EC311: International Economics

The Balance of Payments

Dr. Hussein Hassan

Email: Hussein.Hassan@reading.ac.uk
Office Hours: Wednesday 10-12pm and Friday 10-11am
Room: EM289

Spring 2020/21

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The Balance of Payments (BoP)

The Balance of Payments (BoP) is a table summarises all the

transactions between the residents of a nation with residents of all
other nations recorded during a particular period of time, usually a
calendar year.

An international transaction refers to the exchange of a good, service or

asset (for which payment is usually required) between the residents of
one nation and the residents of other nations. However, gifts and certain
other transfers (for which no payment is required) are also included in a
nation’s balance of payments.

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The Balance of Payments (BoP)

International transactions are classified as credits or debits as follows:

 Credit transactions are those that involve the receipt of payments

from foreigners and are entered with a positive sign in the nation’s
BoP.

 Debit transactions are those that involve the making of payments to

foreigners and are entered with a negative sign in the nation’s BoP.

The main purpose of the balance of payments is to inform the

government of the international position of the nation and to help in
formulating monetary, fiscal and trade policies.

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The Balance of Payments (BoP)

For example:

 The export of goods and services, unilateral transfers (gifts) received

from foreigners and capital inflows are entered as credits (+) because
they involve the receipt of payments from foreigners.

 The import of goods and services, unilateral transfers or gifts made

to foreigners and capital outflows are entered as debits (–) in the
nation’s balance of payments.

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Balance of Payments Accounts

The Balance of Payments has three broad accounts which are Current
Account, Capital Account and Financial Account as follows:

Current account: Imports and Exports

 Goods (DVDs, machines, cars,…)

 Services (payments for legal services, shipping services, Tourism,

education, health,.…)

 Income receipts (interest and dividend payments, …..)

Current account: Net unilateral transfers

 Gifts across countries that do not purchase a good or service nor

serve as income

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US Current Account in 2011 (Billion Dollars)

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Balance of Payments Accounts

Capital account:

 Special (net unilateral) asset transfers, but this is

a minor account, such as debt forgiveness.

Financial account:

 Financial inflows: Foreigners purchase of domestic assets.

 Financial outflows: Domestic citizens purchase of foreign assets.

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US Capital and Financial Accounts in 2011

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Double-Entry Bookkeeping

In recording a nation’s international transactions, the accounting

procedure known as double-entry bookkeeping is used. This means that
each international transaction is recorded twice, once as a credit and
once as a debit of an equal amount. The reason for this is:

1. We sell something and we receive payment for it.

2. We buy something and we have to pay for it.

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Examples of BoP Accounting

Example 1:

Assume that a US consumer imports a Japanese DVD by $10 using his

card. The Japanese DVD producer deposits the funds in his bank account
in San Francisco. The bank credits the account by the amount of the
deposit $10.

DVD Purchase (Current Account) - $10

Credit of Bank Deposit by Bank (Financial Account) + $10

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Examples of BoP Accounting

Example 2:

Assume that a US investor invests in the Japanese stock market by

buying $500 in Sony stocks. Sony deposits your funds in its Los Angeles
bank account. The bank credits the account by the amount of the deposit.

Purchase of Stock (Financial Account) - $500

Credit of Bank Deposit by Bank (Financial Account) + $500

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Examples of BoP Accounting

Example 3:

Assume that US banks forgive a $100 Million debt owed by the

government of Argentina through debt restructuring. US banks who hold
the debt thereby reduce the debt by crediting Argentina's bank
accounts.

Debt Forgiveness: Non-Market Transfer (Capital Account) - $100M

Credit: Reduction of Bank Claims (Financial Account) + $100M

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Accounting Balances and the BoP

Due to the double entry of each transaction, the balance of payments

accounts will balance by the fundamental BoP identity:

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒄𝒐𝒖𝒏𝒕 𝑪𝑨 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑨𝒄 𝒐𝒖𝒏𝒕

𝑲𝑨
+𝑭
𝒏
𝒊𝒂𝒏
𝒂
𝒄𝒊𝒍 𝑨𝒄𝒐𝒖𝒏𝒕
𝑭𝑨 =𝟎
Or

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒄 𝒐𝒖𝒏𝒕 𝑪𝑨 + 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑨𝒄𝒐𝒖𝒏𝒕

𝑲𝑨
= −𝑭𝒏
𝒊𝒂𝒏𝒄𝒂
𝒊𝒍 𝑨𝒄𝒐𝒖𝒏𝒕 𝑭𝑨

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Definitions of the Exchange Rate

Exchange rates can be defined either as:

 Foreign currency per unit of domestic currency.

 Domestic currency per unit of foreign currency.

Depreciation is a decrease in the value of a currency relative to another

currency. A depreciated currency is less valuable (less expensive) and
therefore can be exchanged for a smaller amount of foreign currency.

Appreciation is an increase in the value of a currency relative to another

currency. An appreciated currency is more valuable (more expensive) and
therefore can be exchanged for a larger amount of foreign currency.

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Spot Rates VS Forward Rates

Spot rates are exchange rates for currency exchanges “on the spot’’, i.e.
trading is executed in the present.

Forward rates are exchange rates for currency exchanges that will occur
at a future (“forward”) date. Forward dates are typically 30, 90, 180 or
360 days in the future. Rates are negotiated between
individual
institutions in the present, but the exchange occurs in the future

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The Demand for Currency Deposits

What influences the demand for (willingness to buy) deposits

denominated in domestic or foreign currency?

1. Rate of return: The percentage change in value that an asset offers

during a time period. For example, the annual return for $100 savings
account with an interest rate of 2% is $100 x 1.02 = $102, so that the
rate of return = ($102 - $100)/$100 = 2%

2. Real rate of return: Inflation-adjusted rate of return which is stated

in terms of real purchasing power. For example, the real rate of return
for the above savings account when inflation is 1.5% is 2% – 1.5% =
0.5%.

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The Demand for Currency Deposits

3. Risk: The risk of holding assets also influences decisions

about
whether to buy them.

4. Liquidity: The liquidity of an asset, or ease of using the asset to buy

goods and services, also influences the willingness to buy assets.

We assume here that investors are primarily concerned about the rates of
return on bank deposits, not risk nor liquidity. Rates of return are
determined by:

 Interest rates that the assets earn.

 Expectations about appreciation or depreciation.

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The Demand for Currency Deposits

Suppose that the interest rate on a dollar deposit is 2% and the interest
rate on a Euro deposit is 4%. Does a Euro deposit yield a higher expected
rate of return?

To answer this question, we need to know the expected exchange rate.

suppose today the exchange rate is $1/€1 and the expected rate 1 year in
the future is $0.97/€1.

 A $100 can be exchanged today for €100 and these €100 will yield
€104 after 1 year. These €104 are expected to be worth $0.97 x €104
= $100.88 after a year.

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The Demand for Currency Deposits

 The rate of return in terms of dollars from investing in Euro deposits

is ($100.88-$100)/$100 = 0.88%.

 On the other hand, after 1 year the $100 is expected to yield $102:
($102-$100)/$100 = 2%.

 The Euro deposit has a lower expected rate of return: all investors will
prefer dollar deposits and none are willing to hold Euro deposits.

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