The Balance of Payment

National Income Account and BOP

Y = C + I + G + CA

Y = GDP C = consumption G = government spending CA = current account balance

This is called National Income Identity

Current Account

CA = X M = net export of goods and services

X = export; M = import

Strictly speaking CA = X M +UT but, for a while, we ignore UT = unilateral transfer In a closed economy, we do not have CA. (because X = M = 0)

National Income Account

Consumption = spending by households, including consumer spending on durable goods Investment = Business sectors adding to the physical stock of capital, including inventories. (individual households purchases of stocks, bonds or real estates are not included) Government purchases = spending by federal, state, or local governments

National Income Account

1999 C I G CA

67.6% 17.5% 17.6% -2.7%

$6.3 trillion $1.6 $1.6 -$0.25

Current account balance

(Domestic spending on goods and services produced domestically) =C+I+GM (Foreign spending on goods and services produced domestically) =X

Current account balance (contd)

CA = X M When X > M or CA > 0, we say current account surplus. When X < M or CA < 0, we say current account deficit. CA = Y (C + I + G) = Y A where A = domestic absorption

Current account balance (contd)

A country with current account deficit is buying more from foreigners than it sells to them It has to increase net foreign debts. CA = net foreign wealth US has been a net debtor since 1985. In 1998, debt = $5.5 trillion

Saving and Investment

Let S = national saving = Y C G. Then S = I + CA (In a closed economy S = I) where I = domestic investment = capital stock accumulation CA = foreign wealth acquisition = net foreign investment An open economy can increase investment by borrowing abroad.

Saving
S = SP + SG where SP = Yd C = Y T C SG = T G SP = private saving; SG = government saving; Yd = disposable income; T = net tax. Then SP = (C + I + G + CA) T C = I + CA + (G - T) where G T = government budget deficit. So CA = SP I (G T) A large govt budget deficit leads to a large current

Balance of Payment Accounts

Double-entry bookkeeping each entry is recorded twice. A debit entry a payment to foreigners A credit entry a receipt from foreigners

Current Account (CA)

the record of commodity and services transaction

A. Exports (credit) B. Imports (debit)

1. Merchandise: commodity transaction 2. Services: travel, tourism, royalties, transportation costs, insurance premiums. 3. Income

Income receipts on US assets abroad (credit) Income payments on foreign assets in US (debit) Direct investment receipts and payments Interest, dividends.

Current Account (contd)

C. Unilateral Transfers (debit)

US foreign aid, gifts, retirement pensions, interest payments to foreigners on their US govt debt, workers remittances.

CA > 0: current account surplus the country is a net lender to the rest of world CA < 0: current account deficit the country is a net borrower from the rest of world

Capital Account (KA)

the record of financial assets transaction

A. US assets abroad

1. US official reserve assets (Gold, SDR, reserve in IMF, foreign currencies) 2. US govt assets 3. US private assets (direct investment, foreign securities)
1. Foreign official assets in US (US govt securities, ) 2. Other foreign assets in US (direct investment, US treasury securities)

B. Foreign assets in US

Example (a)

An American buys a share of German stock, paying by writing a $10,000 check on his account with a Swiss Bank.

Debit: US asset held abroad $10,000 Credit: US asset held abroad $10,000. Credit: Foreign asset held in Germany Debit: German asset held abroad

For Germany

Example (b)

An American buys a share of German stock, paying the seller with a $10,000 check on an American bank.

Debit: US asset held abroad $10,000 Credit: Foreign asset held in US $10,000

Example (c)

The French government carries out an official foreign exchange intervention in which it uses dollars held in an American bank to buy French currency from its citizens.

Debit: Foreign asset held in US $1 million Credit: Foreign asset held in US $1 million (US official reserve asset)

Example (d)

A tourist from Detroit buys a meal at an expensive restaurant in Lyons, France, paying with a VISA credit card. VISA uses a checking account in France to make payments.

Debit: Import, Services Credit: US assets held abroad

$300 $300

Example (e)

A California winegrower contributes a case of his best cabernet sauvignon for a London wine tasting.

No market transaction!

Statistical Discrepancy

Theoretically, current account and capital account should add up to zero. But in reality, there is a discrepancy due to errors, time lags, and so on.

Official Reserve Assets

Official reserve assets:

purchase or sale of foreign assets held by the central bank Official international reserves: gold, SDR, foreign currencies, etc.

(current account) + (non-reserve capital account) + (statistical discrepancy) = Balance of Payment (official settlement)

Balance of Payment

Balance of Payment (official settlement) = current account deficit needed to be covered by the central banks official reserve transactions. BOP deficit the country is running down its official reserves.