Balance of Payments

Balance of Payments:

·         Measure of money inflows and outflows between the United States and the Rest of the World (ROW)

o   Inflows are referred to as CREDITS

o   Outflows are referred to as DEBITS

·         The Balance of Payments is divided into 3 accounts

o   Current Account

o   Capital/Financial Account

o   Official Reserves Account

Double Entry Bookkeeping:

·         Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice.

o   Ex. U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland.

§  (-$50 million worth of farm equipment or physical assets)

§  (+$50 million worth of Euros or financial assets)

o   Notice that the two transactions offset each other. Theoretically, the balance payments should always equal zero… Theoretically.

Current Account:

·         Balance of Trade or Net Exports

o   Exports of Goods/Services – Imports of Goods/Services

o   Exports create a credit to the balance of payments

o   Imports create a debit to the balance of payments

·         Net Foreign Income

o   Income earned by U.S. owned foreign assets – Income paid to foreign held U.S. assets

o   Ex. Interest payments on U.S. owned Brazilian bonds – Interest payments on German owned U.S. Treasury bonds

·         Net Transfers (tend to be unilateral)

o   Foreign Aid → a debit to the current account

o   Ex. Mexican migrant workers send money to family in Mexico

Capital /Financial Account:

·         The balance of capital ownership

·         Includes the purchase of both real and financial assets

·         Direct investment in the United States is a credit to the capital account

o   Ex. The Toyota Factory in San Antonio

·         Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account

o   Ex. The Intel Factory in San Jose, Costa Rica

·         Purchase of foreign financial assets represents a debit to the capital account.

o   Ex. Warren Buffet buys stock in Petrochina.

·         Purchase of domestic financial assets by foreigners represents a credit to the capital account.

o   The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ.

What causes Capital/Financial Flows?

·         Differences in rates of return on investment

·         Ceteris Paribus, savings will flow toward higher returns

·         Debit to the Chinese Capital Accounts shifts to the left

·         Credit to the U.S. Capital Account shifts to the right

Relationship between Current and Capital Accounts:

·         The Current Account and the Capital Account should zero each other out

·         If the Current Account has a negative balance (deficit), then the Capital Accounts should then have a positive balance (surplus).

Official Reserves:

·         The foreign currency holdings of the United States Federal Reserve System

·         When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments.

·         When there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments.

·         The Official Reserves zero out the balance of payments.

Foreign Exchange (FOREX)

·         The buying and selling of currency

o   Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their Dollars and buy (demand) Euros.

·         The exchange rate (e) is determined in the foreign currency markets.

o   E. The current exchange rate is approximately 77 Japanese Yen to 1 US dollar

·         Simply put. The exchange rate is the price of a currency.

·         Do not try to calculate the exact exchange rate.

Ex. Increase in the Demand of Euros relative to the U.S. Dollar:

Demand of Euro →:

Credits vs. Debits

Credits: additions to a nation’s account

Debits: subtractions to a nation’s account

How to calculate the following:

1)      Balance on trade:

a.       (Merchandise + service exports) – (merchandise + service imports)

2)      Trade deficit occurs when the balance on trade is negative. (Imports > Exports)

Trade surplus occurs when the balance on trade is positive. (Exports > Imports))

3)      Balance on current account:

Balance on trade (Exports & Imports) + Net investment income + Transfer Payments

4)      Official Reserves

a.       Nationally: Change in Current Account + Change in Financial Account + Change in official reserves = 0