Unit VII

Balance of Payments

• Measures of money inflows and outflows between the U.S. and the rest of the world
  
• Inflow = credit
• Outflow = debit
• Divided into 3 accounts
• Current Account
• Capital/Financial Account
• Official/Reserve Account

Double Entry Bookkeeping

• Every transaction in the balance of payments is recorded twice with standard accounting practive

Current Account

• Balance of trade/Net exports
• Exports of goods/services - import of goods/services
• Exports = credit
• Import = debit
• Net Foreign Income
• Income earned by U.S. owned foreign assets - income paid to foreign held U.S. assets
• Net Transfers
• Foreign aid  - debit to the current account

Capital/Financial Account

• Balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the U.S. is a credit to the capital account
• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account
• Purchase of foreign financial assets represents a debit to the capital account
• Purchase of domestic financial assets by foreigner represents a credit
• What causes these flows?
• Differences in rates of return on investment
• Ceteris Paribus, savings will flow toward higher returns

Relationship between Capital and Current Account

• Double entry bookkeeping
• Zero each other out

Official Reserves

• Foreign currency holding of the U.S. Fed
• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments
• When there is a balance of payments deficit there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments

Credit vs. Debit

• Credit - addition to a nation's account
• Debit - subtractions to a nation's account

How to Calculate

1. Balance on trade
• Merchandise and service exports - merchandise and service imports
2. Trade deficit occurs when the balance on trade is negative
• imports > exports
3. Trade surplus when bot is positive
• exports > imports
4. Balance on current account
• Balance on trade + net investment income + transfer payments
5. Official Reserves
• Nationally change in CA + change in FA + change in official reserves = non zero

Foreign Exchange (FOREX)

• Buying and selling of currency
• The exchange rate is determined in the foreign currency markets
• Exchange rate is price of currency

Changes in Exchange Rates

• Exchange rates are a function of the supply and demand for currency
• An increase in the supply of a currency will decrease the exchange rate of a currency
• Decrease in supply of currency will increase exchange rate
• Increase in demand for currency, increase in e
• Decrease in demand for currency, decrease in e

Appreciation and Depreciation

• Appreciation - when e of currency increases
• Depreciation - when e of currency decreases

Exchange Rate Determinants

• Consumer's Taste
• Relative Income
• Relative Price level
• Speculation

Flexible Exchange Rate

• Set by market forces with little or no government intervention

Fixed Exchange Rate

• Determined by government policies

Absolute Advantage - Faster, more efficient

Comparative Advantage - Lower opportunity cost

• Same country can have absolute advantage in 2 products
• Can only have one comparative advantage in 1