Topic 2 - Balance of Payments Flashcards
Define balance of payments.
The balance of payments (BOP) can be defined as the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping.
The United States has experienced continuous current account deficits since the early 1980s. What do you think are the main causes for the deficits? What would be the consequences of continuous U.S. current account deficits?
The current account deficits of U.S. may be attributable to (i) the strong dollar and undervalued currencies of trading partners such as China, (ii) high consumption and low savings in the U.S., (iii) weak competitiveness of U.S. industries, especially manufacturing sector. If U.S. deficits continue, the dollar may eventually depreciate substantially and the confidence in dollar may suffer.
In contrast to the United States, Japan has realized continuous current account surpluses. What could be the main causes for these surpluses? Is it desirable to have continuous current account surpluses?
Japan’s continuous current account surpluses may have reflected a weak yen and high competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from appreciating more than it did. At the same time, foreigners’ exports to Japan were hampered by closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by the mercantilist policies.
Comment on the following statement: “Since the United States imports more than it exports, it is necessary for the United States to import capital from foreign countries to finance its current account deficits.”
The statement presupposes that the U.S. current account deficit causes its capital account surplus. In reality, the causality may be running in the opposite direction: U.S. capital account surplus may cause the country’s current account deficit. Suppose foreigners find the U.S. a great place to invest and send their capital to the U.S., resulting in U.S. capital account surplus. This capital inflow will strengthen the dollar, hurting the U.S. export and encouraging imports from foreign countries, causing current account deficits.
Explain how a country can run an overall balance-of-payments deficit or surplus.
A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions. For example, an overall BOP deficit can be supported by drawing down the central bank’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central bank’s reserve holdings.
Explain how to compute the overall balance and discuss its significance.
The overall balance is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall balance is significant because it indicates a country’s international payment gap that must be financed by the government’s official reserve transactions.
Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S. Treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio investment on the U.S. balance of payments.
As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in the long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to foreigners. If foreign funds are used productively and contributes to the competitiveness of U.S. industries, however, U.S. BOP may improve in the long run.
Describe the balance-of-payments identity and discuss its implications under the fixed and flexible exchange rate regimes.
The balance of payments identity holds that the combined balance on the current and capital accounts should be equal in size, but opposite in sign, to the change in the official reserves: BCA + BKA = -BRA. Under the pure flexible exchange rate regime, central banks do not engage in official reserve transactions. Thus, the overall balance must balance, i.e., BCA = BKA. Under the fixed exchange rate regime, however, a country can have an overall BOP surplus or deficit as the central bank will accommodate it via official reserve transactions.
Credits on the balance of payments
associated with cash inflows (exports) and have a positive sign
Debits of the balance of payments
associated with outflows (imports, dividends paid to foreigners) and have a negative sign
For the U.S. balance of payments
- Credit entries generate a demand for dollars (supply of foreign currency_
- Debit entries generate a supply of dollars (demand for foreign currency)
Current account
summarizes the flow of funds due to purchases of goods/merchandise or services or the payment of income on financial assets (top of the BOP statement)
Capital account
summarizes the flow of funds resulting from the sale of assets (bottom of the BOP statement)
The official reserve account
Includes transactions undertaken by the central bank (the Federal Reserve in the U.S) to finance the overall balance and intervene in foreign exchange markets
Factor income
the difference between the receipts of interest and dividends on foreign investments by U.S. investors and the payment of interest and dividends on U.S. investments to foreigners.
