International Financial Management

Alan Shapiro and Peter Moles

1st Edition
John Wiley & Sons, Inc.

1 www.wiley.com/college/shapiro
 CHAPTER 5

The International Monetary

System and the
Balance of Payments

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BALANCE-OF-PAYMENT
CATEGORIES
A. The balance of payments (B-O-P)

1. Purpose:
Measures all financial and economic transactions
over a specified period of time.

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BALANCE-OF-PAYMENT
CATEGORIES

2. Double-entry bookkeeping

a. Currency inflows = credits earn

foreign exchange.
b. Currency outflows = debits expend
foreign exchange.

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BALANCE-OF-PAYMENT
CATEGORIES
3. Three major accounts
a. Current.
b. Capital.
c. Official Reserves.

4. Current account
Records net flow of goods, services, and
unilateral transfers.

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BALANCE-OF-PAYMENT
CATEGORIES

5. Capital account
a. Function: records public and private
investment and lending.
b. Inflows = credits.
c. Outflows = debits.

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BALANCE-OF-PAYMENT
CATEGORIES

5. Capital account (cont’d)

d. Transactions classified as
1. Portfolio.
2. Direct.
3. Short term.

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BALANCE-OF-PAYMENT
CATEGORIES

6. Official reserves account

a. Function:
1. Measures changes in international
reserves owned by central banks.
2. Reflects surplus/deficit of
a. Current account.
b. Capital account.

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BALANCE-OF-PAYMENT
CATEGORIES

6. Official reserves account (cont’d)

b. Reserves consist of
1. Gold.
2. Convertible securities.

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BALANCE-OF-PAYMENT
CATEGORIES

7. Net effects
a. Sum of all transactions must be zero:
1. Current account.
2. Capital account.
3. Official reserves.

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BALANCE-OF-PAYMENT
CATEGORIES
8. The balance-of-payment measures
Some definitions:

Basic balance
* Consists of current account and long-term capital
flows.
* Emphasizes long-term trends.
* Excludes short-term capital flows that heavily
depend on temporary factors.

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BALANCE-OF-PAYMENT
CATEGORIES
Net liquidity balance
Measures the change in private domestic borrowing
or lending required to keep payments equal without
adjusting official reserves.

Official reserve transactions balance

Measures adjustments needed by official reserves.

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 THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL
II. LINKS FROM INTERNATIONAL TO
DOMESTIC FLOWS

A. Global linkages
Set of basic macroeconomic identities which
link:
Domestic spending and production to current
and capital accounts.

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THE INTERNATIONAL FLOW OF GOODS,
SERVICES, AND CAPITAL
B. Domestic savings and investment and the
capital account

1. National income accounting

a. National income (NI) is either spent

(C) or saved (S)

NI = C + S (5.1)

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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL

b. National spending (NS) is divided into

personal spending (C)
and investment (I)

NS = C + I (5.2)

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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL

c. Subtracting (5.2) - (5.1)

NI - NS = S - I (5.3)

If NI >NS, S > I

which implies that surplus capital is spent abroad.

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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL
d. In a freely-floating system,
excess saving = the capital account balance.
e. Implications:
1. A nation which produces more than it
spends will save more than it invests domestically
with a net capital outflow producing a capital
account deficit.
2. A nation which spends more than it
produces has a net capital inflow
producing a capital account surplus.
3. A healthy economy will tend to run a
current account deficit.
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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL

C. The link between the current and capital accounts

1. Beginning identity

NI - NS = X - M (5.4)
where X = Exports
M = Imports
X-M = Current account balance (CA)

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THE INTERNATIONAL FLOW OF GOODS,
SERVICES, AND CAPITAL

2. Combining (5.3) + (5.4)

S - I = X - M (5.5)

3. If S - I = Net foreign investment (NFI)

NFI = X - M (5.6)

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THE INTERNATIONAL FLOW OF GOODS,
SERVICES, AND CAPITAL

4. Implications:
a. If CA is in surplus, the nation must be a
net exporter of capital.
b. If CA is a deficit, the nation is a major
capital importer.
c. When NS > NI, the excess must be
acquired through foreign trade.

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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL

d. Solutions for improving CA deficits:

1. Raise national income (output)

relative to domestic investment (I).
2. Increase (S) relative to domestic
investment (I).

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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL
D. Government budgets and current account
deficits

1. Current account balance:

CA = Saving surplus - Gov’t budget deficit

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THE INTERNATIONAL FLOW OF
GOODS, SERVICES, AND CAPITAL

2. CA deficit means:
the nation is not saving enough to finance
(I) and the deficit.

3. CA surplus means:
the nation is saving more than needed to
finance its (I) and deficit.

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COPING WITH THE CURRENT-
ACCOUNT DEFICIT

I. POSSIBLE SOLUTIONS UNLIKELY TO WORK

A. Currency depreciation.

B. Protectionism.

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COPING WITH THE CURRENT-
ACCOUNT DEFICIT

II. CURRENCY DEPRECIATION

A. U.S. experience:
does not improve the trade deficit.

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COPING WITH THE CURRENT-
ACCOUNT DEFICIT
B. Depreciations are ineffective because:

1. It takes time to affect trade.

2. J-Curve effect
States that a decline in currency value will
initially worsen the deficit before improvement.

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THE J-CURVE

Currency
Net depreciation Trade balance
change improves
in trade
balance 0 time

Trade balance
initially deteriorates
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COPING WITH THE CURRENT-
ACCOUNT DEFICIT
III. PROTECTIONISM

A. Trade barriers used:

1. Tariffs.
2. Quotas.

B. Results:
Most likely will reduce both X and M.

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COPING WITH THE CURRENT-
ACCOUNT DEFICIT
C. Foreign ownership
One protectionist solution would place limits
on or eliminate foreign ownership leading to
capital inflows.

D. Stimulate national saving

Change the tax regulations and rates.

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COPING WITH THE CURRENT-
ACCOUNT DEFICIT
IV. SUMMARY: CURRENT-ACCOUNT DEFICITS
– neither bad nor good inherently

A. Since one country’s exports are another’s

imports, it is not possible for all to run a surplus.

B. Deficits may be a solution to the problem of

different national propensities to save and
invest.

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