EC 245 – International Financial

Institutions and Policy

Lecture 1
This lecture
 About this course
 The purpose of the international monetary system
 Understanding the balance of payments

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How this course is organized
 There are 10 regular lecture meetings in the spring term
(plus a revision session in the summer term)
 Each lecture will be 1 hour 40 minutes, starting at 9:10
 Course materials can be found on ORB, including all the
slides you will see in lectures, plus many of the course
readings (although not material from books)
 The main course books can be found in the
library/bookshop/Amazon etc.

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How the course is assessed
 There is a 2 hour exam in the summer term worth 50%
of the module grade (subject to the ‘max rule’)
 You get to choose 2 questions from 5 in the exam
 Past exam questions may be found online.
 There is a term paper of up to 3,000 words, due by Friday
16 January, 2015 at noon
 Term papers are worth 50% of your module grade
(subject to the ‘max rule’)
 Term paper titles are available through ORB
 Full details of assessment can be found in the
undergraduate handbook
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What you need to do
 Be engaged with the module!
 Use the reading list: it’s there to help you with your
term paper and exam preparation
 Come prepared: Keep up with the reading materials
suggested for each lecture
 If you have any practical problems, let someone know as
soon as possible. We’ll do our best to straighten things
out.

It's important for me to know what you

are thinking, so give me feedback
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Purpose of the International Monetary
System, and main actors

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What is the international monetary system?
It has lots of parts...
 Central banks – e.g. the European Central Bank
 International institutions – e.g. the IMF
 Sovereign wealth managers – e.g. Norway’s Government
Pension Fund, the Quatar Investment Authority
 Private banks – e.g. Barclays
 Private wealth managers – e.g. Fidelity

...and evolves in response to changing circumstances...

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What is the international monetary system?

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What is the international monetary system?
The international monetary system supports trade and
economic welfare because it:
 Enables payments for goods and services to flow across
national borders
 Enables people in one country to invest in the assets of
another country
 Enables people in one country to borrow from people in
another country

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What is the international monetary system?
A core purpose of economics is to study the transfer
resources over time, place and states of the world.

But: if we had fully flexible exchange rates to determine the

relative value of currencies in competitive markets, would
there be anything left to discuss?

The IMS is a system of ‘rules of the game’ for how

international capital flows should be managed.

But: why do we need ‘rules of the game’?

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Why do we need an international monetary
system?
A realist view:
It is a fact that there are institutions, they affect economic
performance.

Institutions embody ‘rules’, meaning formal (legal) and

informal (social norms). Economic performance and
institutions evolve together.

“[The arrangements of the IMS have most commonly] arisen spontaneously out of the
individual choices of countries constrained by the prior decisions of their neighbours
and, more generally, by the inheritance of history.”

- Barry Eichengreen [GC Ch. 2]

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Why do we need an international monetary
system?
The economist’s view:
 There are barriers to the operation of competitive
markets...
 ...which economists call ‘frictions’
 Frictions can lead to externalities (spillovers) that cannot
be internalized using a market mechanism
 Externalities mean the actions of one country acting
alone have unintended adverse effects on other countries
 Externalities can be overcome via cooperation and
coordination...
 ...in short, rules of the game

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What to expect from this course
 We’re going to spend a lot of time looking at where the
IMS has failed to achieve its objectives
 In particular, we’ll study some international financial
crises that have beset the system since 1973:
• Mexico, 1982
• East Asia, 1997-1998
• The global financial crisis, 2007-9
• The ongoing eurozone crisis, including Cyprus, 2013
 Our focus as economists is on financial crises for the
same reason that doctors study diseases: one learns
about the system by trying to understand where it goes
wrong
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The national accounts and the balance of
payments

Main reading: Any international macro book, e.g. Krugman and Obstfeld
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The national accounts
Sources of income Uses of income (expenditure)
Personal consumption expenditure
Gross domestic income Gross private domestic investment
Government expenditure
Net exports (1)
Income payments from foreigners (2) Income payments to foreigners (3)
Net unilateral transfers (4)
Gross National Income Gross National Product (GNP)

Notes:
By definition Gross National Income is identically equal to Gross National Product
The balance on the current account is (1) + (2) – (3) – (4)
Gross Domestic Product (GDP) = GNP – (2) + (3) + (4)

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The national accounts
We can write the relationships in the table as equations.
Gross Domestic Product (GDP) is:
𝐺𝐷𝑃𝑡 = 𝐶𝑡 + 𝐼𝑡 + 𝐺𝑡 + 𝑁𝑋𝑡
where 𝑁𝑋𝑡 is net exports (exports less imports).
Gross National Product (GNP) is:
𝐺𝑁𝑃𝑡 = 𝐶𝑡 + 𝐼𝑡 + 𝐺𝑡 + 𝑁𝑋𝑡 + 𝑁𝐼𝑁𝑉𝑡 + 𝑁𝑈𝑇𝑡
where 𝑁𝐼𝑁𝑉𝑡 is net investment income from abroad and
𝑁𝑈𝑇𝑡 is net unrequited income, i.e. net unilateral transfers.
GDP is measured on a geographic or residency basis.
GNP is measured on a nationality basis.
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The balance of payments account
 Record transactions between domestic and foreign residents
over a period of time (a year, a quarter)
 Transactions are grouped into
 Those related to the production of goods and services, the
generation of income, and transfers (the current account)
 Those related to transactions in financial assets and liabilities (the
capital/financial account)
 Every international transaction generates two matching credit
and debits in the account (double entry accounting)
 Credits are receipts from foreigners (and generate demand for the
domestic currency)
 Debits are payments to foreigners (and generate supply of the
domestic currency)

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The current account
 Measures transactions in goods, services, income and
transfers between domestic residents and non-residents
 Transactions relate to current income and production
 Goods – tangible commodities
 Services – intangible commodities
 Income – returns to capital and labour
 Transfers – donations etc.
 In terms of equations, the current account (CA) is:
𝐶𝐴𝑡 = 𝑁𝑋𝑡 + 𝑁𝐼𝑁𝑉𝑡 + 𝑁𝑈𝑇𝑡
i.e. is made up of the three components of GNI related to foreign
transactions (rather than domestic consumption, investment or
government spending)
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The ‘capital’ or ‘financial’ account
 Measures transactions in financial assets and liabilities
between residents and non-residents
 Capital refers to international currency or generally
international financial claims
 Domestically-owned assets abroad
 Split into official reserve assets; other official assets; private
assets
 Foreign-owned assets in the home country
 Split into official and private owners

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The ‘capital’ or ‘financial’ account

Two different terms – ‘capital account’ and ‘financial

account’ – are sometimes used to mean the same thing.
In the US data, the term ‘capital account’ refers to
transactions in the stock of non-produced non-financial
assets (such as mineral rights or copyrights) which are
quantitatively unimportant.
For these lectures, we will follow common practice and use
the term ‘capital account’ to refer to cross-border flows of
financial assets (e.g. Lecture 6).

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Net Foreign Assets
 A country’s net foreign asset position is:

net foreign assets (NFA)

=
value of home country claims on foreigners
˗
value of foreigners’ claims on home country

 Claims on foreigners are home country assets

 Foreigners’ claims are home country liabilities
 Could take the form of stocks, bonds, derivatives, bank
deposits, real estate, etc.
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Net Foreign Assets
 If the current account is in surplus, foreigners are
making net payments to us
 We are exporting more than we are importing
 We have other positive net income flows
 What happens to the money?
 It is foreign currency
 By definition we are not spending it on imports
Our net foreign assets are growing.
 The opposite is true if the current account is in deficit.

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Net Foreign Assets
 Paying off a debt (a claim held by foreigners on us) has
the same effect on NFA as acquiring an asset.
 Build up debt has the same effect on NFS as selling assets
(claims we hold on foreigners).

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The balance of payments
 The fundamental balance of payments identity states that:

balance on the current account

+
balance on the capital account
=
zero
(up to a statistical discrepancy)

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The balance of payments
 Why does the balance of payments identity hold?
 Every dollar (say) that enters the UK as payment for
something – an exported good, the dividend on a share –
must leave the country again, either by buying an import,
or by purchasing a foreign asset:
 Suppose you get physical cash, and keep it. That is a loan to the
US government, i.e. a claim on the US.
 Suppose you get paid to your US bank account. You have
acquired a foreign asset, i.e. the deposit you hold in the US.
 Suppose you get paid to your UK bank account. Then your
bank holds a claim on a US bank, so the UK has again acquired
a foreign asset.

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The balance of payments
 NFA rises → home country acquires foreign assets with
international currency: a capital outflow
 NFA falls → home country sells foreign assets for
international currency: a capital inflow
Hence net capital inflows are equal to minus the current
account, and the BoP identity holds.

 An equation links the current account and the change in

net foreign assets:
𝐶𝐴𝑡 = 𝑁𝐹𝐴𝑡 − 𝑁𝐹𝐴𝑡−1
ignoring valuation changes.
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The balance of payments
 The term balance of payments is commonly used to mean the
surplus or deficit which must be financed by changes in official
reserves:

balance on the current account

+
balance on the capital account excluding official
reserves
+
statistical discrepancy
=
balance of payments

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Key point
 A current account deficit entails a capital account surplus
 Capital is being ‘imported’, i.e. claims on residents held by
foreigners are increasing…
 A current account surplus entails a capital account deficit
 Capital is being ‘exported’, i.e. claims on foreigners held by
residents are increasing
 I remember this by saying:
“If you’re exporting goods, you’re exporting capital (and vice
versa)”

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The balance of payments account
United States, 2009 ($m, *totals rounded)
Current Account Credits (+) Debits (-)
Exports of goods and services 1,570,797
Income receipts 588,203
Imports of goods and services -1,945,705
Income payments -466,783
Unilateral current transfers -124,943
Balance on current account -378,432*
Capital/Financial Account Credits (+) Debits (-)
US-Owned assets abroad (increase -/decrease +) -140,465
(of which) US official reserve assets -52,256
Foreign-owned assets in the US (increase +/decrease -) 305,736
(of which) Foreign official reserve assets 450,030
Financial derivatives, net 50,804
Balance on capital account 216,075
Statistical discrepancy/other 162,357
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Question
 What was the balance of payments surplus (deficit) of the
United States in 2009?

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Practice questions
In each case, explain how the transactions listed give rise to a credit and a debit in the home
(underlined) country balance of payments account:

a) An American buys a share of German stock, paying by writing a check on a Swiss bank.

b) An American buys a share of German stock, paying the seller with a check on a US bank.

c) The European Central Bank (ECB) carries out an official foreign exchange intervention in
which it uses dollars held in an American bank to buy euros from domestic (i.e. euro zone)
residents.

d) A tourist from Colchester, UK buys a meal at an expensive restaurant in Paris, paying with
a debit card from his UK bank account.

e) A US-owned factory in the UK uses local earnings to buy additional machinery.

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