Balance of Payments Chapter 24 Presented by Mattay

Balance of Payments Chapter 24 Presented by: Mattay Botcheff

Overview • • The balance of payments account The current account The capital account The consequences of current account and capital account imbalances How big is a “big” current account deficit or surplus? Methods of correcting a persistent current account deficit The Marshall-Lerner condition The J-curve

The Balance of Payments (BOP) Account • Record of the value of all transactions between the residents of one country and the residents of another country over a period of time • Consists of current account and capital account • Credit – money entering the country • Debit – money leaving the country

The Current Account • Flow of funds from trade in goods and services + other income flows • The balance of trade in goods – – Visible trade balance Merchandise account balance Balance of trade Revenue received from exports minus expenditure on imports • Surplus (X > M) • Deficit (X < M) • The balance of trade in services Invisible balance Services balance Net services Revenue received from export of services minus expenditures on services over a period of time – Banking, insurance, tourism – –

The Current Account • Net income flows – Net investment incomes (net factor income from abroad) – profits, interest, dividends • Net transfers of money (current transfers or net unilateral transfers from abroad) – Between governments – foreign aid and grants – Between individuals – remittances (sending money home) or private gifts – No goods or services change hands • Current Account = Bo. T Goods + Bo. T Services + income + Current Transfers

The Capital Account • Relatively small – little impact on BOP • Capital transfers – transfers of goods or financial assets by migrants entering/leaving; debt forgiveness • Transactions in non-produced, non-financial assets – Land, rights to natural resources – Intangible assets (patents, brand names, etc. )

The Financial Account • Measures net change in foreign ownership of domestic financial assets • Direct investment – Purchase of long-term assets, where the purchaser is aiming to gain a lasting interest in a company in another economy – Example – property, business or stocks • Portfolio investments – stocks, bonds and savings • Reserve assets – gold and foreign currencies • Net errors & omissions – balancing account

Relationship between Current Account & the Exchange Rate • Deficit in current account – Short run – financed by increases in capital and financial accounts or by use of foreign exchange reserves – Long run – leads to devaluation or depreciation • Surplus in current account – Short run – deficits in capital and financial accounts or by build up of foreign exchange reserves – Long run – leads to revaluation or appreciation

The Consequences of Current Account Deficits (HL) • Use of foreign exchange reserves (no long-term solution) • High level of buying of assets for ownership (property, business, stocks) – indicates confidence in the economy – If it is too high, could be considered a threat to economic sovereignty – If confidence drops, there will be a sell-off of assets (currency will drop in value) • High level of lending from abroad – Higher interest payments – drain on economy – Sell-off of debt (currency will drop in value)

The Consequences of Current Account & Capital Account Surpluses (HL) • Surplus in current account may be used to have deficit in capital account – Increase foreign exchange reserves – Increase foreign assets abroad – Protectionism? • Surplus in current account may lead to currency appreciation – Cheap imports – lower inflation – a drop in exports

How Big Is a “Big” Current Account Deficit or Surplus? (HL) • Totals might be misleading • Look at percent of GDP • Burden of deficit depends on ability to repay

Methods of Correcting a Persistent Current Account Deficit (HL) • Expenditure-switching policies – switch expenditures of domestic consumers away from imports • Expenditure-reducing policies – Policies that reduce overall expenditure in economy – AD shifts to the left

Expenditure-Switching Policies • Government policies to depreciate or devalue the currency – Exports become less expensive – Imports become more expensive – Effectiveness depends on how responsive those are • Protectionist measures – Restrict imports through embargoes, quotas, VER’s, administrative, health and safety standards and other barriers to trade, including tariffs – May lead to retaliation – Could create inefficiency in domestic industries

Expenditure-Reducing Policies • Deflationary fiscal policies – unpopular • Deflationary monetary policies – Unpopular • Reduce consumption – In part, reduce imports – Improves current account deficit – Effective depending on MPM • Deflating economy -> – fall in employment – Drop in economic growth

Long-Term Solution • Export-promoting policies – Trade missions – Advertizing campaigns

The Marshall-Lerner Condition (HL) • If currency is devalued or depreciated –X –M – Improvement in current account • Depends on PED for X & M • PEDX + PEDM > 1 • Determinants of PED – time period

The J-Curve (HL) • When currency drops in value: – In short-run - PEDX + PEDM < 1 • Current account deficit – In long-run - PEDX + PEDM > 1 • Current account deficit

The J-Curve

Why Is There a J-Curve Effect? • Information is not perfect – Over time, other countries learn of lower prices • Contracts with suppliers – Existing contracts maintain status quo – Takes time to identify new suppliers

Questions & Answers

Summary • • The balance of payments account The current account The capital account The consequences of current account and capital account imbalances How big is a “big” current account deficit or surplus? Methods of correcting a persistent current account deficit The Marshall-Lerner condition The J-curve

Source: Economics by Jocelyn Blink & Ian Dorton More Resources: For current Economics issues related to our course, please visit: https: //twitter. com/Matt. Botcheff/