Chapter 9

1. Use the following information to answer the questions below. Assume that the capital account is
equal to 0.

Exports of goods and services 500

Primary income received 200
Secondary income received 300
Imports of goods and services 700
Primary income paid abroad 300
Secondary income paid 100
Net acquisition of financial assets 300
Net incurrence of liabilities 400
Net change in financial derivatives 600

a. What is the trade balance?

b. What is the current account balance?
c. Does the financial account equal the current account plus the capital account balance?
d. What is the statistical discrepancy?
Answers:
a. The “trade balance” is 700-600 = 100. Note that this is really the balance on goods and services,
not the merchandise trade balance.
b. The current account is 500  200 + 300  700  300 -100  100
c. The financial account is 300  -200
d. The statistical discrepancy is (–200  (-100))  –100

2. Look at each of the cases below from the point of view of the balance of payments for the United
States. Determine the subcategory of the current account or financial account that each transaction
would be classified in, and state whether it would enter as a credit or debit.
a. The U.S. government sells gold for dollars.
b. A migrant worker in California sends $500 home to his village in Mexico.
c. An American mutual fund manager uses the deposits of his fund investors to buy Brazilian
telecommunication stocks.
d. A Japanese firm in Tennessee buys car parts from a subsidiary in Malaysia.
e. An American church donates five tons of rice to the Sudan to help with famine relief.
f. An American retired couple flies from Seattle to Tokyo on Japan Airlines.
g. The Mexican government sells pesos to the United States Treasury and buys dollars.

Answers:
a. The United States “exports” official reserve assets; it is a credit in the financial account.
b. A resident of the United States transfers money to a foreign locale; it is a debit in the current
account and goes in the secondary income category.
c. There is an “import” of foreign assets; it is a debit in the financial account under the category of a
net change in U.S. private assets abroad.

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 d. An American-based producer imports goods; it is a debit in the current account (imports of
goods).
e. There is secondary income from the United States to abroad foreign country; it is a debit in the
current account.
f. American residents purchase a service from a foreign firm; it is a debit in the current account
(imports of services).
g. There is a net increase in nonreserve foreign assets held by the U.S. government; it is a debit in
the financial account.

3. Weigh the pros and cons of a large trade deficit.

Answer: Trade deficits are generally considered a negative for a country, but the reality is more
subtle. On the negative side, large deficits signal that a country is accumulating foreign
debt that can be difficult to service if the excess imports are not used to enhance national
productivity. Furthermore, trade deficits require capital inflows. If foreign investors lose
confidence, it may be difficult to search the necessary foreign reserves. This is partly
what happened to Mexico in 1994 and Thailand and Indonesia in 1997.
On the positive side, a large trade deficit can also signal that foreigners have confidence
in the current set of economic policies and the future prospects of the economy.
Furthermore, and most importantly, a large trade deficit and the attendant capital inflows
allow a higher level of investment than would be possible solely on the basis of domestic
savings.

4. Is the government budget deficit of a country linked to its current account balance? How so? Explain
how it is possible for the United States’ current account deficit to grow while the budget deficit has
disappeared, as happened in the 1990s.
Answer: The budget deficit and the current account are linked but there are the other variables of
domestic private savings and domestic investment that are also joined in the savings-
investment balance. For this reason, there is no such thing as a one-to-one correspondence
between budget and trade balances. The basic relationship is captured in the equation
(4b in the text): Sp  government budget  I  current account. From this it can be seen
that as the government budget went to zero and the current account became more
negative, either savings fell, investment rose, or some combination of the two occurred.

5. Compare and contrast portfolio capital flows with direct investment capital flows.
Answer: These two types of capital flows are similar in that they both provide a nation with the use
of foreign savings. That is, they both represent financial flows that are a net increase in
the amount of resources available for investment. On the other hand, they are very
different in the time dimensions that they represent and in their liquidity. FDI is illiquid
and generally represents funds with a longer time horizon than portfolio capital. Portfolio
investment can move in or out of a nation extremely quickly and is the main focus of
concerns about the destabilizing effects of foreign investment.

6. Why is a current account surplus equivalent to foreign investment?

Answer: A current account surplus leads to the net accumulation of foreign assets, whether real or
financial. In either case, there is the prospect of a future stream of revenue that will be
generated from the assets.
Another way to look at it is to consider that in order to export a greater value than
imports, a nation must not consume some of its income (production). Instead, the goods and
services are sent abroad. The effect is the same as domestic investment: Consumption out
of current period production is postponed until a future date, and the excess output is used
to increase the capacity of the economy to generate a future stream of income
(production).