Australian National University. Graduate Diploma Macroeconomics Econ Rod Tyers. 5: The Balance of Payments
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1 Australian National University Graduate Diploma Macroeconomics Econ 8026 Rod Tyers 5: The Balance of Payments Components of the current account Components of the capital account The home economy and the balance of payments External balance and the twin deficits 1
2 THE BALANCE OF PAYMENTS Incorporates all transactions between domestic residents and foreigners. The direction, or sign, of entries in the balance is determined by the direction of the associated flow of payments (inflows of payments are positive): Current account, CA: Export Import Capital account, KA Sale of an asset (property, or block of shares) to a foreigner Purchase of a foreign asset Sum of all net inflows Outflow of a good or service Inflow of payment Positive entry Inflow of a good or service Outflow of payment Negative entry Outflow of ownership claim Inflow of payment Positive entry Inflow of ownership claim Outflow of payment Negative entry Zero 2
3 Components of the current account: Net inflow of payments associated with current exchanges of goods and services Need to generalise our definition of services to include both factor and non-factor services. Non-factor services: Outputs from a production process: o transport, communication, tourism, entertainment, law enforcement and defence, as well as personal services such as health and hairdressing Factor services: Use by one party of primary factors owned by another. 3
4 Exports of factor services: Exports of labour services - Australian workers earn wages abroad and repatriate them Inflow on the net income component of the current account. Exports of capital services - Australians buy foreign property or other assets (such as bonds) this flow appears as an outflow on the capital account, KA, because it is in exchange for an asset BUT, subsequently, the Australian lenders or investors are exporting the services of the funds ( capital ) they own their compensation for this export is recurrent interest payments or dividends - an annual inflow on N, the net income component of the current account, CA. 4
5 Components of the current account, CA: Named current because it includes payments associated with the current production and consumption of goods and services (as distinct from flows of claims on assets that might contribute to future production or consumption). ( X M ) : + Exports of goods and non-factor services. - Imports of goods and non-factor services. [ The sum of these alone is called the balance on goods and non-factor services trade.] ( ) N : + Exports of factor services Remitted wages of Australians abroad Profits of Australian firms abroad remitted to Australia Dividends paid by foreign firms to Australian share holders Debt service paid to Australians by foreign borrowers 5
6 - Imports of factor services Wages remitted to home countries by foreign workers in Australia Profits of foreign firms operating in Australia remitted abroad Dividends paid to foreign owners of shares in Australian firms Debt service paid by Australian borrowers to foreign lenders + Inflow of gifts and other unrequited transfers Vaguely, this could be thought of as payments in return for the export of Australian good will - Outflow of gifts and other unrequited transfers Import of foreign good will [The sum of these two and net factor services is called the net income sub-account, N.] 6
7 Components of the capital account: These are payments in return for claims on assets, where ownership of those assets does not move between countries. They can be summarised as: + Sale of a previously Australian-owned property (situated either at home or abroad) to foreigners. - Acquisition by Australians of property (situated either at home or abroad) previously foreign-owned. + New borrowing by Australians from foreign lenders. Note that this is an inflow of principal. Debt service payments associated with this borrowing appear in later periods as outflows on the current account. - New borrowing by foreigners from Australian lenders. This is an outflow of principal. Again, debt service payments associated with this borrowing appear in later periods as inflows on the current account. 7
8 + Sale by Australians of financial assets (paper claims such as stocks and bonds) to foreigners. If originally issued by Australian firms or institutions, as with more explicit borrowing, these transactions will result in future outflows of dividends (stocks) or interest payments (bonds), which will appear as negative entries on the current account. - Acquisition by Australians of financial assets (paper claims such as stocks and bonds) from foreigners. If originally issued by foreign firms or institutions, as with more explicit borrowing, these transactions will result in future inflows of dividends (stocks) or interest payments (bonds), which will appear as positive entries on the current account. 8
9 The balance of payments always nets to zero. Its two components need not balance individually: BOP = CA + KA = 0 Implications: Recall that and Y = C + I + G + X - M A = C + I + G So that: Y A = X - M Add the net inflow of factor payments ( net income component of the CA) to both sides: Y + N A = N + X M Or A = (N) + (X M) = CA GNP Domestic absorption = the current account 9
10 A = (N) + (X M) = CA Net income component of CA Trade balance component of CA Note that positive entries on the balance of payments indicate net inflows. We define N as a net inflow so it carries a (+). For Australia, and most economies (exceptions include the oil producers and Japan), the value of domestic assets owned by foreigners is greater than that of foreign assets owned by domestic residents. So N<0. The full balance of payments (BOP): BOP =KA + CA = 0 Net inflows of payments Net inflows of payments on the capital account on the current account 10
11 The net inflows on the capital account are for asset acquisition and they include such acquisition by both the private sector and central banks. KA = S NF - R Net foreign saving Where (Private) Net accumulation of official foreign reserves (Public) S NF, or net foreign saving, is the inflow of payments for the acquisition of Australian assets (instruments of saving) by foreigners net of the outflow of payments for the acquisition of foreign assets by Australian residents. R, or the change in official foreign reserves, is defined as an outflow. It is the outflow of payments (A$) for the acquisition of foreign assets by the Australian central bank net of the inflow of payments associated with the sale of foreign assets by the Australian central bank and the purchase by it of A$. 11
12 The full balance of payments (BOP) is then: BOP =KA + CA = 0 BOP = [S NF - R] + [N + (X M)] = 0 KA: net asset acquisition inflows: net foreign (private) saving increase in foreign reserves CA: net inflows associated with current purchases of factor services purchases of goods and non-factor services Factor services: Factor service exports: foreign earnings of factors owned by domestic households. Repatriated income from work overseas Dividends on stocks held abroad Interest payments on loans abroad Factor service imports: domestic earnings of factors owned by foreign households. 12
13 The home economy and the balance of payments We have already seen that net inflow on the current account is related to GNP and domestic absorption: A = (N) + (X M) = CA And the disposal of GNP is: So = C + T + S A = (C + T + S) (C + I + G) A = (T G) + S I (1) If we think of the government surplus, (T G), as government saving, then S G = T G. Then, total domestic saving in the economy is S D = (T G) + S = S G + S It is the sum of domestic public and private saving. This gives us something useful from (1): A = S D I (1) 13
14 Finally, since: and BOP = 0 = KA + CA A = CA, we can write: or A = S D I = CA = -KA A = S D I = (N) + (X M) = -[S NF - R] Any current account surplus (capital account deficit) is a surplus of: GNP over domestic absorption domestic saving over investment 14
15 From this we can also see that: or S D I = -S NF + R S D + S NF R = I This is the open economy version of the closed economy no-government identity that S = I. Here domestic investment is financed from domestic saving and net saving by foreigners in the home economy. The total is reduced by the central bank s saving abroad in the form of any increase in official foreign reserves. 15
16 External balance and the twin deficits : Expenditures on GDP: Y = C H + I + G + X Since consumption of home goods, C H = C M, this expands to: Y = C + I + G + X M. This expenditure then finances some net reward to foreigners for their factor services (-N) and the remainder is used by households to pay tax, consume and save: Y = -N + C + T + S. If we equate these, we have that: or that I + G + X - M = - N + T + S G + I + X = - N + T + S + M. Or that total injections (G+I+X) must equal total withdrawals (-N+T+S+M) in the circular flow. This can be rearranged to obtain, as before: N + X - M = CA = ( T - G ) + ( S - I ) = S D - I 16
17 This time, however, we can focus on: This says: CA = ( T G ) + ( S I ). a current account surplus must be the sum of govt saving or the fiscal surplus, (T-G) net saving by the private sector, (S-I). So any current account deficit must be identically equal to the sum of the government deficit and the deficit of private saving relative to investment. It was once imagined that private saving and investment were be stable through time, yielding a direct correspondence between trade deficits and fiscal deficits; hence the twin deficits. This is rarely true any more, since investment in one economy can readily be financed by private saving in others. 17
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