BALANCE OF PAYMENTS

WHY DO COUNTRIES TRADE?

 Trade is simply buying and selling goods and
services from other countries.
 Imports: The purchase of goods and
services from foreign countries leading to
outflow of currency.
 Export: The sale of goods and services
leading to inflow of foreign currencies.
 But what really prompts countries to do these
trades?
WHY DO COUNTRIES TRADE?
 Different countries according to various
factors have different levels of efficiency in
producing different goods.
 Comparative Advantage
 When a country can produce goods at lower
opportunity cost i.e. it sacrifices less resources in
production.
 Absolute Advantage
 When a country can produce goods with fewer
resources than another country.
WHY DO COUNTRIES TRADE?
 A unit of labour can produce either 10 Good1
or 5 Good2 in country A, and a unit of labour
in country B can produce either 20 Good1 or
40 Good2.
 Thus opportunity cost of producing additional
Good2 is high in country A, and opportunity
cost for producing Good1 is higher in country
B.
Countries Good 1 Good 2
Country A 5 2.5
Country B 10 20
Total 15 22.5
WHY DO COUNTRIES TRADE?
 Now suppose the countries produce the goods in
which they have minimum opportunity cost i.e.
they achieve specialisation in the suitable good
and then trade.
 Larger quantities will be produced and they will
have mutual benefits.
 Below is Table for such production.(Lets suppose
still Country B produces good 1 due to fear of
shortage)
Countries Good 1 Good 2
Country A 10 0
Country B 5 30
Total 15 30
WHY DO COUNTRIES TRADE?
 The tables below compare outputs before and
after trading, showing benefits.
Countries Good 1 Good 2
Country A 5 2.5
Country B 10 20
Total 15 22.5

Countries Good 1 Good 2

Country A 5 5
Country B 10 25
Total 15 30
BALANCE OF PAYMENTS
 A country’s balance of payments accounts
keep track of both its payments to and its
receipts from foreigners.
 Any transaction resulting in a payment to
foreigners is entered in the balance of
payments accounts as a debit and is given a
negative (—) sign.
 Any transaction resulting in a receipt from
foreigners is entered as a credit and is given
a positive (+) sign.
BALANCE OF PAYMENTS
 Three types of International Transactions are
recorded in Balance of Payments:
 Transactions that involve the export or import of
goods or services. They enter directly into the
current account.
 The financial account records all international
purchases or sales of financial assets.
 Certain other activities resulting in transfers of
wealth between countries are recorded in the
capital account.
BALANCE OF PAYMENTS
BALANCE OF PAYMENTS:
CURRENT ACCOUNT
 The balance of payments accounts divide
exports and imports into three categories:
 Merchandise trade
 Exports or imports of goods.
 Services
 Payments for legal assistance, tourists’ expenditures,
and shipping fees.
 Income
 International interest and dividend payments and the
earnings of domestically owned firms operating
abroad.
 It also includes unilateral current transfers
(like gifts and foreign aids).
BALANCE OF PAYMENTS:
FINANCIAL ACCOUNT
 It measures the difference between sales of assets
to foreigners and purchases of assets located
abroad.
 Financial inflow (capital inflow)
 A loan from the foreigners with a promise that they will
be repaid.
 Financial outflow (capital outflow)
 A transaction involving the purchase of an asset from
foreigners.
 Example:
 When an American company buys a French factory,
the transaction enters the U.S. balance of payments
as a debit in the financial account.
BALANCE OF PAYMENTS:
CAPITAL ACCOUNT
 These international asset movements differ from
those recorded in the financial account.
 For the most part they result from nonmarket
activities, or represent the acquisition or disposal
of non-produced, nonfinancial, and possibly
intangible assets (such as copyrights and
trademarks).
 Examples:
 If U.S. government forgives $1 billion in debt owed to
it by Pakistan, U.S. wealth declines by $1 billion, or the
$1 billion is recorded as debt in U.S. capital account.
 If wealthy British citizen immigrates to U.S. and brings
along $5billion in British asset, result would be a $5
billion credit in U.S. capital account.
BALANCE OF PAYMENTS
 Simple rule of double-entry book keeping:
 “Every international transaction automatically
enters the balance of payments twice, once as a
credit and once as a debit.”

 It holds true as every transaction has two

sides:
 Ifyou buy something from foreigner, you must
pay him/her in someway.
EXAMPLES
 A U.S. citizen buys a $1000 typewriter from
an Italian company, and the Italian company
deposits the $1000 in its account at Citibank
in New York.
 That is, the U.S. trades assets for goods.

 This transaction creates the following two

offsetting entries in the U.S. balance of
payments:
 It enters the U.S. CA with a negative sign (-$1000).
 It shows up as a $1000 credit in the U.S. financial
account.
EXAMPLES
 A U.S. citizen pays $200 for dinner at a
French restaurant in France by charging his
Visa credit card.
 That is, the U.S. trades assets for services.

 This transaction creates the following two

offsetting entries in the U.S. balance of
payments:
 It enters the U.S. CA with a negative sign (-$200).
 It shows up as a $200 credit in the U.S. financial
account.
EXAMPLES
 A U.S. citizen buys a $95 newly issued share of
stock in the United Kingdom oil giant British
Petroleum (BP) by using a check drawn on his
stockbroker money market account. BP deposits
the $95 in its own U.S. bank account at Second
Bank of Chicago.
 That is, the U.S. trades assets for assets.
 This transaction creates the following two
offsetting entries in the U.S. balance of
payments:
 It enters the U.S. financial account with a negative
sign (-$95).
 It shows up as a $95 credit in the U.S. financial
account.
EXAMPLES
 A U.S. bank forgives $5000 in debt owed to it
by the government of Pakistan.
 This transaction creates the following two
offsetting entries in the U.S. balance of
payments:
 It enters the U.S. capital account with a negative sign
(-$5000).
 It shows up as a $5000 credit in the U.S. financial
account.
BALANCE OF PAYMENTS
 Any international transaction automatically gives
rise to two offsetting entries in the balance of
payments resulting in a fundamental identity:

 Current account + financial account + capital account

=0
BALANCE OF PAYMENTS:
STATISTICAL DISCREPANCY
 Data associated with a given transaction may
come from different sources that differ in
coverage, accuracy, and timing.
 This makes the balance of payments
accounts seldom balance in practice.
 Account keepers force the two sides to
balance by adding to the accounts a
statistical discrepancy.
 It is very difficult to allocate this discrepancy
among the current, capital, and financial
accounts.
BALANCE OF PAYMENTS
 Official Reserve Transactions
 Central bank
 The institution responsible for managing the supply of
money.
 Official international reserves
 Foreign assets held by central banks as a cushion
against national economic misfortune.
 Official foreign exchange intervention
 Central banks often buy or sell international reserves
in private asset markets to affect macroeconomic
conditions in their economies.
CURRENT ACCOUNT BALANCE AS % OF
GDP IN SELECTED COUNTRIES: 1970–
2003
BALANCE OF PAYMENTS
 Case Study: Is the United States the
World’s Biggest Debtor?
 At the end of 1999, the United States had
a negative net foreign wealth position far
greater than that of any other single
country.
 The United States is the world’s biggest
debtor.
 However, the United States has the world’s
largest GNP.
EXCHANGE RATES AND TRADE
 When individuals, businesses and
governments in one country want to trade,
borrow or lend in another country, they must
convert their currency into the other country
currency for the transaction.
 Exchange rates are important because they
enable us to translate different counties’
prices into comparable terms.
 Exchange rates are determined in the same
way as other asset prices i.e. supply and
demand.
EXCHANGE RATES
 An
exchange rate can be quoted in two
ways:
 Direct:
 The price of the foreign currency in terms of
domestic currency.
 Example: $0.01 per yen.

 Indirect:
 The price of domestic currency in terms of the
foreign currency.
 Example: 0.68 euro per dollar.
EXCHANGE RATES
 Nominal exchange rate or the exchange rate
is the price of one country’s currency in
terms of another country’s currency.
 Example: Japan’s yen per U.S. dollar, India’s
rupees per euro.
 When a U.S. consumer wants to buy a
Japanese camera it has two parts:
 Price of camera in yen.
 Price of yen in dollars.
 If camera is worth 25,000 yen and yen is
worth $0.01, then dollar price for camera is
$250.
EXCHANGE RATES
 Two types of changes in exchange rates:
 Depreciation of home country’s currency
A rise in the home currency prices of a foreign
currency.
 It makes home goods cheaper for foreigners and
foreign goods more expensive for domestic
residents.
 Appreciation of home country’s currency
A fall in the home price of a foreign currency.
 It makes home goods more expensive for
foreigners and foreign goods cheaper for
domestic residents.