objectives accounting system of a nation's international transactions: current, capital, and...

Objectives

• Accounting system of a nation's international transactions: current, capital, and financial accounts

• Explain the relationship between GDP and international flows of goods, services, and financial assets

• Examine the meaning of international indebtedness and discuss its consequences

• Balance of Payment to demand and supply for foreign exchange and the exchange rate

Name Economic Actions one can have with a foreign country and say if this will trigger Foreign Currency demand or supply.

Introduction: The Balance of Payment

• The international transactions of a nation are divided into three separate accounts– Current account: record of the goods and

services into and out of the country– Financial account: record of the flow of

financial capital to and from the country– Capital account: record of some specialized

types of relatively small capital flows

The Trade Balance

• Let’s first define the trade balance- measures the difference between exports and imports of goods and services– Trade deficit (this is not the current account balance):

negative trade balance• In 2008, the U.S. had a trade deficit of $695.0 billion• In 2011: $332.9 billion

The Current Account Balance

• Current account balance: Measures all current, non-capital transactions between a nation and the rest of the world

• The current account has three main components:– Goods and services = the value of goods and services

exported – the value of imports– income received/paid = income from investments and

compensation (wage) abroad – income paid to foreigners on their U.S. investments and paid compensation

– Unilateral transfers = any foreign aid or other transfers received by foreigners – that given to foreigners

Components of the Current Account

Leads to Foreign Currency Supply

Leads to Foreign Currency Demand

The U.S. Current Account Balance, 2008

The U.S. Current Account Balance, 2008

How does the current account look today:http://www.bea.gov/iTable/index_ita.cfm

http://www.bea.gov/iTable/index_ita.cfm

The National Income and Product Accounts (cont.)

• GNP = GDP + foreign income received – income paid to foreigners + net unilateral transfers

Distinction between GDP and GNP is not relevant for the exam!

Review GDP

GDP Industry 1

GDP Industry 2

. . .

GDP Industry N

GDP Industry 2 GDP US

C

I

G

X

Is this correct?

Review GDP

GDP Industry 1

GDP Industry 2

. . .

GDP Industry N


C

I

G

X

A certain part of C,I,G, and even Xcomes from foreign production and was imported. -M

Review GDP

GDP Industry 1

GDP Industry 2

. . .

GDP Industry N


C

I

G

XGDP = C + I + G + X -M GDP = C + I + G + (X –M)

-MTrade Balance

Beggar Thy Neighbor Policy

GDP = C + I + G + (X-M)

GDP = C + I + G + (X-M) Increase Trade Balancewill increase GDP

How? • Manipulate (increase) exchange rate• Subsidize Exports• Penalize Imports

• Tariffs• Quotas• Non-tariff trade restrictions

Beggar Thy Neighbor Policy- From neighbor’s view-

GDP = C + I + G + (X-M)

GDP = C + I + G + (X-M) Increase Trade Balancewill increase GDP

How will neighbor react? Retaliate!!!

GDP* = C + I + G + (X*-M*)Increase Trade Balancewill increase GDP

US

Neighbor

Beggar Thy Neighbor Policy- Is not easy to avoid because it creates a Prisoners Dilemma situation -

Solution: International Agreements:next session with Dr. Wihlborg

open economy closed economy

open economy 10, 10 2, 15

closed economy 15, 2 4, 4US

Neighbor

Possible Payoff Matrix

U.S. Current Account Deficit

• There were two periods of large current account deficits in the U.S.:

- The first lasted through most of the 80’s

- The second began in the early 1990s and continues today

FIGURE 9.1 U.S. Current Account Balances, 1950-2008

How does this chart looks today:http://www.bea.gov/iTable/index_ita.cfm



Financial Account Liberalization

• The movement toward open markets over the 1980s and 1990s has resulted in the lifting of controls on financial flows – Developing countries, in particular, have

liberalized financial account transactions in order to get access to financial capital for development

– Although financial flows can be volatile, economists agree that free flows are best for economic efficiency

Limits on Financial Flows

• Until recently, most nations limited the movement of financial flows related financial account transactions across their borders– The European Union liberalized financial flows

between member countries only in 1993

Possible Reasons for CA Deficits

• Consumption of foreign goods due to high income in the US

• Investments of booming US companies • War expenditures (especially cost abroad,

transportation, energy, and partially weapons and ammunition)

• (Globalization. Note, globalization can only explain that exports AND imports increased but not the deficit)

What do the data say :http://www.bea.gov/iTable/index_ita.cfm



Are Current Account Deficits Harmful?

• The relationship between the trade deficit, production and domestic demand is an identity

• if domestic demand is greater than GDP => trade deficit (argument ignores transfers and income payment)

• Consequently, current account balance does not tell us why an economy runs the current account deficit or surplus

U.S. Current Account Deficit(cont.)

• A current account deficit is not necessarily a sign of weakness: in the U.S., the economic boom of the 1990s increased the demand for imports, while sluggish growth abroad limited the expansion of U.S. exports

• However, everyone agrees the U.S. deficit is not sustainable in the long term

CAPITAL ACCOUNT AND FINANCIAL ACCOUNT

The U.S. Balance of Payments, 2008

• Balance of payments = current account + capital account + financial account


Try it yourself for 2011:http://www.bea.gov/iTable/index_ita.cfm



Capital Account

• Capital account: A record of the transfers of specific types of capital, such as:– Debt forgiveness– Personal assets that migrants take with

them abroad– The transfer of official real estate and other

fixed assets, such as a military base or an embassy building


• Balance of payments = current account + capital account + financial account

Financial account: A record of the flow of financial capital to and from a country

• Financial account is divided into three categories: – Net (!) changes in the country’s assets abroad

Increases are – why?• e.g. an U.S. resident transfers money in his Italian bank account.

(Note, if he transfers all or part of the money back this would reduce the amount of the position)

– Net (!) changes in the foreign-based assets in the country• e.g. a Canadian resident transfers money in her U.S. bank

account. Increases are + why?(Note, if he transfers all or part of the money back this would reduce the amount of the position)

– Net change in financial derivatives

Introduction to the Financial and Capital Accounts:

Financial Account (cont.)

• Assets include bank accounts, stocks and bonds, and real property such as factories, businesses, and real estate

• Financial derivatives are instruments linked to an asset or indicator to mediate financial risks and can be traded in financial markets

What do the data say Plot data from 1980 – now! Compare with current account.http://www.bea.gov/iTable/index_ita.cfm


TABLE 9.3 (continued) The U.S. Balance of Payments, 2008




Table 9.4 Components of the U.S. Financial Account, 2008

Main Categories of U.S. Financial Flows

1. U.S. assets abroad (outflows)

A. U.S. Official reserve assets: gold bullion, IMF’s Special Drawing Rights (SDRs), EU euros, British pounds, or Japanese yen

B. U.S. Government assets: loans to foreign governments, rescheduled loans to foreign governments, payments received on outstanding loans, changes in non-reserve currency holdings (e.g., Mexican pesos)

C. U.S. Private assets: direct investment, foreign securities, loans to foreign firms and banks

The Three Accounts are Interdependent

• The current, capital, and financial accounts are interdependent

• Current account measures flow of goods and services

• Capital and financial accounts measure flow of financing

• Therefore, sum of capital account and financial accounts equal to current account with opposite sign

International Debt

• External debt is defined as money owed to nonresidents.

• Current account deficits must be financed through inflows of financial capital (loans)

• Loans from abroad add to a country’s stock of external debt and generate debt service obligations

Statistical Discrepancy

• Statistical discrepancy exists because the record of all the transactions in the balance of payments is incomplete

-Errors tend to lie in the financial account calculation, as it is the hardest to measure correctly

Statistical Discrepancy in theBalance of Payments

• Statistical discrepancy: The amount by which the sum of the current, capital, and financial accounts is off the total of zero

• Statistical discrepancy is calculated as the sum of the current, capital, and financial accounts, with the sign reversed– In 2008, U.S. statistical discrepancy was

[(–1) (–706,068 + 506,013)] = 200,055

Balance of Payments

• Three accounting caveats:1. Both the capital account and the financial account present

the flow of assets during the year in question and not the stock of assets that have accumulated over time

2. All flows are net changes (differences between assets sold and bought, for example) rather than gross (stock) changes

3. As long as the capital account balance is zero (and there is no financial discrepancy), financial account balance = current account balance, but with the opposite sign

American buys BMWPays out of his German Account

Current AccountExports of goods and services and income receiptsImports of goods and services and income paymentsUnilateral current transfers, net

Capital AccountCapital account transactions, net

Financial AccountU.S.-owned assets abroad (increase/financial outflow (-))Foreign-owned assets in the United States (increase/financial inflow (+))Financial derivatives, net


(Credits + (FC Supply); debits - (FC Demand)

American buys BMWPays out of his German Account






$50,000

American donates money to Red Cross HaitiPays out of his Bank of America Account (BA pays

Red Cross out of its Haiti account)






$5,000

American donates truck to Red Cross HaitiPays out of his Bank of America Account (BA pays







American donates truck to Red Cross HaitiPays out of his Bank of America Account (BA pays







$80,000

Your Example transactionCounter transaction






$0,000

Chapter Objectives

• Crucial Question: If at the end FC demand = FC supply what determines the exchange rate ???

Definition of Exchange Rate

• Exchange rate (e) is the price of one unit of foreign courancy (FC)

• We will use the $/€ exchange rate as an example

• An exchange rate of 1.43 $/€ means that one € costs $1.43.

• Note, some textbooks and websites use the reciprocal (how many € can I buy for $1) here 1/1.43 => €0.70

What causes Demand or Supply on the Foreign Currency Market (for example the €/$-Market)

• U.S. Imports cause € demand• U.S. Exports cause € supply• Spent Transfers cause €demand • Received Transfers cause € supply• Financial asset exports cause € demand • Financial asset imports cause € supply

Some Definitions and Mathematical Conclusions

Definition of BP:

BP = CA + FA

Adding-Up Constraint:

Since every trade has a counter trade:

FA+CA + KA = 0

Expost by definition CA + FA = 0

KA is very small for the U.S. and will be neglected in what follows: KA:=0

Important Terms to Agree on

• Ex Post: Measures what already happened during a certain time period (month/year)

• Ex Ante: Measures (?) what economic agents are going to do (what they are planning) in terms of economic activities in this time period (month/year)

An Example for Expost and Exante

At an auction flowers are sold.1. The auctioneer first calls the same price that s/he called at

the end of yesterdays auction.2. Bidders submit their bids (how many flowers they want to

buy or sell).3. No sell or buy is made until D=S4. Based on the overall demand and supply the auctionateer

tries a higher or lower price until a price generates D=S

After the Auctioneer called a lot of price P=$10 generates an expost equilibrium

• Flower Seller A: 1000 Flowers

• Flower Seller B: 500 Flowers

• Flower Seller C: 1000 Flowers

• Flower Shop 1: 500 Flowers



S=D

Valentines Day Morningfirst call P=$10 generates an exante disequilibrium







S<D

Valentines Day at the end of the auction. P=$14 generates an expost equilibrium





• Flower Shop 2: 1150Flowers


S=D

Summary: Expost -Exante

1. Expost: D=S2. Exante: Plans change =>D<S or D>S3. Adjustment: P changes => D and/or S

change(s)4. New Equilibrium: D=S5. Expost: D=S

Some Assumptions• Pure Flexible Exchange Rates (Centralbank does not buy or sell

FC)• FA is determined by expected exchange rates and not by current

exchange rate (this assumption needs to be explored further at a later stage)

• Transfers and Capital Account (KA) depend on none financial determinants

• Demand in the U.S. and abroad depends only on domestic prices (domestic prices abroad is E times domestic price for the U.S.)

• Domestic and foreign supply of goods does not depend on domestic or foreign prices (infinite elastic supply).

Equilibrium FX Market

Current AccountExports of goods and services (possivily correlated with e) 100Imports of goods (negatively correlated with e) -162Unilateral current transfers, net -10

Capital AccountCapital account transactions, net -2

Financial AccountU.S.-owned assets abroad (increase/financial outflow (-)) 250Foreign-owned assets in the United States (increase/financial inflow (+)) -180Financial derivatives, net 4

Net FC Demnd (-) or Supply (+) 0

(Credits + (FC Supply); debits - (FC Demand) in US-$

Euro Crisis Worsens




Net FC Demand (-) or Supply (+) 15


+10+5

S>D => w goes down

How does a change in a foreign exchange rate influence the elements of the balance of payment?

• X will normally increase, if FC exchange rate increases et vice versa.

• IM normally will decrease, if FC exchange rate increases et vice versa.

• Transfers are exogenous.• FA depend not on the level of the exchange rate.

They depend on the expected future change in the FC exchange rate.

w decreased => X decreased, M increased

After Exports/Imports Adjusted






-9-8

Summary: Expost -Exante

1. Expost: FXD=FXS

2. Exante: Plans change => FXD>FXS or FXD<FXS

3. Adjustment: w changes => FXD and/or FXD change(s) because X and/or M change(s)

4. New Equilibrium: FXD=FXS

5. Expost: FXD=FXS

Diagram of the Exchange Rate Market

$/€

€ demand and supply

Supply (e.g. Exports)

Demand(e.g. Imports)

Diagram of the Exchange Rate Market

The FC demand curve is not only based on imports. It builds on capital exports and spent transfers too. But only imports respond to the exchange rate. A change in capital exports and /or spent transfers would result in a shift of the curve.

The FC supply curve is not only based on exports. It builds on capital imports and transfers too. But only exports respond to the exchange rate. A change in capital imports and/or received transfers would result in a shift of the curve.

Try It Yourself:Equilibrium FX Market






Try It yourself: US Debt Rating Worsens Significantly




Net FC Demand (-) or Supply (+) 0


+-

+-S?D => w goes ?

After Exports/Imports Adjusted






Diagram of the Exchange Rate MarketFlexible Exchange Rate: S < D

$/€


Supply

fromExports

Demand

from Imports

$/€0 S<D

FromFA

FromFA

Diagram of the Exchange Rate MarketFlexible Exchange Rate: S < D

$/€




$/€0 S<D

Diagram of the Exchange Rate MarketFlexible Exchange Rate: S > D

$/€




$/€0S>D

Diagram of the Exchange Rate MarketFixed Exchange Rate: S < D

$/€




$/€0 S<DCB

sells €

Diagram of the Exchange Rate Market Fixed Exchange Rate: S > D

$/€




$/€0D<S

CBbuys €

Case StudyChina's Exchange Rate RegimeFor nearly ten years now, the Chinese have maintained a fixed exchange rate for their currency, the Yuan, relative to the Dollar. The rate has been pegged at about 8.28 Yuan/dollar for the entire period. Thus, as the dollar has appreciated or depreciated in value relative to other currencies, such as the Euro, the Yuan has appreciated or depreciated by the same amount relative to these other countries. To maintain this fixed exchange rate, the central bank of China has had to intervene in the foreign exchange market. It sells Yuan in exchange for dollar denominated assets when the demand for the Yuan increases and it buys Yuan with dollar denominated assets when the demand for the Yuan decreases. Recently the central bank has intervened very heavily in the markets to prevent the Yuan from appreciating. Since the end of 2001, Dollar buying has been so great that the foreign reserves held by the Chinese government have risen by $153 billion to over $360 billion. This accumulation of foreign exchange reserves would tend to expand China's money supply, although in recent months the Chinese central bank has moved to reign in monetary expansion. Among other measures to sterilize reserve accumulation, the central bank has - for the first time - begun issuing central bank paper to restrict growth of the monetary base. Nevertheless, the broader money supply continues to grow very rapidly: M2 climbed 22 percent over the 12 months ending in August 2003. It is also important to recognize that China still has significant capital controls. China's capital controls allow for more inflows than outflows, thus bolstering foreign exchange reserves. China is gradually loosening some controls (on securities rather than debt), and outflows are likely to grow as new channels develop for Chinese to seek diversification and better returns than those offered by low domestic interest rates. Indeed, there is already significant leakage of capital. A relaxation of controls on outflows would reduce upward pressure on the yuan. Source: (Dep. of the Treasury, press rel. Oct. 1, 2003) http://www.ustreas.gov/press/releases/js774.htm

http://www.ustreas.gov/press/releases/js774.htm

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