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Economies are becoming more open (in terms of trade as % of GDP), but some countries are more open than others
Exports and imports as % of GDP
1990 Mauritius Zambia Chile China UK 153 99 64 29 51 2003 121 76 68 66 54
Argentina
Bangladesh India Brazil
15
20 17 14
40
37 31 30
United States
20
23
Higher degree of openness => structure of production and employment, and economic growth, are more likely to be affected by external events The balance of payments provides and indication of how international trade and external events feed back into the macroeconomy This presentation describes how balance of payments accounts are recorded and then explores the link between the balance of payments and a countrys exchange rate
A countrys balance of payments accounts record its international trading position and its lending and borrowing
=> records transactions between countries
Transactions that comprise a payment to foreigners are reported as a debit item with a - sign
=> These represent demand for foreign exchange ($) and a supply of the local currency ()
a)
The balance of payments on Current Account The balance of payments on Capital Account
The balance for Official Financing
(International reserves account operated by central bank)
b)
c)
The purchase of foreign investments by UK citizens brings assets to the UK (in exchange for money) and are referred to as a capital outflow
to purchase these foreign assets, locals have to buy $
Foreign investment into the UK increases UK liabilities to foreigners, and it is a capital inflow
foreigners have to buy to undertake their investments credit (positive) entry in the Capital Account
The Capital Account is further divided into shortterm and long-term capital flows
The exchange rate is the price of the in terms of other currencies (e.g. $) If the exchange rate is freely floating then it will adjust to ensure that the demand for s = the supply of s inflows = outflows in the BoP BoP is exactly = zero Since BoP = Current Account + Capital Account:
a Current Account surplus => a Capital Account deficit a Current Account deficit => a Capital Account surplus
c)
If the exchange rate is fixed, and there is a BoP deficit outflows > inflows supply of s > demand for s The Central Bank must offset this excess supply of s by buying them with foreign currency ($); i.e. runs down its reserves of foreign exchange
=> If the exchange rate is freely floating, then the balance for official financing is zero
The balance of payments must always balance since the accounts are constructed such that this must be true by definition
However, there can be measurement error and unreported borrowing from abroad and other illegal activities The discrepancy represents a combination of unrecorded current and capital account transactions
This requires the inclusion of what is referred to as a balancing item, to ensure the accounts balance in practice
AE (=AD) = C + I + G + X - M
Leakages are:
S+T+M
Injections are:
I+G+X S+T+M=I+G+X
or = (G - T) + (I - S) = government + balance
Trade
An
increase in govt. expenditure (G), or a reduction in private saving (S) worsens the trade balance (i.e. raises trade deficit)
A trade deficit is not necessarily a bad thing (e.g. when growing domestic industries attract foreign investments)
if borrowing is financing investment (which generates economic growth and income in future) then it is not a problem
However, if a country persistently runs a trade deficit this is something to worry about (e.g. vulnerability to loss of foreign investors confidence)
excessive borrowing on capital account to finance consumption on current account will incur higher interest payments and eventually lead to reduction consumption