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

servicesX = 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 sector’s adding to the physical stock of

capital, including inventories. (individual household’s purchases of stocks, bonds or real estates are not included)

Government purchases = spending by federal, state, or local governments

National Income Account

1999 C 67.6% $6.3 trillion I 17.5% $1.6 G 17.6% $1.6 CA -2.7% -$0.25

Current account balance

(Domestic spending on goods and services produced domestically)

= C + I + G – M (Foreign spending on goods and services

produced domestically)

= X

Current account balance (cont’d)

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 (cont’d)

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 accumulationCA = 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 gov’t budget deficit leads to a large current account

deficit.

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 (cont’d)

C. Unilateral Transfers (debit) US foreign aid, gifts, retirement pensions, interest

payments to foreigners on their US gov’t 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 gov’t assets 3. US private assets (direct investment, foreign

securities) B. Foreign assets in US

1. Foreign official assets in US (US gov’t securities, …) 2. Other foreign assets in US (direct investment, US

treasury securities)

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.

For Germany Credit: Foreign asset held in Germany Debit: German asset held abroad

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 $300 Credit: US assets held abroad $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 bank’s official reserve transactions.

BOP deficit the country is running down its official reserves.