A system of accounts that measures transactions of goods, services, income and

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Coral McCormick
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1 LECTURE Sept. 15th Hamza Ali Malik Econ 3114: International Finance Fall 2005 The Balance of Payments (BoP) A system of accounts that measures transactions of oods, services, income and financial assets between domestic residents, businesses and overnments and the rest of the world durin a specific time period. Current Account (CA) measures the flow of oods, services, investment income and transfers / ifts between domestic residents, businesses and overnments and the rest of the world. Capital Account (FA) A tabulation of the flows of financial assets between domestic private residents and forein private residents. Official Settlements Balance (OSB) tabulates transactions of reserve assets (old, SDRs, forein currency holdins and reserve position in the IMF) by official overnment aencies. Used for intervention in the FOREX market so as to influence the ER. 1

2 Balance of payments accounts 1 Exports of oods and services (+) Merchandise Services Travel, insurance, bankin etc. Income from assets held abroad: interest, dividends etc. 2 Imports of oods and services (-) Merchandise Services Travel, insurance, bankin etc. Forein investors' income from assets in the reportin country: interest, dividends etc. 3 Unilateral transfers ((-) = net outflow) 4 Current account (= ) 5 Private assets abroad, net (increase = capital outflow (-)) Direct investment Portfolio investment 2

3 6 Private forein assets in reportin country, net (increase = capital inflow (+)) Direct investment Portfolio investment 7 Capital account (= 5 + 6) 8 Chane in forein exchane reserves (4 + 7, increase = (-)) 9 Statistical discrepancy (+ or -) 10 Allocation of special drawin rihts (+) At any point in time, the BoP must balance, i.e. the sum of debit and credit items is zero. CA + FA + OSB = 0 or CA = KA (where FA + OSB = KA) Thus, a CA deficit is financed by a positive KA, i.e. by capital inflow. A net debtor nation is one whose stock of forein financial assets held by domestic residents is less than the stock of domestic financial assets held by forein residents. 3

4 Further Analysis: CA + FA = OSB If the LHS is neative (positive) (implyin that there is an excess supply of domestic currency), then OSB will have to be positive (neative) the central bank finances the deficit by sellin FOREX. Note that, quite confusinly, a reduction (increase) in FOREX reserves show-up as a positive (neative) OSB. BoP Equilibrium and Adjustment C$./US$ S A A S C D Qty of US $ s If ER is flexible, o to C. Note: Exports earn FOREX (S-curve); Imports involve outflow of FOREX (D-curve). 4

5 Money Accountin An important aspect of the CA is that it indicates the rate at which the economy in the areate is addin to its net external assets. In terms of BoP concepts, CA surplus equals the increase in net OSB plus the rate of private capital outflow. CA = NFA (1) The BoP and the Monetary Base Balance Sheet of the Central Bank Assets Liabilities NFA DC H where NFA stands for net forein assets and DC stands for domestic credit. S Domestic M is determined as: M S = hh where h is money multiplier. If assume h = 1 M = H. Usin the balance sheet identity: NFA cb + DC = M 5

6 or NFA cb + DC = M or NFA cb = M DC (2) Thus, usin equation (1) and (2) we can see that to avoid a current account deficit, DC creation has to be held in line with the rowth in M. 2 points: i) Can understand the BoP stabilization prorams conducted by the IMF. To make the proram work, the IMF imposes domestic credit ceilin that will ensure that the central bank does not distort the CA tarets by excessive financin of overnment deficits or by loans to the domestic bankin system. ii) If the central bank intervenes in the FOREX market by buyin or sellin FOREX (to keep ER fixed), there will be a chane in the NFA position and a correspondin chane in M. Thus, FOREX chanes automatically chane the stock of M (and an automatic adjustment process for the external balance). In S deficit countries the M will be contractin, while in surplus countries it expands. 6

7 The CA, Credit Creation and Deficit Finance First, we write the consolidated bankin system s (commercial banks and central bank combined) identity: NFA b = M DC (3) Can write DC as: nb DC = DC + DC (4) nb where DC is credit to overnment and DC is credit to non-bank public. Assumin that the overnment s budet deficit is financed by overnment borrowin form the bankin system or abroad, we have G T = DC NFA (5) Usin (3), (4), (5) NFA b = nb ( M DC ) + ( T G NFA ) Decrease in the bankin system s net external asset position have as their counterpart either an increase in credit to the public in excess of a rise in money or a budet deficit that is financed by the domestic bankin system. 7

Numerical problem. Balance of Payment

Numerical problem. Balance of Payment Numerical problem Balance of Payment Here are some balance of payments data (without pluses and minuses): Merchandise exports, 100 Merchandise imports, 125 Tourism exports, 90 Insurance imports, 80 Income