannot be seen to cross the border but they havethe same effect as visible merchandise trade.

Inflows and outflows of investment income

(factor income) are recorded in the currentaccount because they share two characteristics

with exports and imports of goods and services:

(a) They give rise to claims that must bedischarged by payments.


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(b) They reflect the use, by one country, of another

country's capital, a factor of production, and the

rent, compensation, interest, or reward paymentthereof adds to the national income of the country

that owns it.

Interest paid to Japan which holds U.S. T-bills isan outflow of investment income.

It represents compensation for the use, in the U.S.,

of Japanese capital and such payment adds to thenational income of Japan.


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In general, therefore, inflows of investment

income into the U.S. represent additions to U.S.

national income earned by U.S. capital "working"abroad and outflows from the U.S. represent

additions to the national income of other countries

earned by foreign capital "working" in the U.S.

Every transaction in the current account is an

income related flow.

Every transaction in the capital account is an asset

related flow.


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Capital transaction can be viewed in terms of

trade in paper, deeds to real property, corporate

securities, and various debt instruments. When an American company acquires a plant in

the UK, it is importing the deed to the plant.

When an American pension fund buys bonds in

Tokyo, it is importing securities.

In each case the importer must make payments to

the foreigner just like merchandise imports.


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The Official Settlement Account

Measures the change in a nation's (liquid and non-

liquid) liabilities to foreign official holders and thechange in a nation's official reserve assets during

the year.

A nation's official reserve asset refers to its gold,

convertible currencies, special drawing rights

(SDR), and reserve position in the IMF.


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An increase in a nation's liabilities to foreign

official holders and a decrease in a nation's official

reserve assets are credits (inflows) while adecrease in a nation's liabilities to foreign official

holders and a increase in its official reserve assets

are debts (outflows).

The change in official reserves measures a nation's

surplus or deficit on its current and capital account

transactions by netting reserve liabilities fromreserve assets.


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Errors and Omissions (Statistical Discrepancy)

Theoretically, double entry bookkeeping should cause

total credits to equal total debts when all accounts aretaken together.

However, because of recording errors and omissions

this equality does not always hold.

A special entry to make a nation's BOP "balance" is

necessary, hence the statistical discrepancy.


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Special Drawing Rights (SDR)

Is an "artificial" currency or a unit of account.

It is aninternational reserve asset created by the IMF and

allocated to member countries to supplement their

foreign currency reserves.

The SDR became a five currency composite in

1980, i.e., a weighted average of 5 major

currencies (U.S. Dollar, German Mark, French

Franc, Japanese Yen, British Pound).

(it was a 16 currency composite in 1974-1980)


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3 With the introduction of the euro, the SDR is now

essentially a four currency composite.

The SDR is primarily a means of payment onlyamong governments and/or central banks.

3 The current account transaction include all

transactions which give rise to earnings, expenses,

or distribution of earnings.

3 The capital account is the record of changes in anation's claims on foreigners and of changes in

liabilities to foreigners resulting from current

account transactions.


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Other Adjustments:

These include counterpart items, exceptional

financing, and liabilities constituting foreignauthorities' reserves.

3 Counterpart items are transactions that create or

reduce official reserves.3 The monetization of gold (or demonetization)

arises because gold is a commodity when held by

private parties, but a monetary reserve item whenheld central authorities.

3 Monetization of gold means gold has moved from

private hands to official accounts.


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3 Allocation or cancellation of SDR represents a

change in official holdings.

3 Exceptional financing refers to financing

mobilized by authorities outside of reserve

transaction, e.g., postponing debt payment, or

drawing on loans to finance transactions thatwould otherwise deplete the country's reserve

assets.


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The BOP account identifies transactions along

functional lines. One useful classification is:

3 (a) Current Account: include Merchandise; Services;Investment Income: (factor income): e.g. royalties,

licensing fees, education, telecom, legal, computer and

data processing, management, medical, insurance etc, and

Unilateral Transfers (gifts and grants)

3 (b) Capital Account: L-T capital & S-T capital.

3 (c) Statistical Discrepancy: Errors and omissions.

3 (d) Official Reserve Account: Official reserve assetsand foreign official assets.


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3 Services include such invisible items as military

expenditures, interests and dividends, travel and

transportation, fees and royalties, insurancepremiums.

3 Unilateral Transfers: Gifts and Grants both private

and official.Private: Personal gifts, philanthropic activities,

shipments by relief organizations.

Official: Money, goods, services to othercountries.


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Capital Account: Recordsloans, investments and other transfer of financial assets

and creation of liabilities.

Long-term Capital: Maturities > 1 year, e.g., Foreign

Direct Investment (FDI) , Portfolio Investments, and

Loans.

Private flows are usually in the form of FDI and portfolio

investments.

Government (official) flows are usually loans, financial

support in economic development projects overseas, andsubscription to various regional development banks.


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3 Short-term Capital: Maturity of < 1 year, e.g.,

demand deposits, short-term loans, and short-term

securities.

3 Short-term capital may be:

3

An accommodating adjustment induced bymerchandise trade, service trade, unilateral

transfer, investments (to finance other items in BOP).

3 An autonomous adjustment attributable to interestrate differences among nations and expected

changes in exchange rates (purely economic reasons).


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Account Balances:

3 The Trade Balance:

Records the balance on merchandise trade.3 The Balance on Current Account:

Indicates the balance on current spending.

It tells whether we are spending more abroad thanforeigners are spending in our country (ignoring

investment flows and accommodating flows).

The most important types of transactions included areimports and exports of goods and services, receipt and

payment of interests, dividends, and investment

incomes and net transfer payments.


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The Basic Balance:Is the sum of the balance on current account

and the long-term investment account.3 It indicates the extent to which autonomous long-term

investments are affecting the balance of payments.

3 When a country is a net recipient of long-term

investment funds, the basic balance should be more

positive than the current account balance.

Thus, long-term investment (net) may alleviate oraggravate the pressure on the domestic currency.


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The Performance Balance

3 Provides a summary of all autonomous flows

plus some accommodating transactions.

It is computed by

adding short-term capital account to the basic

balance.

3 It therefore provides insights into the extent to

which short-term investment flows are affectingthe pressure on domestic currency.


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3 A negative performance balance means that

additional accommodating transaction will be

needed to meet payment requirements.3 A country's ability to execute accommodating

transaction is limited to the availability of reserves.

3 In the absence of reserves, governments may

resort to restrictive measures on current and

capital account activities


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Accommodating transactions have two characteristics:

(a) They are undertaken by a government

(b) Their purpose is to finance a deficit or surplus in

the BOP.

However, not all international transactions conducted

by the government are accommodating.

Foreign aid is given for political or humanitarian

purposes, not to finance BOP surplus or deficit, henceit is not accommodating.

h i


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3 The Net Liquidity Balance: Measures changes inprivate domestic borrowing or lending required to keeppayments in balance without adjusting official

reserves.3 It includes the basic balance plus short-term private

non-liquid capital balance, the allocation of SDR anderrors and omissions.

3 The Official Reserve Transactions Balance: Measuresthe adjustment required in official reserves to achievebalance of payments equilibrium.

Because double-entry bookkeeping ensures that debitsequal credits the sum of all transactions equal zero, i.e.

Current Account Balance + Capital Account Balance +

Official Reserve Balance = Balance of Payments.


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3 A drawing down of official reserves (credit entry)

measures a nations BOP deficit

3 A building up of official reserves (debit entry)measures a BOP surplus

3 Deficits, while not necessarily bad, cannot be

sustained indefinitely because official reserves arelimited.

3 E h f h b l h i h i i l


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3 Each of these balances has its shortcomings mainlybecause of the increasing complexity of internationalfinancial transactions.

For example:

3 Changes in official reserves may now reflectinvestment flows as well as central bank interventions

3 The distinction between short-term and long-termcapital flows has become blurred.

3

While FDI is still determined by longer-tern factors,portfolio investment can now be just as speculative asbank deposits and liquidated just as quickly.


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Relative to GDP, U.S. Imports have Topped ExportsSince 1976, and the Trade Deficit has Widened


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U.S. Trade Deficits in 2003 by Country or Region

U S B l f P t 2003 ($B)


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U.S. Balance of Payments 2003 ($B)


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Some Typical Transactions (simplified form):

1. A U.S. firm exports $1000 worth of goods to UK and is paid with:(a) A deposit of $1000 worth of sterling into its account at a

London bank.

Debit(-) Credit(+)

Short-term private liquid capital: $1000 Exports: $1000

( U.S. claims on foreigners) - An outflow

If payment is made for U.S. exports in dollars against foreign

owned U.S. deposits then,

(b) Th "d bit" i d i b k d it f f i if


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(b) The "debit" is a decrease in bank deposits of foreigners if

payment is made for U.S. exports in dollars against their U.S.

deposits, so that

Debit(-) Credit(+)Short-term liquid liability (capital): $1000 Exports: $1000

( in U.S. liabilities to foreigners)

(c) Merchandise Imports:

U.S. residents import $50m worth of merchandise. Payment

made by transferring,

$20m (equivalent) from balance they hold in foreign banks, and

$30m from balance held in U.S. banks


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Debit(-) Credit(+)

Merchandise Imports: $50m U.S. private short-term claims: $20m

( in U.S. claims on foreigners)

Foreign private short-term claims: $30m

( in U.S. liability to foreigners)

2. U.S. tourists in London spend $30m for hotel and meals.

When U.S. tourists cash dollar traveler's checks at hotels in the

U.K., the hotels deposit the checks in their U.K. banks and the

banks send them for deposit credits in U.S.

The resulting increase in U.K. banks' deposits in the U.S.

shows additions to U.S. short-term liquid liabilities.

Debit(-) Credit(+)

Service category (travel): $30m Short-term liquid liability: $30m

(or tourist expenditure) (an increase in U.S. liability to

foreigners)

3 A E li h l d b $5 A i t k d ( ) b d i


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3. An English lady buys $5m American stocks, and pays: (a) by drawing

down her dollar deposits in a New York bank OR (b) by increasing

U.S. firms' demand deposit in U.K.

Debit(-) Credit(+)

Short-term liquid liabilities: $5m Portfolio investment: $5m

(a) ( in U.S. liabilities to foreigners)

(b) ( in U.S. claims on foreigners)

OR(c) A receipt of a $5m of investment income by U.S. firms from their

foreign investments. Checks sent to U.S. firms are drawn on U.S.

account holdings of foreign firms.

Debit(-) Credit(+)

Short-term liquid liabilities: $5m Income from investment abroad:

( in U.S. liabilities to foreigners) $5m


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5. The IMF allocates $50m of SDR to the U.S.

Debit(-) Credit(+)

Acquisition of official reserves: $50m Allocation of SDR: $50m

The debit shows additions to U.S. reserve assets, the credit

indicates its source.

NOTE


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NOTE:

3 Often one entry for a transaction is either a credit or a

debit to short-term liquid liabilities (capital) because in

U.S. transactions, most payments are made by

increasing or decreasing foreign deposits in U.S. banks.

3 It is possible to have entries for short-term liquid assets.

When dollar traveler checks are spent in England,

British banks increase their dollar deposits in U.S.

banks.

This is a debit (an outflow) to short-term liquid assets inthe British BOP or a credit in U.S. BOP to record an

increase in U.S. liability to foreigners (the British) - a

capital inflow to the U.S.

3 A current account surplus is not necessarily a sign of


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3 A current account surplus is not necessarily a sign ofeconomic strength, nor is a current account deficit a signof economic weakness or lack of competitiveness.

3 Economically healthy nations that provide goodinvestment opportunities tend to run trade deficits andcapital account surpluses.

3

Nations that are growing rapidly will import more goodsand services while weak economies will reduce theirimports because imports are positively related to income.Therefore, the faster a nation grows relative to other

economies, the larger its current account deficit tends tobe or the smaller its surplus.

3 Conversely, the slower a nation grows the smaller will beits current account deficit or the larger its current account

surplus.

3 Current account deficits may therefore reflect strong


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3 Current account deficits may, therefore reflect strongeconomic growth or a low level of savings and currentaccount surplus may signify a high level of savings or

slow rate of growth.3 Since current account deficits are financed by capital

inflows, the cumulative effect of these deficits is toincrease net foreign claims against the deficit nation and

reduce the nations international wealth.3 On the other hand, a nation that consistently runs current

account surpluses will increase its net international wealth.

3 A deficit country like the U.S. becomes net international

debtor and a surplus country like Japan or China becomesnet international creditor. In 2006, the U.S. net international investment position = - $2.8 T In 2006, Japans net international investment position = Y 215 T

In 2006, Chinas net international investment position = $662 B

H h US b d h if / di l i ? Di !


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Has the US become a spendthrift/prodigal nation? Discuss!

Recall that:

Private gross investment = savings (personal, business,

public sector) + borrowing from abroad.

In complete and frictionless markets, capital flows

towards the most productive uses, raising the standard ofliving for both recipients and owners.

In reality international capital markets are segmented and

far from frictionless.Therefore there are limits to the current account deficit

that a nation may incur/sustain.

The current US situation calls for (sustainability) concern.49

Factors Affecting Bop Components Economic Factors


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Factors Affecting Bop Components Economic Factors

3 Inflation Rates(relative inflation rates): A higher

domestic inflation relative to a nation's tradingpartners, ceteris paribus, will result in current accountdeficit.

Foreign goods become more attractive (imports ) or

domestic goods become more expensive and foreigndemand drops (exports ).

3 Interest Rates: An increase in domestic interest

(real) rates compared with ROW attracts funds fromforeign investors, so that, ceteris paribus, increase indomestic interest rate leads to improvements in capitalaccount balance.

3 Income Le el: A relati el higher domestic


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3 Income Level: A relatively higher domestic

income level leads to increased domestic

consumption, part of the additional consumption

coming from higher imports.

This will tend to increase current account

deficits.

Domestic Currency Value


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Domestic Currency Value:

3 The higher the domestic currency value in terms of

foreign currencies, ceteris paribus, the worse the current

account balance.

3 This is because domestic goods become more expensive

to the importing countries. As a result, the demand for

such goods will decrease.3 On the other hand, an appreciating domestic currency

makes foreign goods (domestic imports) more attractive

to domestic residents who will increase their demand for

such goods.

3 A decrease in export demand increase in import demand

has a negative effect on the domestic current account

balance.

3 Government Restrictions


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3 Government Restrictions

Tariff:

Tax on imported goods.Quota:

Quantitative limit on amount of a particular

product imported.

3 If a government imposes restrictions, BOP,

especially the current account, may improve

provided no retaliatory measures are taken by

foreign governments (ROW).

3 Tax on Foreign Income:


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3 Tax on Foreign Income:

May reduce the amount of foreign investment

undertaken by domestic residents.3 Restrictions on International Capital Flows:

Dual exchange rates (multiple exchange rates)

For example:different rate for government payments.

different rate for importers etc.

3 These restrictions will tend to reduce domestic

currency outflows.

Government Monetary and Fiscal Policies:


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Government Monetary and Fiscal Policies:

May affect economic variables such as inflationand interest rates which in turn influence BOPcomponents.

Impact of BOP on the Economy:

3

A current account deficit is associated with higherdomestic inflation and often results in higherunemployment .

3 A capital account deficit may be associated withhigher domestic interest rates which discouragedomestic borrowing for investment and result in aslowdown of economic expansion.

Correcting BOP Problems


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Correcting BOP Problems

Current Account / Capital Account Deficit

3 Any policy which improves foreign demand for

domestic goods and services or for investment

securities, e.g., more attractive export prices

resulting from low inflation or depreciatingcurrency value.

3

Under a floating exchange rate regime, anyinternational trade imbalance should be corrected

automatically.

A Trade Account Deficit:


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A Trade Account Deficit:

3 Implies that we are selling our currency (supplying

our currency) to buy foreign goods than foreigndemand for our currency to buy domestic goods.

3 A depreciation of our currency should stimulate

foreign demand for domestic goods (ceteris

paribus). (See Marshall-Lerner conditions)

Restrictions on Imports:3 If domestic imports can be restricted while

domestic exports can be increased, the trade

balance should improve.

Question: Why are managers and investors vitally interested in the


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Question: Why are managers and investors vitally interested in theBOP of countries?

3 The balance of payments helps to forecast a country's market

potential, especially in the short run. A country experiencing aserious balance of payments deficit is not likely to import as much as

if it were running a surplus.

3 The balance of payments is an important indicator of pressure on a

country's foreign exchange rate, and thus on the potential for a firm

trading with or investing in that country to experience exchange gains

or losses.

3 Continuing deficits in a country's balance of payments may signal

future controls on outgoing capital movements, such as payments of

dividends, fees, and interest to foreign firms and investors.3 Continuing surpluses in a country's balance of payments may indicate

that country's strong international competitive position, and therefore

a potentially good location for an operating subsidiary, or portfolio

investment.

*** International Economic Linkages (59 72)


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*** International Economic Linkages(59-72)

Define:

Y = National Income (or National Product)

C = Consumption

S = Savings

National Income is either spent on consumption or saved, so

Y = C + S ........ (1)Similarly, the amount that a nation spends on goods and

services (National Expenditure), E, can be divided into

Consumption (C) and Real Investment, Id(Plant & Equipment,

R&D, etc). Hence:

E = C + Id

........ (2)

(1) - (2) gives

Y - E = S - Id

........ (3)

3 If a nation's income exceeds its spending, then


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p g,savings will exceed domestic investment resulting insurplus capital.Excess capital must be invested overseas: Thus:S - Id = If ........ (4)

3Net Foreign Investment (If) equals the nations' netpublic and private capital outflows plus increase inofficial reserves.

3 A nation that produces more than it spends, Y- E > 0,will save more than it invests domestically, S - Id > 0,

and will have a net capital outflow.

3 The capital outflow, If > 0, will appear as somecombination of a capital account deficit and an

increase in official reserves.

The Current & Capital Accounts


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The Current & Capital Accounts

Let D = spending on domestic goods and services:

X = exports, M = imports, E = national expenditure.

Then

Y - D = X ........ (5)

E - D = M ........ (6)

Combining (5) and (6) we have,

Y - E = X - M ........ (7)

National Income - National Expenditure= Exports - Imports

Equation (7) says that a Current Account Surplus, X - M > 0,


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Equation (7) says that a Current Account Surplus, X M 0,

arises when national output exceeds domestic expenditures.

A current account deficit, (X - M < 0), will be the reverse.

Combining (3) and (7) we have:

S - Id = X - M ........ (8)

(8) means that if a nation's saving exceed its investments, thenthe nation will run a Current Account Surplus.

Note that: S - Id = If = X - M.

So that:

If = X - M ........ (9)

Net Foreign Investment = Exports - Imports

3 For example, the Japanese have a high savings rate (= 15 %)


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p , p g g ( )

relative to their investment rate hence they have a Current

Account Surplus.

The US saves less (= 2%) than it invests and must run a currentaccount deficit.

3 Equation (9) means that funds earned by selling abroad must

be either spent on imports or exchanged for claims against

foreigners (foreign investment).3 Between the US and Japan, for example, any deficit in the

Current Account, (X- M < 0), is exactly equal to the surplus

in the capital account. Otherwise there would be imbalance in

the foreign exchange market and exchange rate would change.

Equation 9 can be re written as:

X - M - If = 0 ........ (10)

3 In (10), current account balance and capital account balance exactly


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( ), p y

offset each other under a freely floating exchange rate system.

Without intervention in exchange market, the sum of the

current account balance + capital account balance + balance on

official reserves account equals zero.

3 These identities allow us to assess the efficacy of proposed

solutions for improving the current account balance.

3 Therefore if a nation wants to reduce its current account deficit

or increase its current account surplus it must:

Raise national product relative to national spending, (Y- E) > 0

Increase savings relative to domestic investment, (S - Id) > 0

Budget Deficits & Current Account Deficits


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Budget Deficits & Current Account Deficits

By decomposing aggregate domestic spending and income

into government and private sectors we can relate

government deficits to current account deficits:

Let:

E = National Expenditure (or Spending)

Ch = Household SpendingId = Private Investment (Domestic)

G = Government Spending

T = Taxes; S = SavingsThen we have

E = Ch + Id + G

E = Y - (S + T) + Id + G ....... (11)

Rearranging (11) we get a new expression for


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Rearranging (11) we get a new expression forexcess spending:

E - Y = (Id- S) + (G - T) ........ (12)

3 A nation's excess spending equals its netborrowing from abroad.

3 Alternatively, a nations excess spending equals the

sum of its excess of private investment overprivate savings and total government deficit.

Combining (7) and (12) we get:


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g ( ) ( ) g

X - M = S - Id

- (G - T) ........ (13)

C/A Saving GovernmentBalance Surplus Budget Deficit

3 A nation's current account balance is identically equal

to its private savings minus investment balance lessgovernment budget deficit.

3 Therefore a nation running a current account deficit,X - M < 0, is not saving enough to finance its private

investment and its government budget deficit.

3 Conversely a nation running a current account surplus issaving more than is needed to finance its private

investment and government deficit.

Coping With Current Account Deficit:


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Coping With Current Account Deficit:

1 - Devaluation

2 - Protectionism

3 - Restriction on Foreign Ownership of Domestic Assets

4 - Boosting the National Savings Rate

On Currency Devaluation / Depreciation:

(A) Disequilibrium View:

3 Posits that nominal disturbances can cause changes in

real exchange rates because of sluggish / slow price

adjustment. It

proposes a systematic relationship between exchange

rate and the current account balance.

(B) Equilibrium Theory of Exchange Rate:


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3 Agues that no simple relation exists between exchange rates and thecurrent account balances.

3 Maintains that trade deficits do not "cause" currency depreciation,nor does currency depreciation by itself help reduce trade deficits.

The necessary conditions for devaluation to improve anation's current account can be analyzed in three contexts:

1. Elasticity Approach:3 Focuses on effects of relative price changes, brought about

by devaluation, on consumption and production.Devaluation will improve a nation's balance of trade ifMarshall Lerner Conditions (e

MD

+ eXD

> 1) are met, that is,change in quantity of import and export demand must besufficiently large to offset the lower foreign currency priceof a nation's exports and higher domestic currency price ofimports following devaluation.

Volume effect must dominate price effect.

2. The Absorption Approach:


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p pp3 Shifts attention to the whole economy.

Any improvement in the Balance on Current Account,

(X - M), must cause an increase in the difference betweenTotal Output and Total Domestic Expenditure, (Y- E).

3 Total absorption of goods and services, E + X, must equal theaggregate amount of goods and services available, Y+M, so that:

E + X = Y + Mor X - M = Y E

3 A trade surplus, X - M > 0, arises when national output is greaterthan domestic expenditures, (Y- E > 0).

3 When underemployed resources exist, output, Y, can increase

without inflation if there are no bottlenecks in the economy.

With full employment, domestic expenditures, E, must be reduced.

Devaluation will not succeed otherwise

3. The Monetary Approach:


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3. The Monetary Approach:3 Concentrates on demand for money balances.

An excess demand for goods and services (a tradedeficit) reflects excess supply of money.

3 Devaluation reduces the real value of the moneysupply because of price increases for traded goods and

services.

3 It works by causing the public to reduce its spendingin order to restore the real value of its money balances

and other financial assets.3 The reduction in expenditures will improve the

balance of payments as long as monetary expansion

does not follow the devaluation.

3 Protectionism:


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The use of Tariffs and Quotas

3 Restriction on Foreign Ownership of DomesticAssets.

3 Boosting the Savings Rate:

Social security benefits.

Tax changes.

IRA and other tax deferred savings ***

Other Issues:

3 Current Account Deficit and Unemployment

3 Current Account Deficits / Surpluses: Good or Bad?

3 Is the Trade Deficit a Subtraction from GDP?

3 Is the U.S. Spending too Much and Saving too Little?

3 The U.S. current account deficit can be viewed as an efficientd i diff i i i d i


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adaptation to different savings propensities and investmentopportunities in the US and the rest of the world.

The real problem, if any, may be either too much consumption and

too little savings or too much investment.The hard fact is that the situation confronting the US and ROWsince the early 90s is an expression of national preferences towhich trade flows have adjusted in a timely manner .

3

Long term consequences for a nation that runs a current accountdeficit:

3 (i) If the Current Account deficit and the resulting capital accountsurplus finances productive domestic investments, then the nationis better off as the returns from these added investments will help

to service the foreign debts with income left to improve domesticliving standards.

3 (ii) If the capital account surplus finances current consumption, itmerely increases a nation's well being today at the expense of

future well being.

3 In popular discussions, the U.S. trade deficit is often referred


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to as a subtraction from the GDP.Economic analysis suggests otherwise.

3 Some imported goods (e.g. agricultural products, oil)

cannot be produced in the U.S., while other imports providelow-cost products for consumers and firms.

3 Production at some firms might even decrease if importedproducts were not available.

3 Furthermore, in a tight labor market, some firms might find itdifficult to hire enough labor to expand output by the size ofthe trade deficit.

3 The basic economics of trade deficit suggests that with

floating exchange rates, a trade deficit can persist only if

foreigners willingly accumulate financial claims issued by

a countrys household and firms (if foreigners continue

to invest in the country).

3 Absent this, the value of domestic currency would fall and


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the trade gap would tend to close as import prices increaseand export prices decrease.

3 At the same time the yields available on domestic investmentsmust remain attractive especially to foreign investors.

3 Economists view the trade deficit as part of an overall

general equilibrium involving domestic demand,production, and investment opportunities, relative to

economic conditions in the rest of the world.

Therefore, the trade deficit is not a subtraction from GDP.


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The Case for Free Trade

3 The case for free trade is based on the theory of

comparative advantage.

When countries specialize and trade based on

comparative advantage, consumers pay less and

consume more, and resources are used moreefficiently.

3

When tariffs and quotas are imposed, many of thegains from trade are eliminated.

C f i


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The Case for Protection

3

Protection saves jobs.3 Some countries engage in unfair trade practices.

3 Cheap foreign labor makes competition unfair.

3 Protection safeguards national security.

3 Protection discourages dependency.

3 Protection safeguards infant industries.3 Protection fights neo-colonialism

bop & international economics linkages

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