Module 4 - Assignment 2: International Balance of Payments and Exchange Rates

November 23, 2014

Contents
The balance of payments............................................................................................................................2
Exchange rates............................................................................................................................................3
Theories and assessment of the balance of payments................................................................................3
References...................................................................................................................................................5
 Module 4 - Assignment 2: International Balance of Payments and Exchange Rates
November 23, 2014

The balance of payments

The balance of payments refers to the all the money payments between a given country and
the rest of the world. The term can be used in two ways: It can refer to the record of all
international payments, maintained by national Statistical agencies or it can refer to the sum of
all payments made by people in one country to people in another.

Economists sometimes say that a country is running into balance of payments problems or
facing a balance of payments constraint. This means that it is in a situation where the total
flows of foreign exchange into the country are not enough to maintain the total flows out of the
country. For example, United States can never run into balance of payments problems, since US
dollars are accepted as payment by the rest of the world. The US could only face a balance of
payments constraint if the dollar ceased to be accepted as payment in the rest of the world and
US can always print as much of its own currency as it needs to, to make its international
payments.

The balance of payments consists of the current account: imports, exports, income flows and
transfers. Imports and exports consist of trade flows purchases of goods and Services from one
country by a person, business or government in a different Country. Trade flows can be further
divided between goods and services. Tourism is considered a service export from the country
visited. Income flows are the payments for the use of factors of production labor, capital, or
money from one country for production in a different country. The most important income
flows are profits paid out to owners of foreign Investment.

Suppose that a Brazilian company owns a factor in Mexico, and profits made by that factory are
counted as an income payment from Mexico to Brazil. Interest and on foreign loans is also
counted as income. Wages count as income flows in the balance of payments when a person
resides in one country but works in a different one. Income flows are counted in Gross National
Product (GNP), but not in Gross Domestic Product (GDP).

The capital or financial account consists of international lending and borrowing and asset sales.
This was formerly called the capital account, and is now officially called the financial account; in
practice both names are used. Purchases of assets in another country are also called foreign
investment, and are divided into portfolio investment and direct investment. Foreign
investment that that involves only financial assets is called Portfolio investment. Foreign
investment that involves purchases of real productive assets like land, buildings or businesses is
called foreign direct investment (FDI).
 Module 4 - Assignment 2: International Balance of Payments and Exchange Rates
November 23, 2014

A final item, usually reported separately but sometimes included in the financial account, is
official foreign exchange reserves. If the economy is in balance of payments equilibrium, the
above items will sum to zero. If they don’t, the country is gaining or losing foreign exchange
reserves. A deficit refers to a situation where outgoes exceed income. In the context of
international finance, there are several different deficits that people may refer to. A trade
deficit means more money is flowing out of the country in payments for goods and services
than is flowing in for goods and services; in other words, it means that imports are greater than
exports. A current account deficit means that the current account as a whole is negative. This
might well mean that the country has a trade deficit, since trade flows are usually the largest
items in the current account. But it is possible for a country to have a trade surplus and a
current account deficit, for instance if it is making large payments on foreign debt. The current
account balance is important because a current account deficit means that country is a net
borrower from the rest of the world. Finally, a balance of payments deficit means more money
is flowing out of the country taking all payments together, than is flowing in taking all payments
together. In this case, the country must be losing international reserves, and may face a crisis if
reserves are inadequate.

Exchange rates

The nominal exchange rate between two countries indicates how many units of the first
country’s currency you can buy for one unit of the second country’s currency. For example, the
nominal exchange rate between the US and the UK might be 2 dollars per pound. We speak of a
country’s currency appreciating or getting stronger when one unit of that currency can buy
more of a foreign currency than it was formerly able to. We speak of a currency depreciating or
getting weaker when one unit can buy fewer Units of a foreign currency than formerly.

Theories and assessment of the balance of payments

A number of theories have been developed to explain the adjustment process of the balance of
payments. In a world without capital flows the elasticity’s approach provides an analysis of how
changes in the exchange rate affect the trade balance, depending on the elasticity’s of demand
and supply for foreign exchange and/or goods. Exchange rate depreciation increases the
domestic price of imports and lowers the foreign price of exports.
 Module 4 - Assignment 2: International Balance of Payments and Exchange Rates
November 23, 2014

United States balance of payments, 1970-2005

(In millions of U.S. dollars)
Column1 1970 1980 1990 2000 2005
Current account
Exports of goods and services and
68,387.00 344,440.00 706,975.00 1,421,515.00 1,749,892.00
income receipts
Exports of goods and services 56,640.00 271,834.00 535,233.00 1,070,597.00 1,275,245.00
Income receipts 11,748.00 72,606.00 171,742.00 350,918.00 474,647.00
Imports of goods and services and
259,901.00 –333,774 –759,290 –1,778,020 –2,455,328
income payments
Imports of goods and services –54,386 –291,241 –616,097 –1,448,156 –1,991,975
Income payments –5,515 –42,532 –143,192 –329,864 –463,353
Unilateral current transfers, net –6,156 –8,349 –26,654 –58,645 –86,072
U.S. Government grants –4,449 –5,486 –10,359 –16,714 –31,362
U.S. Government pensions and other
–611 –1,818 –3,224 –4,705 –6,303
transfers
Private remittances and other
–1,096 –1,044 –13,070 –37,226 –48,407
transfers
Capital account
Capital account transactions, net — — –6,579 –1,010 –4,351
Financial account
U.S.-owned assets abroad, net
–8,470 –85,815 –81,234 –560,523 –426,801
(increase/financial outflow (–))
U.S. official reserve assets, net 3,348.00 –7,003 –2,158 –290 14,096.00
U.S. Government assets, other than
–1,589 –5,162 2,317.00 –941 5,539.00
official reserve assets, net
U.S. private assets, net –10,229 –73,651 –81,393 –559,292 –446,436
Foreign-owned assets in the U.S., net
–6,359 62,612.00 141,571.00 1,046,896.00 1,212,250.00
(increase/financial inflow (+))
Foreign official assets in the United
6,908.00 15,497.00 33,910.00 42,758.00 199,495.00
States, net
Other foreign assets in the United
–550 47,115.00 107,661.00 1,004,138.00 1,012,755.00
States, net
Statistical discrepancy (Sum of above
–219 20,886.00 25,211.00 –70,213 10,410.00
items reversed)

Elastic; the same is the case for the behavior of exports after a decline in export prices. Thus,
the final impact on the current account balance depends on the elasticity of demand in each
country for the other country’s goods and services.
 Module 4 - Assignment 2: International Balance of Payments and Exchange Rates
November 23, 2014

References

Dornbusch, Rudiger, Stanley Fischer, and Richard Startz. 2004. Macroeconomics, 8th ed. Boston: McGraw-Hill.

Frenkel, Jakob, and Harry G. Johnson, eds. 1976. The Monetary Approach to the Balance of Payments. Toronto: University of
Toronto Press.

Husted, Steven, and Michael Melvin. 2007. International Economics, 7th ed. Boston: Pearson/Addison-Wesley.

International Monetary Fund. Various years. Balance of Payments Statistics Yearbook. Washington, DC: Author.

SOURCE: Bureau of Economic Analysis, International Economics Accounts, U.S. Department of Commerce,
http://www.bea.gov/international, Washington, D.C., 2006.