CHAPTER 14.

4
THE BALANCE OF PAYMENTS

INTRODUCING THE BALANCE OF PAYMENTS

The role of the balance of payments

01 Innumerable transactions between residents of different countries involve activities like importing -1 exporting travel , investments in stocks ,

+ bonds, investments by multinational corporations , buying property sending / receiving gifts

, , -1 in general , anything that gives rise to a flow

of money across international boundaries

01 All these transactions are recorded in the balance of payments

-
the balance of payments of a country is a record lusyally a year ) Of all transactions between the residents of the country + the

residents of all other countries

-
its role is to show all payments received from other countries , called credits ,
+ all payments made to other countries , called debits
-
in the course of a year , all inflows of payments loved its ) must exactly equal the outflows of payments / debits ) ; the sum of all

credits is equal to the sum of all debits

01 Why do countries record all their foreign transactions ; why do keep records of all possible inflows -1 Outflows of money ?

-
no attempt is ever made to record all money flows within countries

the reason is that when money flows into / Out of a country , it involves the exchange of different national currencies
- -

→ these currency exchanges are an important part of understanding the balance of understanding the balance of payments

Relating the demand + supply of a currency to the balance of payments

0 ) consider the balance of payments accounts of Bop land , whose national currency is the bone
-
all the inflows of money from abroad into Bop land / all credits , can only be made if foreigners buy bop lies

→ therefore , credits represent a foreign demand for bones , corresponding to a foreign supply of all Other currencies given up to buy

bones

outflows of money from Bop land other countries / debits , represent Bop lander supply of bop IPs , corresponding Dopier demand for
-
to a to

foreign currencies

01 In the balance payments accounts of a country all credits ( inflows of money into the country ) create a foreign demand for the country 's
,

currency it all debits 1outflows Of money from the country / create a supply of the domestic currency

THE STRUCTURE OF THE BALANCE current account

OF PAYMENTS 1 . Exports of goods +40

01 Table 14.2 :B Upland 's balance of payments for 2010 2 .

Imports of goods -65

-
consists of 3 accounts : current account, capital Balance of trade in goods / items 7+21 -25

account , + financial account 3 .

Exports / services -125

'

Imports of services
'
t : credits Inn only inflows ) 4 -15
-
.

- '
-
'
: debits 1money outflows ) Balance of trade in services 1 items 3+41 +10

The current account Balance of trade in goods 1- services litem 7+2-131-4 ) -

15

01 Balance of trade in goods 5 . Income 1 inflows minus outflows ) -6

-
items 7-12 in Table 14.2 show the value of 6 . Current transfers /secondary income ) ( inflows Outflows ) -
-11

exports + the value of imports of goods Balance on current account -20

respectively capital account

→ exports : the sale of goods to other countries, 7 . On pitot transfers / inflows minus outflows ) -10.7

for which payment is received in bop Ies ; 8 . Transactions in -

produced , non -

financial assets 1 inflows Outflows )

-

to } .

credit capital account / items 7+81

'
exports are a + have a 't sign Balance on -11

→ imports the purchase of goods from other

: Financial account

countries , for which payment is made in 9 .

Direct investment / inflows -
outflows ) -123

foreign currencies 1generating a supply of 10 .

portfolio investment tint lows Outflows ) -
-4

bones ) ; imports are a debit + have a

' -
'
sign it .
Reserve assets loffioiql reserves I +1

-
the balance of trade in goods is calculated by Balance on financial account /items 94101-11 ) +20

subtracting imports from exports litem it item 2) 12 .

Errors + omissions -1

→ 40-65=-25 billion tuples Balance / SUM Of all items . I -12 ) 0

↳ negative balance of trade in goods/deficit Table 14.2 Balance of payments of Bop land / 20101in billions of bop test
 -
a deficit in an account occurs whenever a balance has a negative value, meaning that debits > credits 1there's an excess of debits)

01 Balance of trade in services

items 31-4 are analogous to items 1+2 , only they involve the value of exports + value of imports of services

-
services include a variety of activities , such as insurance tourism , transportation , -1 consulting ,

-
when foreigners visit Bop land as tourists Bop land is exporting tourism services ; similarly , when foreigners buy insurance from Bo plunder
.

companies this represents exports of insurance services

,

-
when Bo plunders visit other countries as tourists / buy insurance from other countries , they're importing tourism +
insurance services

-
Table 14.2 : Bop land is exports of services > imports of services

→ balance of trade in services / items 3-141=-110 million bop les

→
Bop land has a surplus in its balance of trade in services

-
a surplus in an account occurs whenever a balance has a positive value, meaning that credits > debits 1 there is an excess of credits )

01 Balance Of trade in goods + services

-
sum of all items 7- 4

'
-
often referred to as the
'
trade balance 'll balance of trade ,
+ includes the value of all exports minus the value of all imports thot

exports , ✗ M)
-

-
BOP land has a negative trade bald hop 1-15 Million Dopiest

01 Income

-
item 5 / income refers to all inflows into Bopland of wages , rents , interest , -1 profits from abroad minus , all outflows of wages , rents interest
, ,

+ profits
-
Bo plunders may earn income abroad , such as from wages if they work outside Bopland + send their wages home / it they own rental

property abroad that earns rental income / have bank accounts abroad that earn interest / if they own stocks in another country that

earn dividend income /if they own a subsidiary of a multinational Corporation that earns profits
-
credit : whatever income flows into Bopland from abroad
-
debit : whatever income flows out Of Bop land

-
in Bop land , income outflows > income inflows , leading to a value of -6 billion bop IPs for income

01 current transfers

-
item 6 / current transfers : inflows into Bop land due to transfers from abroad like gifts / foreign aid + pensions minus outflows of such ,

transfers to other countries

-
this item is positive 1+1 billion bop 1051 indicating , that credits > debits , as Bop land receives more transfers from abroad than it makes to

other countries

01 Balance on current account

-
sum of all items in current account 1 items 1- 6)

-
Bop land has a deficit on its current account of -20 billion bop 1ps ; the debits 1 Outflows) are larger than the credits 1 inflows ) by this amount

→ from the pov of supply + demand of bop 1ps , the deficit on this account means there's an excess supply of the currency in the forex

market : the quantity of bones supplied / debits created by Bo plunders ) > the quantity Of boples demanded loved its created by foreigners )

↳ Qd Of bop 1ps to make the credits possible is equal to the sum of All the credits 1-140-125-17=-166 billion bop/ PS )

↳ Qs of bones to make the debits possible is 09491 to the sum of all the debits 1-65-16-6=-86 )

↳ adding the credits to the debits we have -166-86=-20 billion bop IPs which is excess supply of bones /the deficit on the current
,

account

- in general , the trade balance I balance of trade in goods -1 services) is the most important part of the current account in most

countries

→
therefore , a deficit on the current account is usually due to an excess of imports of goods over exports , whereas a surplus on

the current account is usually due to an excess of exports of goods over imports
-
the current account of the balance of payments is the sum of : Ii ) the balance of trade in goods ; Iii ) the balance of trade in services ;

liii ) income inflows minus outflows ; -11in current transfer inflows minus outflows

→
the most important part in most countries is the balance of trade in goods + services lit in

The capital account

01 Consists of 2 items :

in item 7 , capital transfers include inflows minus outflows for such things as debt forgiveness 1 when debt is cancelled ) non life
-
- -
,

insurance claims + investment grants 1 money given as a gift by 90h5 to finance physical capital )
 -
in item 8. transactions in non -
produced , non -
financial assets , consist mainly of the purchase / use of natural resources that haven't

been produced hand mineral rights forestry rights , water fishing rights airspace
, , , ,
+ electromagnetic spectrum )

→ includes all inflows of funds into BOP land loved its / minus outflows of funds from Bopldnd 1 debits 1 due to such transactions

01 The sum of items 7-18 gives the balance on capital account, in which Bop land has a surplus of -11 billion bones meaning that
, the credits

1 Payment inflows ) > the debits / Payment outflows )

-
Qd Of bop IPs > Qs of bop les
-
a surplus on an account indicates there's an excess demand of the currency in the forex market

01 In general , the capital account is relatively unimportant in terms of site compared to the other 2 accounts

01 The capital account of the balance of payments of a country is composed of inflows minus outflows of funds for capital transfers -1

transactions in non produced non financial assets

- -
,

-
relatively small compared to the current account 1- financial account

The financial account

consists of 3 items :

01 Direct investment

-
item 9 deals w/ direct investment / FDI

-
includes investments in physical odpitdl such as in buildings , 1- factories usually undertaken by multinational corporations
,

-
the figure for this item includes inflows due to FDI in Borland loved its ) minus outflows due to Bop lander investment abroad 1 debits I

→ Bop land accepted more FDI than it made in other countries , by the amount of 23 billion bop lies

01 Portfolio investment
-
item 10 , portfolio investment , shows financial investments / stocks -1 bonds )

-
in Bop land inflows loved its )
, for the purchase of stocks -1 bonds ( outflows Idp bits ) for the same purpose

→ by -4 billion bop IPs

-
inflows of funds into Bop land due to borrowing by the Bop lander govt from foreign lenders appear as orpd its

→ similarly BOP lander loans to foreign govt lead to an outflow of funds from Bop land appearing as debits
,

→ the reason is that when a govt borrows it issues bonds that're purchased by the lenders

↳ from the Pov of the lenders to BOP land , the purchase of Bo plunder govt bonds by foreigners represents financial investments in

BOP land

↳ similarly , Bop lander tending to other countries represents financial investments abroad

→ the distinction between inflows / outflows of funds due to the purchase of assets , -1 inflows / outflows of funds due to income generated

by the purchase of assets

↳ if a multinational Corporation decides to invest in Bop land by purchasing physical capital , the result is an inflow of funds

into Bopland , appearing as a credit in Bop land 's financial account

↳
if the owners of the multinational Corporation decide to take their profits out of Bop land + book to the home country , there's an

outflow of funds from Bop land , appearing as a debit in BOP land 's current account

01 Reserve assets

-
item in reserve assets / official reserves, refers to foreign currency reserves that the central bank can buy / sell to influence the value of

the country 's currency

suppose the central Bank of Bop land holds reserves of USD

→ if it sells USD , it does so by buying bones

→ this is an inflow of bop IPs, appearing as a credit in the financial account

→
Table 14.2 Shows the central Bank to have bought 1 billion bop IPs , appearing w/ a plus sign / a credit)

→
if the central bank had sold bones by buying us D. this would be an outflow of bones + would appear as a debit in the financial

account

01 The financial account of the balance of payments consists of inflows minus outflows of funds for lil direct investment , Iii ) Portfolio

investment , -1 liii) reserve assets

01 Balance on financial account

-
the balance on financial account, given by the sum of items 9,10 , -111 , shows a surplus of 20 billion bones 1 the credits are more than the debits )

-
therefore, there's an excess demand of 20 billion bones in the forex market for this account
Errors + omissions

ol Irl , it's extremely difficult lit at all possible ) to record every single transaction between a country -1 all other countries , 4 some of those 90

unrecorded

01 However, since the sum of all bred its must equal the sum of all debits , it's necessary for actual accounts to include an item creating this

equality

-
this is the role of errors + omissions

01 If sum of credits > sum of debits , this includes a debit item to create the equality
01 If sum of debits > sum of credit , the statistical discrepancy consists of a credit

01 This is simply a statistical Arial that doesn't affect our analysis of the balance of payments
'

01 In the case of Bop land , not errors + omissions are -1 billion bop les la debit ) , making the sum of debits equal to the sum of credits

A clarification concerning the capital account + the financial account

01 Economists often use the term capital aooouht ' '

to refer to both the capital -1 financial accounts that appear in Table 14.2

01 However , since 1997 , countries around the world are increasingly using the classification system shown in table 14.2 in their balance of

payments

01 Th Prd fore, '

capital account
'
=
'
financial account 't the relatively unimportant loop ital account
'

THE RELATIONSHIPS BETWEEN THE ACCOUNTS

The meaning of 1
balance in the
'
balance of payments

01 In the balance of payments, the sum of all the items is always 0

-
this is another way of saying that the sum of all credits always balances w/ the sum of all debits

01 However, there's more to the idea of balance

-
in Bop land 's case , the deficit in the current account of -20 billion bop 1ps is exactly matched by the surplus in the combined capital 4 financial

accounts (together w/ errors + omissions ) : -17+20-1=-120 billion bop 1ps

-
the excess supply of bones in the current account , which is in deficit, is exactly matched by an excess demand for bones in the remaining 2

accounts terrors + omissions ) which altogether are in surplus

01 The current account balance is matched by the sum Of the capital account balance + the financial account balance / terrors -1 emissions )

- a current account deficit is matched by a surplus in the other 3 items combined

-
a current account surplus is matched by a deficit in the other 3 items combined

-
more simply, current account + Kapital account + financial account 1- errors -1 Omissions ) :O

→ therefore, current account = Kapital account -1 financial account terrors + omissions )

-

why the current account 1- financial account are interdependent

01 When a country trades w/ other countries its , imports of goods + services

are unlikely to be equal to its exports 1dL W/ a trade deficit , country consumes outside its PPO

o) If imports > exports it has a deficit in its trade balance , + since this is food A
%
.

the most important component of the current account , it's also likely

to have a current account deficit

-
Fig 14.61dL : the country's PPC defines the Max it can
.
produce but the
,

country is attaining a point outside its PPO , such as point 0 , bo it 's

importing more than it 's exporting

→
achieving a point outside the PPG by means of a trade deficit is ← PPO
O
u
different from achieving such a point by specialization + trade Good B

according to comparative /absolute advantage Ib ) W/ a trade surplus country consumes inside its PPC
,

→ the theory of comparative advantage presupposes that imports -1 Good A

exports balance each other , so there's no trade deficit / trade

surplus :D point outside the Ppo is achieved bo Of an increase in

all ooati v0 efficiency it is beneficial for trading partners

→
by contrast, being outside the PPG by means of a trade deficit D
•

may have positive / negative consequences for the economy ,

PPO
deporting on a number of factors ✗
°
-
if there's a current account deficit, there must be a financial Good 13

account surplus 1the capital account being v small 11 Which

figure 14.6 using a ppo to illustrate a trade deficit -1 a trade surplus
 provides it w/ the foreign exchange it hoods to pay for the excess of imports over exports

→ the surplus on the financial account may arise from investments in physical /financial capital by foreigners including loans from ,

foreigners
→ it follows, then that a , deficit in the current account is matched by a surplus in the financial account lulong w/ the unimportant

Gap ital account)

0) if the economy 's exports > imports , it has a surplus in its current account , meaning it 's buying from foreigners less than what it sells to them

-
Fig 14.6lb ) : while it's producing somewhere on the ppo.it 's consuming less , so the output available for domestic consumption is at a point

inside its Ppo , such as D

-
the difference between what it consumes -1 What it produces is the excess of exports over imports

- when there's a surplus on the current account , the country is accumulating forex ( as it earns more forex from exports than it pays

out to buy imports) , which it can use to buy assets abroad Idi root / portfolio investments , including loans to other countries )
→
it follows then , that
,
a surplus in the current account is matched by a deficit in the financial account

→ more realistically , in terms of the 3 accounts in Table 14.2 , the spending of forex that 's over + above receipts of forex in the current

account , leading to a deficit in this account must be somehow paid for , + that can only happen through a surplus in the financial

capital accounts

↳ it , on the other hand , spending is less than receipts in the current account , there 'll be forex left over to be used for investments

+ lending abroad

01 Most economists believe that the surplus /deficit of a financial account of a country is the result of what's happening in the current account
-
if there's a deficit in the current account , the financial account is a
reflection of the need to finance that deficit

if there's a surplus in the current account , the financial account reflects investments in foreign countries undertaken to dispose of the

extra foreign exchange

01 A current account deficit means a country consumes more than it produces ; + it pays for extra output consumed through a financial

account surplus

01 A current account surplus means a country consumes less than it produces, -1 part of the income generated from the sale of extra output

produced corresponds to a financial account deficit

The meaning of '

imbalance ' in the balance of payments

01 A balance of payments deficit : there's a deficit in the combined current capital ,

+ financial accounts / terrors -1 omissions) , excluding

central bank intervention

01 A balance of payments surplus : there's surplus in the combined 3 accounts It errors + omissions ) excluding central bank intervention
-

a ,

01 EX : BOP land has a balance of payments deficit :

-
current account deficit I -20 billion ) + capital account surplus 1-11 billion ) + financial account surplus excluding the control bank purchase

of 1 billion 1-119 billion / terrors to missions 1- 7 billion ) : -7 billion = balance of payments deficit

-
the reason for central bank intervention can be found in just this deficit

→
by buying up excess bones of 1 billion, the central bank creates a balance in the balance of payments

01 Such imbalances 1 deficits /surpluses) occur in virtually all countries all the time , but a "
balance " is always created in the sense that debits

are made to equal credits

-
there 're many ways to do this , which involve either reliance on market forces /on govt intervention

TEST YOUR UNDERSTANDING 147

1 .
The balance of payments of a country is a record lush ally a year ) Of all transactions between the residents of the country and the

residents of all Other countries Its role is to show all .

payments received from other countries , called credits and ,
all payments made to

other countries , called debits .

2. Ia ) In the balance payments accounts of a country all credits 1 inflows of money into the country ) create a foreign demand for the
,

country 's currency ; and all debits loutflows Of money from the country / create a supply of the domestic currency

Ibl FDI loved it ) , dividend payment / profit repatriation / debit)

3. lol ) the current account of the balance of payments is the sum of : Ii ) the balance of trade in goods ; Iii ) the balance of trade in services ;

Iii it income inflows minus outflows ; and 1in current transfer inflows minus outflows

Ib) The capital account of the balance of payments of a country is composed of inflows minus outflows of funds for capital transfers

and transactions in non produced non financial assets

- -
,

101 The financial account of the balance of payments consists of inflows minus outflows of funds for lil direct investment , Iii ) Portfolio

investment , and liii) reserve assets

4 .
It ensures that the sum of all bred its is equal to the sum of all dpb its

5. Ia ) A deficit in an account occurs whenever a balance has a negative value, meaning that debits > credits 1there's an excess of debits) ,

while a surplus in an account occurs whenever a balance has a positive value, meaning that credits > debits 1 there is an excess

of credits )

(b) A current account deficit means a country consumes more than it produces ; and it pays for extra output consumed through a

financial account surplus . A current account surplus means a country consumes less than it produces, and part of the income

generated from the sale of extra output produced corresponds to a financial account deficit

101 Most economists believe that the surplus /deficit of a financial account of a country is the result of what's happening in the current

account

6. 191 A trade surplus 00 ours when a country has an excess of exports over imports meaning , it is consuming less than it is producing .

I b) A trade deficit occurs when a country has an excess of imports over exports meaning it is consuming more than
. it is producing .

7 .
The current account balance is matched by the sum Of the capital account balance and the financial account balance / plus errors and

omissions Hence current account tloapital account

. , + financial account 1- errors and omissions ) :O , or current account = -
Kapital account

+ financial account -1 errors and omissions )

8. lol ) A
"
balance " is always created in the sense that debits are made to equal credits through market forces or central bank /

government intervention .

I b) A balance of payments deficit occurs when there's a deficit in the combined current capital , and financial accounts / pins errors ,

and omissions) , excluding central bank intervention A balance of payments surplus occurs when there's
. a surplus in the combined

3 accounts-1 plus errors and omissions ) , excluding central bank intervention

9. A current account deficit means a country consumes more than it produces ; and it pays for extra output consumed through a financial

account surplus A current account

.
surplus means a country consumes less than it produces, and part of the income generated from the

sale of extra output produced corresponds to a financial account deficit .