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20ECC003 - International Money and Finance > Week 3 - Balance of Payments > Flashcards

Week 3 - Balance of Payments Flashcards

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1
Q

What is the Balance of Payments?

A

The balance of payments records a country trade in goods, services,
and financial assets with the rest of the world.

  • Every transaction entered on both sides of balance sheet (Credit and Debit) -> If all transactions included, sum of all credits must equal to sum of all debits
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2
Q

What is Credit?

A

entries that bring foreign exchange into the country

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3
Q

What is Debit?

A

entries that foreign exchanges leave the country

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4
Q

When do we see a surplus or a deficit?

A

When credits > debits = a surplus

When credits < debits = a defcit

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5
Q

What can there be a deficit or surplus in?

A
  • merchandise trade (goods),
  • services trade,
  • foreign investment income,
  • unilateral transfers,
  • private investment,
  • the flow of gold and money between central banks and treasuries, or
  • any combination of these or other international transactions
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6
Q

What is the definition of a current account?

A

Good imports and good exports + Service imports and service exports +
Net receipts of investment income + Unilateral transfers

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7
Q

What does the Current Account measure the value of trade from?

A
  1. Net receipts of investment income = net factor income from abroad.
  2. Unilateral transfer, ex. gifts, pensions, and foreign aid
  3. Trade balance = exports - imports
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8
Q

What is the Net Receipts of Investment Income?

A

Foreign payments to capital, labor, and land owned by domestic firms
Domestic payments to capital, labor, and land owned by foreign firms

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9
Q

When can we see surpluses and deficits in the Trade Balance?

A

TB > 0 = Exports > Imports = trade surplus
TB < 0 = Exports < Imports = trade deficit
TB = 0 = Exports = Imports = balanced trade

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10
Q

What is the Capital Account?

A

Purchases and sales of financial assets (ex. buying
private or government bonds, stocks, and bank deposits) and direct
investment (ex. purchase of a plant in another country).

  • > Purchases of UK assets by foreigners -> Capital Inflow
  • > UK residents purchases foreign financial assets -> Capital Outflow
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11
Q

What is a Capital Account Surplus?

A 
Net capital inflow
 the home country received more capital transfers than it made
 Net borrower (issuing IOUs to lenders)
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12
Q

What is a Capital Account Deficit?

A 
Net capital outflow
The home country make capital transfers than it received
Net lender (acquiring IOUs from borrowers)
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13
Q

What do Capital Account transactions include?

A 
Official transactions
-any intervention in the foreign exchange market done by official
government sources.
-U.K. government assets abroad
- Foreign government assets in the U.K.

Private transactions:

  • Direct investment: private sector invests in foreign firms
  • Security purchases: purchases and sells stocks and bonds
  • Bank claims and liabilities: bank loans and deposits abroad
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14
Q

What is the Official Settlement Balance?

A

reflects transactions involving gold, foreign exchange reserves, bank deposits and special drawing rights (SDRs).

  • measures the net change in foreign exchange reserves and official government borrowing.
  • Can serve as measure for potential foreign exchange pressure on a dollar
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15
Q

Since BoP always balances what does this mean for CA and Capital Account

A

BOP = CA + KA = 0

CA + KA = 0

  • Current account surplus means Capital account deficit
  • Current account deficit means Capital account surplus
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16
Q

What does the Statistical discrepancy add to the BoP calculation?

A

Because not all international transactions properly recorded, the SD errors added:

CA + KA + SD = 0
SD = -(CA+KA)

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17
Q

What are some explanations for the large US trade deficit?

A
  1. Unfair trade
    US open to trade and thus imports a lot. Other countries closed so that they don’t buy enough from US
  2. Twin Deficit
    Because our govt runs budget deficit, so we would have trade deficit
  3. Investment Demand Shift
    People invest more in the US than before
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18
Q

What is the claim for Unfair Trade?

A

According to the claim, to explain US deficit since 1982, two things must happen:
1. Foreign countries must have suddenly increased their trade protection
in 1982.
2. All countries must have decided to protect themselves against the U.S.
at the same time

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19
Q

Why is the Claim for Unfair trade wrong?

A
  1. In fact, many countries reduced trade protection and opened their
    economies.
  2. There was no coordinated protection against the U.S.

Unlikely that this is an explanation for US trade deficit

20
Q

How can we identify twin deficits mathematically?

A

(Y-T-C)-I+(T+G)=(X-M)

Where:
(Y-T-C)=Private Saving
((T+G) = Public Saving

If LHS is negative(Total Savings), then so is RHS (NX)

Thus when budget deficit also trade deficit

(SEE NOTE FOR CLEARER DETAIL)

21
Q

With public saving when do we see a budget surplus or deficit?

A

T-G

T>G = Budget Surplus
T

22
Q

How does a trade deficit arise from a budget deficit?

A
  1. If Govt spending exceeds tax revenue (T-G<0), govt has to borrow money by issuing bonds (T Bills)
  2. Interests in US rise
  3. Suppose Interest US > Interest Japan, than Japan invest in US (via T-bills) increasing demand for dollar
  4. Dollar appreciates as more japanese trade Y for $
  5. US exports more expensive
  6. Imports cheaper

Thus, trade deficit

23
Q

How could the investment demand shift be a cause of the US trade deficit?

A

An increase in investment demand could come from 1980s deregulations and 1990s IT boom.

These events have increased demand for investment capital and driven the interest rate in the U.S. upward.

Leading to appreciation of dollar and with it NX down

24
Q

How can we eliminate the trade deficit?

A

Via twin deficits -> Eliminate the fiscal budget deficit

Via Investment Demand shift -> Ban foreign investment or make US unappealing for investment

(BOTH NOT BEST PRACTISE IN LR)

-> Trade deficit symptom of foreigners belief in country

25
Q

What happens if disequilibrium in the BoP?

A
  • Under floating:
    the exchange rate will adjust to restore the BOP equilibrium.
  • Under Fixed:
    the central bank must finance the trade imbalance by international reserve flows (there will be reserve assets losses from deficit countries and reserve accumulation by surplus countries).

Or, countries may use trade restriction on imports, exports or capital flows

26
Q

What are some of the main things that is focused on in traditional approaches to BoP determination? (CONSIDERING ALL THE THEORIES THAT DISCUSS BOP DETERMINATION)

A

-Focus on effect of a devaluation on a nation’s balance of payments.

  • Capital flows are not explicitly considered in the models, which focus
    only on a nation’s trade in goods and services.
  • The elasticities approach emphasizes price effects, while the absorption approach emphasizes income effects.

-.The quantity of a currency demanded in the foreign exchange market
is derived from the nation’s demand for imports.

-In this setting, capital flows are ignored, the quantity of euros demanded by residents of the United States is equal to the value of
their demand for imported European-produced items. (SEE GRAPH)

27
Q

What does elasticity tell us?

A

Elasticity tells us the proportionate change in quantity demanded or
supplied in response to a given proportionate change in price.

(SEE GRAPH)

28
Q

What is PED?

A

A measure of the proportional change of the quantity demanded to a
proportional change in price.

29
Q

What is PES?

A

A measure of the proportional change of the quantity supplied to a
proportional change in its price.

30
Q

What does the traditional, trade based theory of exchange-rate determination argue?

A
  1. The supply of foreign exchange to a nation results from its exports of
    goods and services.
  2. To purchase goods and services from foreign residents, domestic
    residents provide foreign currency.
  3. Hence, the domestic nation’s supply of exports implies a supply of
    foreign exchange.

-> Demand for imports generate demand for foreign exchange
-> Supply of exports generate supply of foreign exchange
(THIS IS BECAUSE CAPITAL FLOW ONLY OCCUR TO FINANCE CURRENT ACCOUNT TRANSACTIONS)

(SEE GRAPH FOR CLARITY)

31
Q

How do elasticities affect the trade based theory?

A

->Just as the elasticity of import demand determines the elasticity of
the demand for foreign exchange demand, the elasticity of export
supply also determines the elasticity of the supply of foreign exchange.

->If the supply of exports is more elastic, the supply of foreign exchange
is also more elastic

(SEE GRAPH FOR CLARITY)

32
Q

What does the Elasticities approach argue?

A

->Centers on changes in the prices of goods and services as the determinant of a nation’s balance of payments and the exchange
value of its currency

->the main determinant of a nation’s balance of
payments and the exchange value of its currency

-> U.S. residents demand for imported goods and services generates their demand for foreign exchange and that U.S. producers’ supply of
exports yields the supply of foreign exchange

-> When foreign exchange demand by US residents exceeds the one supplied by US producers, US has a deficit.

33
Q

What is the role of elasticity in the elasticities approach?

A
  • Elasticities of S and D for foreign exchange are fundamental determinants of adjustment to a BoP deficit
  • The elasticity measures of the demand and supply curves for foreign exchange merely reflect the elasticities
  • Elasticities of export supply and import demand depend on many factors
34
Q

What can a depreciation theoretically do?

A

a depreciation can increase the difference between the quantity of foreign exchange supplied and the
quantity demanded

35
Q

What is an exchange rate instability?

A

situation in which a currency depreciation increases the difference between the quantity of foreign exchange supplied and the quantity of
foreign exchange demanded instead of reducing the difference.

36
Q

What is the Marshall Lerner Condition?

A

A devaluation in the exchange rate eventually leads to a net improvement in the trade balance if the sum of PED for X and M>1

37
Q

What is the J curve?

A

depreciation in the exchange rate can cause a deterioration of the current account in the short-term (because demand is inelastic)
But in the long term as demand become more price elastic we see an improvement in the current account

-> Represent the time lag seen in macroeconomic policies

(SEE GRAPH IN NOTES)

38
Q

What does the absorption approach assume?

A

-Assumes prices remain constant and emphasizes changes in real domestic income

39
Q

What is the definition of the absorption approach?

A

Theory of balance-of-payments and exchange-rate determination that emphasizes the role of a nation’s expenditures, or absorption, and income.

According to the absorption
approach, if a nation’s real income exceeds the amount of goods and services that it absorbs, then the nation will run a current account surplus.

40
Q

What is the model the Absorption approach does for the market?

A

a = c + i + g + im

Exports not included as represent another nation’s expenditure on domestic final goods and services

41
Q

What is Absorption?

A

A nation’s total expenditure on final good and services net of exports

42
Q

Under the Absorption approach what is defined as a nation’s real income?

A

->Equivalent to the real
expenditures on its output of final goods and services

->Hence, real income is equal to real consumption expenditures, real
investment expenditures, real government expenditures, and other
nations real expenditures on its output, or its real exports

43
Q

What is a nation’s real income represented as (In Absorption)?

A

y = c + i + g + x

Where:
y = Real Income
x = Real Exports

CA repped by difference between foreign real expenditures on exports and real expenditures on imports:

ca = x - im

44
Q

What does the Absorption Approach argue overall?

A

->If real exports exceed real imports, the nation is running a current
account surplus.

->If real exports are equal to real imports, the nation’s current account
is balanced.

->If real exports are less than real imports, the nation is running a
current account deficit.

Nation’s current account determined by difference between income and absorption

45
Q

How can we rewrite the Absorption method including absorption?

A

y-a = (c+i+g+x) - (c+i+g+im)

Rewritten as:
y - a = x - im
or
y - a = ca

Hence, nation’s current account determined by difference between real income and its absorption

20ECC003 - International Money and Finance (11 decks)

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