Unit VII

 

• Balance of payments
• Measure of money inflows and outflows between the United States and the Rest of the World (ROW)
• Inflows are referred to as CREDITS
• Outflows are referred to as DEBITS
• The Balance of Payments is divided into three accounts
• Current Account
• Capital/Financial Account
• Official Reserves
• Double Entry Bookkeeping
• Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice
• Ex: U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland
• A credit of $50 million to the current account (-$50 million worth of farm equipment or physical assets
• A debit of $50 million to the capital/financial account (+$50 million worth of Euros or financial assets)
• Notice that the two transactions offset each other. Theoretically, the balance payments should always equal zero… Theoretically
• Current Account
• Balance of Trade or Net Exports
• Exports of goods/services (inflow)
• Import of goods/services (outflow)
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments
•  Net Foreign Income
• Income earned by U.S. owned foreign assets – Income paid to foreign held U.S. assets
• Ex. Interest payments on U.S. owned Brazilian bonds – Interest payments on German owned U.S. Treasury bonds
• Net Transfers (tend to be unilateral)
• Foreign Aid → a debit to the current account
• Ex. Mexican migrant workers send money to family in Mexico
• Capital/Financial Account
• The balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the United States is a credit to the capital account
• Ex. The Toyota Factory in San Antonio
• Direct investment by US. firms/individuals in a foreign country are debits to the capital account
• Ex. The Intel Factory in San Jose, Costa Rica
• Purchase of foreign financial assets represents a debit to the capital account
• Ex. Warren Buffet buys stock in Petrochina
• Purchase of domestic financial assets by foreigners represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ
• What causes capital/financial flows?
• Differences in rates of return on investment
• Ceteris Paribus, savings will flow toward higher returnRelationship Between Current and Capital Account
• Remember Double entry bookkeeping?
• The current account and the capital account should zero each other out
• That is… if the current account has a negative balance (deficit), then the capital account should then have a positive balance (surplus)
• Official Reserves
• The foreign currency holdings of the United States Federal Reserve System
• 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, the Fed depletes its reserves of foreign currency and credits the balance of payments
• The official reserves zero out the balance of payments
• Credits vs. Debits
• Credits - additions to a nation's account
• Debits - subtractions to a nation's account
• How to Calculate the Following
• Typically...
• Balance on trade:
• Merchandise & service exports minus merchandise & service imports
• If have both, then goods exports minus goods imports
• Trade deficit occurs when the balance on trade is negative (imports > exports)
• Trade surplus occurs when the balance on trade is positive (exports > imports)
• Balance on Current Account
• Balance on trade (exports & imports) + Net investment income + Transfer payments
• Official Reserves
• Nationally: Change in CA + Change in FA + Change in Official Reserves = 0
• Foreign Exchange (Forex)
• The buying and selling of currency
• Ex. In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros
• The exchange rate (e) is determined in the foreign currency markets
• Ex. The current exchange rate is approximately 77 Japanese Yen to 1 U.S. Dollar
• Simply put, the exchange rate is the price of a currency
• Do not try to calculate the exact exchange rate
• Ex. We demand (tourist places) Cancun from Mexico
• Changes in Exchange Rates
• Exchange rates (e) 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
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency
• Appreciation and Depreciation
• Appreciation of a currency occurs when the exchange rate of that currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases
• Ex. If German tourists flock to America to go shopping, then the supply of Euros will increase and the demand for dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate
• Exchange Rate Determinants
• Consumer Tastes
• Ex. A preference for Japanese goods creates an increase in the supply of dollars in the currency exchange market which leads to depreciation of the dollar and an appreciation of Yen
• Relative Income
• Ex. If Mexico's economy is strong and the U.S. economy is in recession, then Mexicans will buy more American goods, increasing the demand for the dollar, causing the dollar to appreciate and the Peso to depreciate
• Relative Price Level
• Ex. If the price level is higher in Canada than in the U.S., then American goods are relatively cheaper than Canadian goods, thus Canadians will import more American goods causing the U.S. dollar to appreciate
• Speculation
• Demand $ - exports and capital inflows
• When the U.S. exports goods/services to other countries, they need OUR dollar to complete the transaction. So they demand OUR money, first they need to SUPPLY theirs.
• Supply $ - imports and capital outflows
• When we import goods/services from other countries, we need THEIR money to complete the transaction. So we demand THEIR money, we need to SUPPLY ours.
• Tips
• Always change the D line on one currency graph, the S line on the other currency's graph
• Move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer
• If D on one graph increases, S on the other will also increase
• If D moves to the left, S will move to the left on the other graph
• Flexible/Floating Exchange Rate
• Set by market forces with little or no government intervention
• Fixed Exchange Rate - determined by government policies
• Absolute Advantage v. Comparative Advantage
• Absolute Advantage
• Faster, more, more efficient
• Comparative Advantage
• Lower opportunity cost
• The same country can have an absolute advantage in two products