Balance of Payments

• International transaction
• Exchange of goods, services, or assets between residents of one country and those of
another

• Balance of payments
• Record of the economic transactions between the residents of one country and the rest of
the world
• Uses a “double-entry” accounting system. Every time one country records a transaction,
another country records the same transaction from the opposite perspective.
• Residents
• Businesses, individuals, and government agencies
• Credit transaction (+)
• Receipt of a payment from foreigners
• Debit transaction (-)
• Payment to foreigners
 Balance of Payments Components
• Current Account: The value of all imports and exports over a period of
time, including both goods and services (visible and invisible trade)
• Income
• Current transfers (including remissions of workers living in foreign
countries)
 Balance of Payments Components
• Financial Account: This records money flowing between countries resulting from
transactions relating to saving or investment; we are not trying to consume a good or
service, but trying to put our money somewhere in order to earn value. NOT the same
as “I” investment in macroeconomics. Purchasing Assets.
• When something is purchased for the purpose of earning income instead of
consumption it’s going to be recorded in the capital or financial account.
• Income earned from investments, however, gets recorded in the current account.
• Shortcut: If it’s bought for consumption, current account. If it’s bought for financial
investment: financial account. If it’s bought for business investment: Capital account.
 Capital Account
• Capital Account is relatively small for most countries, but includes
government debt forgiveness, money brought into and taken out of the
country by immigrants, and the sales of copyrights, patents, and
trademarks (intellectual property).
 Financial Account or Current Account?
• A man from Cambodia purchases an apartment in Shenzhen, planning to rent it
out to local families.
• A Singaporean citizen purchases a new Playstation 5 from Japan.
• An American buys a very large building in Vietnam to be used as a clothing
factory.
• A British citizen goes to Italy during vacation and stays in a hotel for 6 nights.
• A man from Brazil living in China deposits 1/3rd in his salary into a savings
account which pays 3.5% interest annually.
• Clearly, the value of a countries imports and exports are unlikely to be
equal. A difference in the value of imports and exports are called surpluses
(if the value of exports exceeds that of imports) or deficits (if the value of
imports exceeds exports)
• Any individual account within the BOP can be in a deficit or surplus at
any given time.
• Why does the balance of payments overall always equal out to zero? Because every transaction in one
account is matched by a transaction in one of the other accounts, typically through foreign exchange of
currencies.
• For example: Let’s say that Huawei sells 100,000 RMB worth of phones to Vietnam. This represents a
credit of 100k rmb for China and 100k RMB debit for Vietnam.
• But how did Vietnam get the 100k rmb? They must have exchange some amount of VND (Vietnamese
currency) for that 100k rmb. How is the transaction recorded in the financial account? It actually is
represented by a 100k DEBIT for China and 100k CREDIT for Vietnam. So even though the Chinese
current account has a 100k credit, it’s financial account has a 100k debit. Thus the overall value of the
transaction is 0 for the balance of payments overall.
• All of this assumes everything is tracked with 100% accuracy and no transaction costs. Is this accurate?
No. That’s why it won’t actually equal out to zero.
• The Balance of Payments, however, must be equal to 0. Why?
• As an example, if a country sells exports, the revenue from these gets recorded
as credit items. To purchase the exports, foreigners need to get the currency of
the country to purchase those imported goods they might do this by borrowing
or purchasing it from that country’s banks, which is a corresponding debit item
in the financial account.
• Every debit in the current account is matched by a credit in the financial
account; every credit in the current account is matched by a debit in the
financial account.
• Although they should hypothetically equal out to 0; there are tons of
transactions involved it is difficult to keep an accurate record.
• We add another category to the BOP net errors and omissions
(sometimes called a balancing item on the exam). This is added in the case
where the BOP does not equal out to 0 from current, capital, and financial
accounts to make sure that it does equal 0.
 Why is this important?
• When the current account is in a surplus or deficit, this is income entering
(leaving) our country and affecting our living standards, employment
rates, and the value of our currency.
• It’s very important, therefore, for countries to track surpluses and deficits
in order to choose the “correct” policy (very often the correct policy is “do
nothing”)
• For example, if the current account plus the capital and financial accounts
add up to $-200 million, we add a balancing item, or net errors and
omissions, item of +200 million to the BOP to compensate for whatever
errors occurred during the recording process.
 Bellwork 11/22
• What is the current account in the balance of payments?
• What is the financial account?
• For each, write down two examples of a transaction that would be
recorded in that account.
 Current Account Details
• The current account is further sub-divided into “visible” and “invisible”
trade; this just corresponds to goods and services, respectively.
• Within the income section of the CA, another subdivision occurs between
primary and secondary income. Primary income includes primarily
profits, interest, and rents from the private sector, whereas secondary
income includes the same but from governments.
 Financial Account Details
• Direct investment: Buying assets that grant ownership of firms.
• Portfolio investment: Buying government bonds and shares that don’t
grant legal control of a firm.
• Other investments: This part covers shorter-term movements of financial
investment like bank loans and loans between governments.
 Financial Account Details
• Reserve Assets: Central banks all hold assets like gold, foreign currencies,
and a special International Monetary Fund currency called Special
Drawing Rights (SDR) which is an “index currency” tied to the value of
USD, RMB, Japanese Yen, GBP, and the Euro.
 How do we calculate income balance in the
current account?
• Sum the following: 1. All investment income and all income our workers earn from
foreign companies or foreign investments.
• 2. All investment income and all income foreign workers earn from our domestic
companies/investments.
• Subtract the two (Income earned by our citizens – income earned by foreigners) and we
have the net income balance
• Recall that income can include lots of things besides wages, including rents, interest
payments from lending or bonds, capital gains from the sale of financial assets, dividends,
profits earned from businesses we own in other countries, profits earned from businesses
foreigners own in our country etc.
• In which situation must a country’s balance of trade in goods and services
improve?
A Export costs rise more than import costs.
B Export prices rise more than import prices.
C Export revenues rise more than import revenues.
D Export volumes rise more than import volumes.
• A country produces washing machines. The government lowered both the
tax on washing machines produced in its country and the quota on imports
of foreign washing machines. What is the likely result?
A Government revenue increased.
B Home production decreased.
C Prices of foreign washing machines fell.
D The balance of trade in goods improved.
• A US company receives a US$20 million dividend from shares that it
owns in a Brazilian company. How would this dividend be shown in the
balance of payments of the United States?(2014 s11)
A a credit in the capital account
B a credit in the current account
C a debit in the capital account
D a debit in the current account
• 20. What is not an item in a country’s current account of its balance of
payments?(2013 w13)
A exports of primary commodities
B money received from banking services
C overseas investment
D profits sent back by companies overseas
 Bellwork 11/25 (pg 98 oxford, 93
Cambridge)
• Why might a country experience a current account deficit?
• A large portion of the labour is from another country (UAE, Qatar, Bahrain, Kuwait all have this
issue)
• A highly valued exchange rate. As our currency appreciates (gets stronger) it costs foreigners more
of their currency to buy each unit of our currency and therefore it also costs them more money to
buy our exports, thus our export revenues are reduced. At the same time the prices our citizens pay
for imports decrease by the same logic; our strong currency means its easier to buy foreign
currencies and thus foreign imports leading to more import spending. (There is more to this with the
Marshall-Lerner conditions, but we’ll get to that later).
• Growing domestic economy: Higher wages means more import spending, labour costs are higher
leading to more expensive production costs for exports.
 Continued: Reasons for current account
deficit
• If there is a recession in other trading partner countries. They have less
income and thus less demand for our exports (imports for them, and recall
that imports have relatively high positive YED, so when incomes fall,
spending on imports falls by comparatively more than domestically
produced goods).
• Structural weaknesses in our domestic firms: Our firms are less
competitive than their international counterparts; they can’t produce
things as high quality or as cheaply as a competitor.
 Continued: Reasons for current account
deficit
• Reliance on imported input goods. We may have a current account deficit
because its cheaper for us to import input goods such as energy, steel,
lumber, etc. By importing these things, we lower our cost of production
both for our domestically produced goods and for the goods we export. So
in this case, trying to “fix” the current account deficit by lowering our
reliance on imported input goods actually raises our costs of production
and causes cost-push inflation.
• 1. Growing domestic economy
• 2. Lots of foreign labour
• 3. Reliance on imported inputs
• 4. Recession in trading partner countries
• 5. Structural weaknesses
• 6. Highly valued exchange rate.
 What’s the main point?
• We can’t simply look at the presence of a current account deficit and say that it
needs to be “fixed” or “solved” because it may not even be a problem in the first
place. In assessing whether or not a current account deficit is a problem, we need to
know the source of the current account deficit. For the most part, current account
deficits are not a problem unless they are caused by structural deficiencies and non-
competitiveness of our domestic firms and labour. In that case, a current account
deficit does need to be “fixed”, but in many other cases, the deficit doesn’t actually
indicate there is a problem that needs to be fixed at all.
• Many times, the best policy when faced with a current account deficit “do nothing”.
In class assignment: Article on China
Current Account balance Q1-2 2018
 In class assignment: Article on China
Current Account balance Q1-2 2018
• 1. What are likely causes for the current account deficit in China for the 1st quarter of
2018?
• 2. How might tariff's affect a current account balance for the country raising the tariff?
The country on who’s goods the tariff is raised?
• 3. The article mentions “a falling domestic saving rate, which may be partly because of
the aging population.” Why might an aging population slow down a country’s saving
rate? Why would a lower (national) savings rate potentially make the current account
more negative?
• 4. How do you think a current account deficit might impact everyday Chinese citizens?
 Exchange rates and international trade
• The relationship between exchange rates and international trade is somewhat
nuanced and not quite as straight forward as one might think.
• The rate at which one currency can be exchanged for another currency is it’s
exchange rate. When a country’s exchange rate gets stronger, it takes less of that
country’s currency to buy a foreign currency.
• When a country’s exchange rate is weaker, it takes more of our currency to buy a
foreign currency.
• What do you think has happened in the past 10 years to the RMB:USD exchange
rate?
 Bellwork 11/17
• What is the difference between a fixed and floating exchange rate?
• Fixed exchange rate: A fixed exchange rate denotes a nominal exchange rate
that is set firmly by the monetary policy makrers with respect to a foreign
currency or a basket of foreign currencies. In plain English, the central bank
decides what the exchange will be and uses various policy tools to hold it there.
• Floating exchange rate: This is determined by foreign exchange (abbreviated as
“forex) markets depending on demand and supply. It’s gonna move around a
lot.
 Managed floating exchange rate
• This has elements of both fixed and floating; the exchange rate is
permitted to fluctuate within a specific range of prices but central bank
will take action if it moves outside this specific price range. Think about
setting both a minimum and a maximum price for an exchange rate.
 What actually impacts the demand for our
domestic currency?
• 1. Demand for our exports
• 2. Demand for our financial products
• 3. Demand for our physical capital and business investment (how much do
foreigners want to invest in factors of production located in our country?)
 What actually impacts the supply of our
currency?
• 1. Our citizens demand for imports.
• 2. Our citizens demand for foreign investments.
• 3. How easy can our domestic businesses set up offices/factories/locations in other
countries?
• What do we actually mean by “the supply of our currency?” We people who hold
our currency selling our currency and buying something else with it. If people who
hold our currency are incentivized to sell it, we are increasing the supply of our
currency. If people are incentivized to buy and hold our currency, our currency has
a contraction in supply.
 How are exchange rates determined?
• Floating, fixed, and managed float.
• A floating exchange rate is one determined by market forces.
• We allow supply and demand for a currency to work freely. Governments do not try to
manipulate the exchange rate.
• This has a very key advantage: The exchange rate should be able to help restore a BOP
Current Account deficit or surplus. For example, if a country has a BOP current account
deficit, demand for the currency will fall while it’s supply increases. This brings down the
equilibrium price of the currency, thus it depreciates making exports cheaper and imports
more expensive. If demand for both is elastic, this results in an increase in export revenue
and a fall in import spending.
• This has a very key advantage: The exchange rate should be able to help
restore a BOP deficit or surplus. For example, if a country has a BOP
deficit, demand for the currency will fall while it’s supply increases. This
brings down the equilibrium price of the currency, thus it depreciates
making exports cheaper and imports more expensive. If demand for both
is elastic, this results in an increase in export revenue and a fall in import
spending.
 S+D shifters in a floating exchange rate

1. Changes in Tastes-
Ex: British tourists flock to the U.S…
Demand for U.S. dollars increases (shifts right)
Supply of British pounds increases (shifts right)
Pound-depreciates
Dollar-appreciates
2. Changes in Relative Incomes (Resulting in more
imports)-
Ex: US growth increase US incomes….
U.S. buys more imports…
U.S. Demand for pounds increases
Supply of U.S. dollars increases
Pound- appreciates
Dollar- depreciates
3. Changes in Relative Price Level (Resulting in
more imports)-
Ex: US prices increase relative to Britain….
U.S. demand for cheaper imports increases…
U.S. demand for pounds increases
Supply of U.S. dollars increases
Pound- appreciates
Dollar- depreciates
4. Changes in relative Interest Rates-
Ex: US has a higher interest rate than Britain.
British people want to put money in US banks
Capital Flow increase towards the US
British demand for U.S. dollars increases…
British supply more pounds
Pound-depreciates
Dollar- appreciates
 Floating exchange rates
• How do governments and central banks usually hold exchange rates
fixed? They keep very large reserves of foreign currencies. They use this
as a way of buying more of their own currency in order to stimulate
demand for that currency to raise it’s eq’m price.
• Another advantage of a floating exchange rate, then, is that they no longer
need to hold onto large amounts of foreign currency and spend resources
and time manipulating their exchange rate.
 Floating exchange rate
• When allowed to respond to supply and demand, we expect more variance
in exchange rates. Changes in the exchange rate may make it difficult to
estimate how much a country might earn by selling imports or the spending
on imports. This uncertainty can discourage trade and international
investment.
• A big advantage of a fixed exchange rate is that it makes the profits from
FDI much more stable; there is no longer a risk of the exchange rate falling
and reducing the profits of foreign companies operating in a country as
denoted in their home currency.
 Bellwork 11/21/22
• 2. How can a floating exchange rate allow a balance of payments current account to be self
correcting?

• The floating exchange rate can restore a current account because if a country is in a current
account deficit then the currency will depreciate. This is because a deficit means there has
been too much import spending or too little export revenue or some combination of the
two. The currency deprecation can reverse a current account deficit because it reduces the
prices of a country’s exports while increasing the prices of imports; this means they we will
end up with more export revenue and less import spending, thus reducing the deficit that
we started with. (Note that this depends on the PED of imports and exports being “elastic”)
• 1. How do countries who have fixed exchange rates maintain the prices of their
currencies?
• They can modify interest rates; raising interest rates results in more dedemand for
the currency while lowering them leads to less demand.
• We can also use capital controls.
• We either sell foreign currencies our central bank is holding in order to raise
demand (and the price) for our domestic currency or we buy foreign currencies
using our domestic currency in order to lower demand (and thus price) for our
domestic currency.
 Advantages of a Fixed Exchange Rate
System
• 1. Provides stability and certainty for international investors (both
financial and business investment/FDI).
• 2. Provides stability and certainty for export based economies
• 3. Price Stability domestically, lower inflation rates
• 4. Easier and more stable importation of raw materials and other input
goods leading to more stable costs of production.
 Disadvantages of a Fixed Exchange Rate
System
• 1. We need to have our central bank hold a very large amount of foreign reserve
currencies. This is costly.
• 2. More disequilibrium in the current account; deficits or surpluses won’t fix
themselves and may become very large. Really problematic if a surplus is from
low international competitiveness.
• 3. Possible policy objective conflicts: An economy facing a recession needs to
lower interest rates but doing so puts downward pressure on the price of its
currency and so it becomes harder to maintain the fixed exchange rate if also
trying to use gov’t intervention to combat a recession.
• Governments often have less incentive to maintain price stability. A
government might actually rely on a fall in a floating exchange rate to
restore a loss in international competitiveness resulting from inflation. IE:
with a floating exchange rate, when there’s inflation, the real prices of our
g+s might actually become lower, thus government may choose to ignore
this problem.
 Fixed exchange rates
• The value of a currency is determined jointly between a central bank and
government of a country. The central bank maintains the rate by
intervening directly in the foreign exchange market or by changing the
country’s rate of interest (complicated, discuss in more detail next chapter.
Cliffs: increasing interest rates=more saving=less demand for
currency=appreciation of the currency. Lower interest rates=more
spending=more demand for money=depreciation).
 Fixed exchange rates
• If the current value of the currency is relatively close to it’s true
equilibrium value as determined by consumers and firms demand,
managing the value of the currency isn’t too hard; the central bank only
has to make small adjustments. If the exchange rate is very different from
where it would be in equilibrium, things become much harder.
• One disadvantage then, is the necessity to keep a lot of foreign currency in
reserves.
• It may lead to conflicting objectives; central banks may need to raise
interest rates in order to keep exchange rates at a higher price, but raising
the interest rate will also impact aggregate demand negatively.
• A fixed exchange rate does create some certainty, which can promote
international trade and investment.
• A fixed exchange rate also encourages governments to keep inflation low
so that a loss of international price competitiveness does not put
downward pressure on the exchange rate.
 Exchange Rates Cont’d
• To add layers of difficulty, countries trade with several partners
simultaneously; it’s currency can rise in value relative to one of its
partner’s currencies while falling in value relative to another partners.
• Ie: The RMB loses value against the dollar, but it gains value against the
Indian Rupee.
 Bellwork 11/22/22
• 1. Explain why a current account deficit might not actually be a problem.
• When there is a deficit than the import spending is more than export revenue so
the price of exports will decrease as a result of depreciation and this will lead to
more export revenue and less import spending in the future, thus a deficit will
correct itself.
• A current account deficit may be caused by reliance on imported inputs. These
cheaper input goods will reduce the cost of production and increase the level of
aggregate output, therefore the source of the current account deficit is directly
raising our living standards while making price levels lower.
• 2. Explain two advantages and one disadvantage of a fixed exchange rate system.
• It can promote FDI and trade in general. More countries want to invest in fixed exchange rate places
because they avoid exchange rate volatility causing uncertainty and variance in their profits when
denoted in their domestic currency. In other words, even if they are certain about the amount of
money they will earn denoted in the host country, because they need to convert it back to their
domestic currency, this poses an exchange rate risk where their profits may decrease simply because
of exchange rate variation.
• Keeps inflation low usually
• Central bank needs to hold onto a lot of foreign currencies.
• Possible policy conflicts. If there’s a recession, the expansionary policy we need to use will directly
counteract the things we do to raise the value of our currency.
 Trade Weighted Exchange Rate
• This is a measure of the value of a currency against a bundle of other
currencies in a given time period weighted according to the importance of
the currencies in the country’s trade.
• Essentially it’s an index computed by taking a weighted average of many
different exchange rates of the form “Our currency = x*(foreign
currency)*w) where w (weight) represents the percentage of total trade
our country does with the respective country we are comparing currencies
with.
• Data unavailable for China : (
 Trade Weighted Exchange Rate
• 100 = base year, movements up mean that our currency has appreciated
or strengthened; we can buy more of other currencies and thus other
country’s goods and services. Movements down mean our currency has
depreciated and we can buy less of other currencies and thus other
country’s goods and services.
• Data for U.S.A …
 Country X trades with only two countries, USA and Japan. 90 % of the
country’s trade in goods and services is with the USA and 10 % is with
Japan. The original value of the trade-weighted exchange rate index is 100.
The change in the value of country X’s currency against the US$ is +10 %.
The change in the value of country X’s currency against the Japanese yen is
+50 %. What will be the value of country X’s new trade-weighted exchange
rate index?
• A 114 B 115 C 130 D 160
• We calculate a weighted average of the % change in our country’s currency vs Japan and USA.
• We do 10% of our trade with Japan and our currency increases 50% against japans, so: 0.1 * 50 =
5
• We do 90% of our trade with USA and our currency increases 10% against USA’s, so: 0.9*10 = 9
• The base year for any “index” number, is 100, so: 100+9+5 = 114
• Take the percentage change in the currency (positive or negative) and multiply by the % of total
trade your country does with that country’s currency. Do this for each country in the trade
weighted exchange rate, sum together (you’ll have some positive and some negative numbers) and
then add to the base year (100) to get the trade weighted exchange rate.
• UK does trade with Ireland, France, and Germany. It does 20% with
France, and 40% with both Ireland and Germany.
• Let’s say that the GBP depreciates 10% against the Irish currency, it
appreciates 15% against the German currency, and it appreciates 2% with
the French currency. Calculate the trade weighted exchange rate. Base
year= 100
• 0.2*2 + 0.4*-10 + 0.4 *15 = .4 – 4 +6 = 2.4
• 102.4 is my new trade weighted exchange rate for the UK.
• 24. What is most likely to cause a rise in a country’s exchange rate?(2013
w12)
A a fall in its direct taxes
B a fall in its export orders
C a rise in its interest rates
D a rise in its imports
• What is most likely to immediately reduce the deficit on the current
account of a country’s balance of payments?(2013 w13)
A a cut in its interest rates
B a rise in its income tax rates
C cuts in subsidies to domestic industry
D purchases of its currency by its government
6. The value of the Swiss franc changes against the US dollar ($) from $0.60
to $0.80. Which statement is consistent with this information?
• A Swiss visitors to the US will now be worse off.
• B The cost to the US of maintaining its embassy in Switzerland will
decrease.
• C The dollar has depreciated against the Swiss franc.
• D US exports to Switzerland will now be more expensive.
• Which is most likely to cause country X’s exchange rate to depreciate?
A an increase in country X’s demand for imports
B an increase in country X’s interest rate
C an increase in foreign demand for country X’s exports
D an increase in tourist visits to country X
• A depreciation of the exchange rate of the pound sterling against the US
dollar from £1 : $1.50 to £1 : $1.00 must mean that
A the pound will be undervalued.
B US imports from the UK will become more expensive.
C UK imports from the US will become cheaper.
D dollars will become more expensive in terms of pounds.
• 1. If there is a current account surplus, what is the impact on aggregate
demand in the current time period? (not in the future when the current
account balance corrects)
• Although there are exceptions with that income section, MOST of the
time, when there is a current account surplus, there is also positive net
exports and this raises AD.
• 1. The country needs to acquire and hold a lot of foreign currencies for it’s central bank to use to
manipulate the value of it’s currency. This is arguably somewhat wasteful as it wouldn’t need to be done
under a floating exchange rate system.
• 2. With a floating exchange rate, a current account disequilbrium (surplus or deficit) will correct itself.
But with a fixed exchange rate system it’s going to require government or central bank intervention if it’s
from a problematic cause and needs to be fixed.
• 3. Policy conflicts: If there’s a recession and we need to boost the value of our currency, for example, the
things we need to do to fix the value of our currency are directly opposed to what we need to do to
correct a recession. If we want to raise the value of our currency, it requires raising interest rates and
slowing down on monetary/fiscal expansion. But these are exactly the things we need to do to fix a
recession, so whatever we do to fix a recession will destabilize our exchange rate while anything we do
to fix our exchange rate will make the recession worse.
Bellwork 11/23/2022
 Exchange Rates and BOP
• The balance on the current account can also impact the exchange rate in
addition to the exchange rate affecting the balance on the current account!
If a country has a surplus on the current account from selling more
exports, then there is more demand for that country’s currency.
• If we plot a demand and supply diagram using price of a country’s
currency in terms of another currency on one axis and quantity on the
other axis, what happens to both our exchange rate and our BOP when
there is an increase in demand for our currency?
 Exchange Rates and international trade
• If a country’s exchange rate gets stronger (the currency can buy more
foreign currencies/foreign currency can buy less of the country’s
currency), exports become more expensive and imports become cheaper.
This often (not always) results in less export revenue and more import
spending.
• If fewer exports are sold and more imports are purchased, what is the
likely impact on the current account balance? DEPENDS ON PEDs!
 Depreciation/Devaluation effects
• Our currency weakens. This will make exports cheaper in terms of foreign
currencies while making imports more expensive in terms of our domestic
currency. Domestic firms are now more easily able to export, but also
domestic consumers want to buy more domestic goods and less foreign
imports.
• What impact does this (likely) have on NX? AD? PL? GDP?
Unemployment?
• In this example, a lower exchange rate made the current account more
positive. Will this always be the case? NO!
• This is where price elasticities of demand for both imports and exports
need to be considered.
• If demand for both exports and imports is elastic, a fall in the exchange
rate will clearly make a positive impact on current account. Why?
 Marshall-Lerner Conditions
• Alfred Marshall and Abraham Lerner, not a guy called “Marshall Lerner”.
• Specifies that if the sum of the (absolute values of) price elasticities of
demand for imports and exports is larger than one, then a fall in the
exchange rate will cause positive movement in the current account.
• MLC: if|PEDx|+|PEDm|>1, then when a country’s currency depreciates
there will be long run positive movement in the current account balance
and when the country’s currency appreciates, there is long run negative
movement in the current account balance.
• Imagine now that this is NOT the case, say their combined value is
only .5. What happens as exchange rates fall?
 The J-Curve
• The J-curve describes the temporal (in relation to time) relationship
between exchange rate depreciation and a country’s current account
balance.
• It posits that a depreciation in the exchange rate will initially have a
negative impact on a country’s current account balance, before rebounding
with a positive impact.
• Why does the J curve describe the relationship between current account
balance and time in response to devaluation?
• Recall back to Price Elasticity of Demand; what happened to the PED of
all goods and services as time passed?
• Recall to the Marshall Lerner conditions: we need a combined elasticity
s.t. PED of imports + PED of exports>1, what do you think happens to
import spending and export revenue when the values of elasticity increase
and what impact does this have on Current Account balance?
 Reverse J Curve
• We have the opposite effect in response to an appreciation of the currency.
A stronger exchange rate will initially result in the current account balance
becoming more positive.
 J-Curve side-notes
Strangely enough, the J-curve describes lots of relationships in science,
social science, and medicine.
• 18. What would most help a country to achieve a surplus on the current account of the
balance of payments?(2014 s11)
A a depreciating exchange rate combined with a high rate of inflation and falling productivity
B a depreciating exchange rate combined with a low rate of inflation and rising productivity
C an appreciating exchange rate combined with a high rate of inflation and falling
productivity
D an appreciating exchange rate combined with a low rate of inflation and rising productivity
Demand for imports is often price inelastic in the short term. Over time, demand tends
to become more price elastic. What does this help to explain?
A why a fall in the exchange rate causes a deficit on the current account of the balance
of payments to increase before decreasing
B why a fall in the exchange rate causes inflation to rise before falling
C why a rise in the exchange rate causes a surplus on the current account of the balance
of payments to decrease before increasing
D why a rise in the exchange rate causes the terms of trade to worsen before improving
 External Consequences of Inflation
• External Consequence 1: Loss of international competitiveness of our
exports
• Demanding higher prices (in response to inflation and higher input prices)
in the domestic market prompts firms to demand higher nominal prices for
their exports, otherwise they would simply sell them in the domestic
market. This is why exports become “less competitive”
 External Consequences of Inflation
• Consequence 2: When our currency inflates and loses value, it is also highly
likely to depreciate.
• Demand for our exports decreases. Assuming elastic demand for those exports,
export spending also falls. This means we have less demand for our currency,
thus inflation causes depreciation.
• It is not enough to say “the currency devalued because of inflation so there is
also depreciation”. We must explicitly describe the process of higher export
prices, less export spending, and then lower demand for the currency resulting
in depreciation.
 Consequence 2 continued
• Imports don’t immediately respond to an increase in domestic price level; in
the short run imports will be cheaper than domestically produced goods,
incentivizing consumers to switch to consuming imports instead of
domestically produced goods. As a result, this raises the equilibrium price
and demand for imported goods until their price is roughly equivalent to that
of the domestically produced goods. This increase in demand for imported
goods, if they are elastic, will result in more import spending, and thus more
demand for foreign currencies, a higher price for foreign currencies, and
further downward pressure on the exchange rate (depreciation).
 External Consequences of inflation
• Consequence 3. Our current account experiences negative movement
because of inflation(if MLC is met).
• However we will see long run positive movement in the current account
because of the depreciation that was initially caused by inflation. In this
case, this particular consequence of inflation is self-correcting, to some
degree.
 Self-Correcting Vs Self-Reinforcing
• Self-correcting: A problem that eventually fixes itself automatically.
• Self-reinforcing: A problem that makes itself more severe or worse
automatically.
• (b) If an economy is experiencing inflation, discuss the view that its
government should be more concerned about the external effects than
its effects within the domestic economy.
• The external consequences are arguably less severe because they are
self-correcting, whereas some of the domestic (internal) consequences
are self-reinforcing. Int’l trade may also be a fairly small portion of
total GDP. But if exchange rates are fixed, NX is a big portion of GDP,
or the country heavily relies on imported raw materials…
 Causes of a current account deficit
• A growing domestic economy: As firms develop, they may source their
raw materials and inputs from foreign countries. This will increase import
expenditure, even if it reduces domestic prices while increasing output.
• Declining economic activity in trading partners: If countries that buy the
country’s imports have recessions or economic declines, because YED is
likely to be large and positive for their import spending, their expenditure
on imports (our exports) is likely to decrease.
• Structural problems: A long run deficit that lasts over the long run is
sometimes a serious threat. It indicates that domestic firms are not
internationally competitive and that the country may have to borrow to
finance the surplus spending. It might be because of an overvalued
exchange rate, a high inflation rate, or low labour/capital productivity.
 Financial Account deficits/surpluses
• A deficit in the financial account is not necessarily a bad thing at all. It
likely gives rise to an inflow of profits, interest, and dividends. It may just
mean that citizens and firms are investing abroad and making higher
returns doing so.
 Consequences of a Current Account
Deficit/Surplus
• A deficit allows residents of a country to consumer more products than the
country makes; they be “living beyond their means” and required to
borrow to finance this deficit.
• A deficit can reduce AD.
• A surplus does not necessarily indicate that the country is better off; the
country’s citizens may be deprived of options and would spend more on
imports if they could.
 Bellwork 12/4/2019
• How can inflation cause depreciation of a country’s currency? Describe
the exact process step-by-step.
 The Terms of Trade
• A measurement of the ratio between export and import prices
• Terms of Trade index = (index of export prices)/(index of import prices) *
100
• What causes changes in the Terms of Trade (TOT)? Simply, changes in the
supply and demand for imports and exports change their respective
equilibrium prices.
• When the TOT index rises, we call this favourable movement.
 Impacts of a change in TOT
• While when TOT increases this is called “favorable”, it’s impact is not
always actually good. This is because there can be different causes for
changes in the TOT.
• Imagine two scenarios:
• 1.) Exports rise in price because of an increase in demand abroad for a
country’s exports.
• Will the impacts for people living in the exporting country be favorable or
unfavorable?
• 2. Export prices go up because of an increase in the costs of production.
• Is the impact for people living in the exporting country positive?
 International Trade (quickly) Revisisted
• Trade Blocs
• Trade Creation and Diversion
 Trade Blocs
• These are regional groups of countries that agree to certain rules regarding
free trade.
• Effectively, they serve as agreements to maximize the benefits of free
trade for member nations
• They are Free trade areas, customs unions, and economic unions.
 Free Trade Areas
• A free trade area is exactly what it sounds like; member countries agree
not to have any trade restrictions placed on any other members.
• North American Free Trade Area (NAFTA) is one example. USA, Canada,
and Mexico agree not to use any protectionism against each other.
• They can still use tariffs and quotas against other countries, but do so
individually. For example, if Mexico sets a tariff on Belize, this does not
imply Canada and USA must as well.
 Customs union
• Same as a Free Trade Area, but now they share tariffs/quotas/etc with non
members.
• Countries within the customs union don’t have any trade protection
between members, but if one wants to set a tariff or quota on a non
member, all members must follow.
• Ex: In the previous example, if Mexico sets a tariff on Belize and it is in a
customs union with America and Canada, now the tariff also applies when
America and Canada buy Belize imports.
 Economic Union
• Here we have an even more integrated agreement. Now, not only is there
free trade between members and the same tariff/quota policy against non-
members, but labor and capital is mobile between members and they may
adopt a common currency.
• EU is an example.
 Trade Creation
• Joining an economic union means some removal of tariffs and quotas.
when the removal of tariffs allows members to specialize in comparative
advantage, we call this trade creation. Previously, we were unable to
import sufficient quantities of goods, but after tariffs are removed, we can.
This results in more productive resources being available for other uses.
 Trade Diversion
• Joining a trade bloc, in the case of economic or customs union, may
involve adopting other member nations tariffs with countries outside the
union. This may result in a country being forced to either domestically
produce something it used to import, or import it from a more expensive
and less efficient supplier.
 Ch 4. Section 1-2 practice questions
Q.4 2013 Jun
The best way to reduce a deficit on the current account of the balance of
payments is to change the value of the deficit country’s exchange rate.
(a) Explain how a change in a country’s exchange rate might reduce a deficit
on the current account of its balance of payments. [8]
(b) Discuss whether changing the exchange rate or imposing tariffs is the
better way of reducing a deficit on the current account of the balance of
payments. [12]
2013 Jun Q.4
The best way to reduce a deficit on the current account of the balance of
payments is to change the value of the deficit country’s exchange rate.
(a) Explain how a change in a country’s exchange rate might reduce a deficit
on the current account of its balance of payments. [8]
(b) Discuss whether changing the exchange rate or imposing tariffs is the
better way of reducing a deficit on the current account of the balance of
payments. [12]
2013 Nov Q.4
In October 2011, the Chinese Government said that they would not allow a
further rise in the international value of China’s currency, the yuan, because the
Chinese economy would be damaged.
(a) Explain how exchange rates are determined in a free market and how some
governments intervene to manage their exchange rate. [8]
(b) Explain the costs and benefits of a rising exchange rate and discuss whether
on balance an economy ‘would be damaged’ by a rising exchange rate. [12]
2014 Jun Q.4
(a) Explain the factors that might cause an economy to experience a current
account deficit. [8]
(b) Discuss the policies available to a government faced with a current
account deficit and consider which policy has the fewest disadvantages for
the consumers in that economy. [12]
Be careful to mention that the cause of the deficit heavily influences what
the optimal policy for fixing it is, and sometimes the answer is “do nothing”.
• (a) Explain what is used as money in a modern
economy. Consider how an increase in the money
supply can cause inflation. [8]
• (b) Discuss the consequences of high inflation.
Consider whether the internal consequences can ever
be more serious than the external consequences in an
economy that has extensive foreign trade. [12]