AJAFIN 6605-04

BOP & INTERNATIONAL ECONOMICS LINKAGES

✦ This chapter presents financial and real linkages
between domestic and global economies and analyzes
how these linkages affect business activities.
✦ It examines the basic forces underlying the flow of
goods, services and capital between countries and how
these flows are impacted by economic, political and
cultural factors.
✦ BOP statistics are closely followed by economists,
bankers, investors, foreign exchange traders, and
policy makers. 1
 An Outline:
 The BOP definition.
Credits & Debits as Sources & Uses of Funds
 Three Major BOP Categories.
✦ The Current Account: Is
the balance on current spending.
Records flow of goods, services, factors, and
transfers.
– Balance on Trade
– Balance on Goods, Services and Factor Incomes
– Transfer Payments --- Gifts and Grants
– The Current Account Balance
Current account transactions are income-related flows. 2
✦ The Capital Account: Records public and privates
investment and lending activities.
– Long-term Capital – Trade in paper e.g. deeds, corporate
securities, and various debt instruments.
– Short-term Capital – Short-term financial instruments e.g.
Demand Deposits, T-Bills, CD's, Bankers Acceptance (BAs),
Commercial Papers (CP), and Repurchase Agreements (Repos).

Capital account transactions are asset related flows.

✦ Official Reserve Account: Measures changes in
holding of gold and convertible currencies by Central
bank or monetary authorities.
Reserve assets consist of gold, convertible currencies,
SDR, and reserve position in the IMF.
3
 Other Components of the BOP Include:
✦ The Basic Balance - is the sum of the balance on current
account and the long-term capital account.
It indicates the extent to which long-term capital flows
(autonomous) are affecting the balance of payments.
✦ The Performance Balance -provides a summary of all
autonomous flows plus some accommodating flows. It
is computed by adding short-term capital account to the
basic balance.
It shows the extent to which short-term investments are
affecting the pressure on domestic currency.
✦ Errors and Omissions (Statistical Discrepancies)
4
✦ The SDR - is an artificial currency or a unit of
account, computed as:
5
SDR = ∑W
i=1
i Ci

A five currency composite since 1980

(16 currency composite, 1974-1980).
(With Euro, SDR is a 4 currency composite)

5
 BOP and International Economic Linkages
Definition:
 The balance of payment is a systematic record of all
economic transactions between the residents of the
reporting country and the residents of foreign
countries (the rest of the world) during a given period
of time - usually 1 year.

 An international economic transaction involves

the transfer of title or rendering of service from
residents of one country to residents of another
country.
6
 The BOP is based on the rule of double-entry
bookkeeping in which every credit entry brings about
an equal and offsetting debit entry so that debits equal
credits and the sum of all transactions equal zero.
 In practice many transactions are only partly recorded,
estimated on the basis of surveys, or missed
altogether.
 A credit transaction is one that leads to the receipt of a
payment from foreign entities.
 A debit transaction leads to a payment being made to
foreign entities.
7
 Alternatively, viewed as "sources" and "uses“ of
funds, the BOP is a form of flow of funds statement
showing changes in assets, liabilities, and net-worth
overtime.
 In this framework, exports, investment income from
abroad, gifts received from abroad, borrowing from
abroad, and other credits (e.g., allocation of SDR) are
sources of funds.
 Imports, investment income paid to foreign residents,
gifts sent abroad, lending and investing abroad, and
acquisition of international reserve assets (acceptable
for final settlement of international debt) are uses of
funds.
8
 The Current Account:
 Includes trade in goods and services and transfer
payments.
Transfer payments are gifts made by private and
public entities to foreigners, and gifts received from
foreign private and public entities.
 Exports of goods and services and the receipt of
transfer payments are entered as credits because they
lead to receipt of payments from foreigners.
 Imports of goods and services and the granting of
transfer payments are entered as debits because they
lead to payments to foreigners. 9
 The Capital Account:
Shows flows of international investments and loans,
both long-term and short-term.
 Long-term refers to a maturity of one-year or more
and include direct investments (building of foreign
plants) portfolio investments (purchase of foreign
stocks and bonds) and international loans for one-year
or more.
 International capital movements (both L-T & S-T) are
further subdivided into private and official (i.e., of
monetary authorities) and non-liquid (such as foreign
bank loans to finance trade) and liquid (such as
foreign bank deposits). 10
 Decreases in a nation's foreign assets (e.g. U.S.
claims on foreigners) and increases in a nation's
foreign liabilities (e.g. foreign claims on U.S.)
represent capital inflows or credits because they
lead to the receipt of payments from foreigners.

 Increases in foreign assets and decreases in

foreign liabilities represent capital outflows or
debits, because they lead to payments being made
to foreigners.

11
 On Services and Investment Incomes:
 Exports and imports of services are treated analogously to
those of merchandise.
 For example, when a foreign airline (e.g., British Airways)
pays for baggage handling and aircraft maintenance at a
U.S. airport (e.g., NY, Chicago, Atlanta) it is doing much
the same thing as a foreign firm that buys computers in the
U.S.
It is using the services of American factors of production
and incurring an obligation that must be discharged by
payment to the U.S. owners.
 Also when an American tourist buys tickets from a foreign
airline, he/she is doing much the same thing as an
American firm that buys oil from Saudi Arabia, Nigeria,
or Kuwait. 12
 Exports and imports of services are sometimes
described as “Invisible Trade” because they
cannot be seen to cross the border but they have
the same effect as visible merchandise trade.
 Inflows and outflows of investment income
(factor income) are recorded in the current
account because they share two characteristics
with exports and imports of goods and services:
(a) They give rise to claims that must be
discharged by payments.

13
(b) They reflect the use, by one country, of another
country's capital, a factor of production, and the
rent, compensation, interest, or reward payment
thereof adds to the national income of the country
that owns it.

 Interest paid to Japan which holds U.S. T-bills is

an outflow of investment income.
It represents compensation for the use, in the U.S.,
of Japanese capital and such payment adds to the
national income of Japan.

14
 In general, therefore, inflows of investment
income into the U.S. represent additions to U.S.
national income earned by U.S. capital "working"
abroad and outflows from the U.S. represent
additions to the national income of other countries
earned by foreign capital "working" in the U.S.
 Every transaction in the current account is an
income related flow.
 Every transaction in the capital account is an asset
related flow.
15
 Capital transaction can be viewed in terms of
trade in paper, deeds to real property, corporate
securities, and various debt instruments.
 When an American company acquires a plant in
the UK, it is importing the deed to the plant.
 When an American pension fund buys bonds in
Tokyo, it is importing securities.
 In each case the importer must make payments to
the foreigner just like merchandise imports.

16
 The Official Settlement Account
 Measures the change in a nation's (liquid and non-
liquid) liabilities to foreign official holders and the
change in a nation's official reserve assets during
the year.
 A nation's official reserve asset refers to its gold,
convertible currencies, special drawing rights
(SDR), and reserve position in the IMF.

17
 An increase in a nation's liabilities to foreign
official holders and a decrease in a nation's official
reserve assets are credits (inflows) while a
decrease in a nation's liabilities to foreign official
holders and a increase in its official reserve assets
are debts (outflows).
 The change in official reserves measures a nation's
surplus or deficit on its current and capital account
transactions by netting reserve liabilities from
reserve assets.

18
 Errors and Omissions (Statistical Discrepancy)
 Theoretically, double entry bookkeeping should cause
total credits to equal total debts when all accounts are
taken together.
However, because of recording errors and omissions
this equality does not always hold.
 A special entry to make a nation's BOP "balance" is
necessary, hence the statistical discrepancy.

19
 Special Drawing Rights (SDR)
 Is an "artificial" currency or a unit of account.
It is an
international reserve asset created by the IMF and
allocated to member countries to supplement their
foreign currency reserves.
 The SDR became a five currency composite in
1980, i.e., a weighted average of 5 major
currencies (U.S. Dollar, German Mark, French
Franc, Japanese Yen, British Pound).
(it was a 16 currency composite in 1974-1980)
20
✦ With the introduction of the euro, the SDR is now
essentially a four currency composite.
The SDR is primarily a means of payment only
among governments and/or central banks.

✦ The current account transaction include all

transactions which give rise to earnings, expenses,
or distribution of earnings.

✦ The capital account is the record of changes in a

nation's claims on foreigners and of changes in
liabilities to foreigners resulting from current
account transactions. 21
 Other Adjustments:
These include counterpart items, exceptional
financing, and liabilities constituting foreign
authorities' reserves.
✦ Counterpart items are transactions that create or
reduce official reserves.
✦ The monetization of gold (or demonetization)
arises because gold is a commodity when held by
private parties, but a monetary reserve item when
held central authorities.
✦ Monetization of gold means gold has moved from
private hands to official accounts. 22
✦ Allocation or cancellation of SDR represents a
change in official holdings.

✦ Exceptional financing refers to financing

mobilized by authorities outside of reserve
transaction, e.g., postponing debt payment, or
drawing on loans to finance transactions that
would otherwise deplete the country's reserve
assets.

23
 The BOP account identifies transactions along
functional lines. One useful classification is:
✦ (a) Current Account: include Merchandise; Services;
Investment Income: (factor income): e.g. royalties,
licensing fees, education, telecom, legal, computer and
data processing, management, medical, insurance etc, and
Unilateral Transfers (gifts and grants)
✦ (b) Capital Account: L-T capital & S-T capital.
✦ (c) Statistical Discrepancy: Errors and omissions.
✦ (d) Official Reserve Account: Official reserve assets
and foreign official assets.
24
✦ Services include such invisible items as military
expenditures, interests and dividends, travel and
transportation, fees and royalties, insurance
premiums.

✦ Unilateral Transfers: Gifts and Grants both private

and official.
– Private: Personal gifts, philanthropic activities,
shipments by relief organizations.
– Official: Money, goods, services to other
countries.

25
 Capital Account: Records
loans, investments and other transfer of financial assets
and creation of liabilities.

 Long-term Capital: Maturities > 1 year, e.g., Foreign

Direct Investment (FDI) , Portfolio Investments, and
Loans.
 Private flows are usually in the form of FDI and portfolio
investments.
 Government (official) flows are usually loans, financial
support in economic development projects overseas, and
subscription to various regional development banks.

26
 Portfolio Investment: Purchase of Stocks, bonds, and
other financial assets.
The asset owner does not control the
foreign firms.

 Foreign Direct Investment: Takes place when real

assets, e.g., land, factories, equipment are acquired in
a foreign country.
Also includes acquisition of stocks if control can be
exercised by buyer.

27
✦ Short-term Capital: Maturity of < 1 year, e.g.,
demand deposits, short-term loans, and short-term
securities.
✦ Short-term capital may be:
✦ An accommodating adjustment induced by
merchandise trade, service trade, unilateral
transfer, investments (to finance other items in BOP).
✦ An autonomous adjustment attributable to interest
rate differences among nations and expected
changes in exchange rates (purely economic reasons).
28
 Account Balances:
✦ The Trade Balance:
Records the balance on merchandise trade.
✦ The Balance on Current Account:
Indicates the balance on current spending.
It tells whether we are spending more abroad than
foreigners are spending in our country (ignoring
investment flows and accommodating flows).
The most important types of transactions included are
imports and exports of goods and services, receipt and
payment of interests, dividends, and investment
incomes and net transfer payments.
29
 The Basic Balance:
Is the sum of the balance on current account
and the long-term investment account.
✦ It indicates the extent to which autonomous long-term
investments are affecting the balance of payments.
✦ When a country is a net recipient of long-term
investment funds, the basic balance should be more
positive than the current account balance.
Thus, long-term investment (net) may alleviate or
aggravate the pressure on the domestic currency.

30
 The “Performance Balance”

✦ Provides a summary of all autonomous flows

plus some accommodating transactions.
It is computed by
adding short-term capital account to the basic
balance.

✦ It therefore provides insights into the extent to

which short-term investment flows are affecting
the pressure on domestic currency.

31
✦ A negative performance balance means that
additional accommodating transaction will be
needed to meet payment requirements.

✦ A country's ability to execute accommodating

transaction is limited to the availability of reserves.

✦ In the absence of reserves, governments may

resort to restrictive measures on current and
capital account activities

32
Accommodating transactions have two characteristics:

(a) They are undertaken by a government

(b) Their purpose is to finance a deficit or surplus in
the BOP.

However, not all international transactions conducted

by the government are accommodating.

Foreign aid is given for political or humanitarian

purposes, not to finance BOP surplus or deficit, hence
it is not accommodating.

33
✦ The Net Liquidity Balance: Measures changes in
private domestic borrowing or lending required to keep
payments in balance without adjusting official
reserves.
✦ It includes the basic balance plus short-term private
non-liquid capital balance, the allocation of SDR and
errors and omissions.
✦ The Official Reserve Transactions Balance: Measures
the adjustment required in official reserves to achieve
balance of payments equilibrium.
Because double-entry bookkeeping ensures that debits
equal credits the sum of all transactions equal zero, i.e.
Current Account Balance + Capital Account Balance +
Official Reserve Balance = Balance of Payments. 34
✦ A drawing down of official reserves (credit entry)
measures a nation’s BOP deficit
✦ A building up of official reserves (debit entry)
measures a BOP surplus
✦ Deficits, while not necessarily bad, cannot be
sustained indefinitely because official reserves are
limited.

35
✦ Each of these balances has its shortcomings mainly
because of the increasing complexity of international
financial transactions.
For example:
✦ Changes in official reserves may now reflect
investment flows as well as central bank interventions
✦ The distinction between short-term and long-term
capital flows has become blurred.
✦ While FDI is still determined by longer-tern factors,
portfolio investment can now be just as speculative as
bank deposits and liquidated just as quickly.

36
Relative to GDP, U.S. Imports have Topped Exports
Since 1976, and the Trade Deficit has Widened

37
U.S. Trade Deficits in 2003 by Country or Region

38
U.S. Balance of Payments 2003 ($B)

39
 Some Typical Transactions (simplified form):

1. A U.S. firm exports $1000 worth of goods to UK and is paid with:

(a) A deposit of $1000 worth of sterling into its account at a
London bank.
Debit(-) Credit(+)

Short-term private liquid capital: $1000 Exports: $1000

( U.S. claims on foreigners) - An outflow

If payment is made for U.S. exports in dollars against foreign

owned U.S. deposits then,

40
 (b) The "debit" is a decrease in bank deposits of foreigners if
payment is made for U.S. exports in dollars against their U.S.
deposits, so that
Debit(-) Credit(+)
Short-term liquid liability (capital): $1000 Exports: $1000
( in U.S. liabilities to foreigners)

(c) Merchandise Imports:

U.S. residents import $50m worth of merchandise. Payment
made by transferring,
→ $20m (equivalent) from balance they hold in foreign banks, and
→ $30m from balance held in U.S. banks

41
 Debit(-) Credit(+)
Merchandise Imports: $50m U.S. private short-term claims: $20m
( in U.S. claims on foreigners)
Foreign private short-term claims: $30m
( in U.S. liability to foreigners)
2. U.S. tourists in London spend $30m for hotel and meals.
When U.S. tourists cash dollar traveler's checks at hotels in the
U.K., the hotels deposit the checks in their U.K. banks and the
banks send them for deposit credits in U.S.
The resulting increase in U.K. banks' deposits in the U.S.
shows additions to U.S. short-term liquid liabilities.
Debit(-) Credit(+)
Service category (travel): $30m Short-term liquid liability: $30m
(or tourist expenditure) (an increase in U.S. liability to
foreigners)
42
3. An English lady buys $5m American stocks, and pays: (a) by drawing
down her dollar deposits in a New York bank OR (b) by increasing
U.S. firms' demand deposit in U.K.
Debit(-) Credit(+)
Short-term liquid liabilities: $5m Portfolio investment: $5m
(a) ( in U.S. liabilities to foreigners)
(b) ( in U.S. claims on foreigners)
OR
(c) A receipt of a $5m of investment income by U.S. firms from their
foreign investments. Checks sent to U.S. firms are drawn on U.S.
account holdings of foreign firms.
Debit(-) Credit(+)
Short-term liquid liabilities: $5m Income from investment abroad:
( in U.S. liabilities to foreigners) $5m

43
4.(a) a $20m Gifts sent by U.S. residents to families abroad .

Debit(-) Credit(+)
Private transfer payment: $20m Short-term liquid liabilities: $20m
( in U.S. liabilities to foreigners)

OR

(b) The U.S. government gives $20m cash aid to the government of
Maldives: same as above except that debit is to government transfer
payment.

44
5. The IMF allocates $50m of SDR to the U.S.

Debit(-) Credit(+)
Acquisition of official reserves: $50m Allocation of SDR: $50m

The debit shows additions to U.S. reserve assets, the credit

indicates its source.

45
 NOTE:
✦ Often one entry for a transaction is either a credit or a
debit to short-term liquid liabilities (capital) because in
U.S. transactions, most payments are made by
increasing or decreasing foreign deposits in U.S. banks.
✦ It is possible to have entries for short-term liquid assets.
When dollar traveler checks are spent in England,
British banks increase their dollar deposits in U.S.
banks.
This is a debit (an outflow) to short-term liquid assets in
the British BOP or a credit in U.S. BOP to record an
increase in U.S. liability to foreigners (the British) - a
capital inflow to the U.S.
46
✦ A current account surplus is not necessarily a sign of
economic strength, nor is a current account deficit a sign
of economic weakness or lack of competitiveness.
✦ Economically healthy nations that provide good
investment opportunities tend to run trade deficits and
capital account surpluses.
✦ Nations that are growing rapidly will import more goods
and services while weak economies will reduce their
imports because imports are positively related to income.
Therefore, the faster a nation grows relative to other
economies, the larger its current account deficit tends to
be or the smaller its surplus.
✦ Conversely, the slower a nation grows the smaller will be
its current account deficit or the larger its current account
surplus. 47
✦ Current account deficits may, therefore reflect strong
economic growth or a low level of savings and current
account surplus may signify a high level of savings or
slow rate of growth.
✦ Since current account deficits are financed by capital
inflows, the cumulative effect of these deficits is to
increase net foreign claims against the deficit nation and
reduce the nation’s international wealth.
✦ On the other hand, a nation that consistently runs current
account surpluses will increase its net international wealth.
✦ A deficit country like the U.S. becomes net international
debtor and a surplus country like Japan or China becomes
net international creditor.
 In 2006, the U.S. net international investment position = - $2.8 T
 In 2006, Japan’s net international investment position = Y 215 T
 In 2006, China’s net international investment position = $662 B48
Has the US become a spendthrift/prodigal nation? Discuss!

Recall that:
 Private gross investment = savings (personal, business,

public sector) + borrowing from abroad.

 In complete and frictionless markets, capital flows

towards the most productive uses, raising the standard of
living for both recipients and owners.
 In reality international capital markets are segmented and
far from frictionless.
Therefore there are limits to the current account deficit
that a nation may incur/sustain.
 The current US situation calls for (sustainability) concern.
49
Factors Affecting Bop Components Economic Factors
✦ Inflation Rates (relative inflation rates): A higher
domestic inflation relative to a nation's trading
partners, ceteris paribus, will result in current account
deficit.
Foreign goods become more attractive (imports ) or
domestic goods become more expensive and foreign
demand drops (exports ).
✦ Interest Rates: An increase in domestic interest
(real) rates compared with ROW attracts funds from
foreign investors, so that, ceteris paribus, increase in
domestic interest rate leads to improvements in capital
account balance.
50
✦ Income Level: A relatively higher domestic
income level leads to increased domestic
consumption, part of the additional consumption
coming from higher imports.
This will tend to increase current account
deficits.

51
 Domestic Currency Value:
✦ The higher the domestic currency value in terms of
foreign currencies, ceteris paribus, the worse the current
account balance.
✦ This is because domestic goods become more expensive
to the importing countries. As a result, the demand for
such goods will decrease.
✦ On the other hand, an appreciating domestic currency
makes foreign goods (domestic imports) more attractive
to domestic residents who will increase their demand for
such goods.
✦ A decrease in export demand increase in import demand
has a negative effect on the domestic current account
balance. 52
✦ Government Restrictions
Tariff:
Tax on imported goods.
Quota:
Quantitative limit on amount of a particular
product imported.

✦ If a government imposes restrictions, BOP,

especially the current account, may improve
provided no retaliatory measures are taken by
foreign governments (ROW).
53
✦ Tax on Foreign Income:
May reduce the amount of foreign investment
undertaken by domestic residents.
✦ Restrictions on International Capital Flows:
Dual exchange rates (multiple exchange rates)
For example:
→ different rate for government payments.
→ different rate for importers etc.
✦ These restrictions will tend to reduce domestic
currency outflows.
54
 Government Monetary and Fiscal Policies:
May affect economic variables such as inflation
and interest rates which in turn influence BOP
components.

Impact of BOP on the Economy:

✦ A current account deficit is associated with higher
domestic inflation and often results in higher
unemployment .
✦ A capital account deficit may be associated with
higher domestic interest rates which discourage
domestic borrowing for investment and result in a
slowdown of economic expansion. 55
 Correcting BOP Problems
Current Account / Capital Account Deficit

✦ Any policy which improves foreign demand for

domestic goods and services or for investment
securities, e.g., more attractive export prices
resulting from low inflation or depreciating
currency value.

✦ Under a floating exchange rate regime, any

international trade imbalance should be corrected
automatically.
56
 A Trade Account Deficit:
✦ Implies that we are selling our currency (supplying
our currency) to buy foreign goods than foreign
demand for our currency to buy domestic goods.

✦ A depreciation of our currency should stimulate

foreign demand for domestic goods (ceteris
paribus). (See Marshall-Lerner conditions)
Restrictions on Imports:
✦ If domestic imports can be restricted while
domestic exports can be increased, the trade
balance should improve. 57
 Question: Why are managers and investors vitally interested in the
BOP of countries?
✦ The balance of payments helps to forecast a country's market
potential, especially in the short run. A country experiencing a
serious balance of payments deficit is not likely to import as much as
if it were running a surplus.
✦ The balance of payments is an important indicator of pressure on a
country's foreign exchange rate, and thus on the potential for a firm
trading with or investing in that country to experience exchange gains
or losses.
✦ Continuing deficits in a country's balance of payments may signal
future controls on outgoing capital movements, such as payments of
dividends, fees, and interest to foreign firms and investors.
✦ Continuing surpluses in a country's balance of payments may indicate
that country's strong international competitive position, and therefore
a potentially good location for an operating subsidiary, or portfolio
investment. 58
*** International Economic Linkages (59-72)
Define:
Y = National Income (or National Product)
C = Consumption
S = Savings
National Income is either spent on consumption or saved, so
Y = C + S ........ (1)
Similarly, the amount that a nation spends on goods and
services (National Expenditure), E, can be divided into
Consumption (C) and Real Investment, Id (Plant & Equipment,
R&D, etc). Hence:
E = C + Id ........ (2)
(1) - (2) gives
Y - E = S - Id ........ (3) 59
✦ If a nation's income exceeds its spending, then
savings will exceed domestic investment resulting in
surplus capital.
Excess capital must be invested overseas: Thus:
S - Id = I f ........ (4)
✦ Net Foreign Investment (If) equals the nations' net
public and private capital outflows plus increase in
official reserves.
✦ A nation that produces more than it spends, Y- E > 0,
will save more than it invests domestically, S - Id > 0,
and will have a net capital outflow.
✦ The capital outflow, If > 0, will appear as some
combination of a capital account deficit and an
increase in official reserves. 60
The Current & Capital Accounts
Let D = spending on domestic goods and services:
X = exports, M = imports, E = national expenditure.
Then
Y - D = X ........ (5)
E - D = M ........ (6)

Combining (5) and (6) we have,

Y-E = X- M ........ (7)

National Income - National Expenditure

= Exports - Imports
61
Equation (7) says that a Current Account Surplus, X - M > 0,
arises when national output exceeds domestic expenditures.
A current account deficit, (X - M < 0), will be the reverse.
Combining (3) and (7) we have:

S - Id = X - M ........ (8)

(8) means that if a nation's saving exceed its investments, then

the nation will run a Current Account Surplus.
Note that: S - Id = If = X - M.
So that:

If = X - M ........ (9)

Net Foreign Investment = Exports - Imports

62
✦ For example, the Japanese have a high savings rate (= 15 %)
relative to their investment rate hence they have a Current
Account Surplus.
The US saves less (= 2%) than it invests and must run a current
account deficit.
✦ Equation (9) means that funds earned by selling abroad must
be either spent on imports or exchanged for claims against
foreigners (foreign investment).
✦ Between the US and Japan, for example, any deficit in the
Current Account, (X- M < 0), is exactly equal to the surplus
in the capital account. Otherwise there would be imbalance in
the foreign exchange market and exchange rate would change.
Equation 9 can be re written as:
X - M - If = 0 ........ (10)
63
✦ In (10), current account balance and capital account balance exactly
offset each other under a freely floating exchange rate system.

Without intervention in exchange market, the sum of the

current account balance + capital account balance + balance on
official reserves account equals zero.
✦ These identities allow us to assess the efficacy of proposed
solutions for improving the current account balance.
✦ Therefore if a nation wants to reduce its current account deficit
or increase its current account surplus it must:
→ Raise national product relative to national spending, (Y- E) > 0
→ Increase savings relative to domestic investment, (S - Id) > 0

64
Budget Deficits & Current Account Deficits
By decomposing aggregate domestic spending and income
into government and private sectors we can relate
government deficits to current account deficits:
Let:
E = National Expenditure (or Spending)
Ch = Household Spending
Id = Private Investment (Domestic)
G = Government Spending
T = Taxes; S = Savings
Then we have
E = C h + Id + G
E = Y - (S + T) + Id + G ....... (11) 65
 Rearranging (11) we get a new expression for
excess spending:

E - Y = (Id - S) + (G - T) ........ (12)

✦ A nation's excess spending equals its net

borrowing from abroad.
✦ Alternatively, a nations excess spending equals the
sum of its excess of private investment over
private savings and total government deficit.

66
 Combining (7) and (12) we get:
X - M = S - Id - (G - T) ........ (13)
C/A Saving Government
Balance Surplus Budget Deficit
✦ A nation's current account balance is identically equal
to its private savings minus investment balance less
government budget deficit.
✦ Therefore a nation running a current account deficit,
X - M < 0, is not saving enough to finance its private
investment and its government budget deficit.
✦ Conversely a nation running a current account surplus is
saving more than is needed to finance its private
investment and government deficit. 67
 Coping With Current Account Deficit:
1 - Devaluation
2 - Protectionism
3 - Restriction on Foreign Ownership of Domestic Assets
4 - Boosting the National Savings Rate

On Currency Devaluation / Depreciation:

(A) Disequilibrium View:
✦ Posits that nominal disturbances can cause changes in
real exchange rates because of sluggish / slow price
adjustment. It
proposes a systematic relationship between exchange
rate and the current account balance. 68
(B) Equilibrium Theory of Exchange Rate:
✦ Agues that no simple relation exists between exchange rates and the
current account balances.
✦ Maintains that trade deficits do not "cause" currency depreciation,
nor does currency depreciation by itself help reduce trade deficits.
The necessary conditions for devaluation to improve a
nation's current account can be analyzed in three contexts:
1. Elasticity Approach:
✦ Focuses on effects of relative price changes, brought about
by devaluation, on consumption and production.
Devaluation will improve a nation's balance of trade if
Marshall Lerner Conditions (eMD + eXD > 1) are met, that is,
change in quantity of import and export demand must be
sufficiently large to offset the lower foreign currency price
of a nation's exports and higher domestic currency price of
imports following devaluation.
Volume effect must dominate price effect. 69
 2. The Absorption Approach:
✦ Shifts attention to the whole economy.
Any improvement in the Balance on Current Account,
(X - M), must cause an increase in the difference between
Total Output and Total Domestic Expenditure, (Y- E).
✦ Total absorption of goods and services, E + X, must equal the
aggregate amount of goods and services available, Y+M, so that:
E+X = Y+M
or X-M = Y–E
✦ A trade surplus, X - M > 0, arises when national output is greater
than domestic expenditures, (Y- E > 0).
✦ When underemployed resources exist, output, Y, can increase
without inflation if there are no bottlenecks in the economy.
With full employment, domestic expenditures, E, must be reduced.
Devaluation will not succeed otherwise 70
 3. The Monetary Approach:
✦ Concentrates on demand for money balances.
An excess demand for goods and services (a trade
deficit) reflects excess supply of money.
✦ Devaluation reduces the real value of the money
supply because of price increases for traded goods and
services.
✦ It works by causing the public to reduce its spending
in order to restore the real value of its money balances
and other financial assets.
✦ The reduction in expenditures will improve the
balance of payments as long as monetary expansion
does not follow the devaluation. 71
✦ Protectionism:
The use of Tariffs and Quotas
✦ Restriction on Foreign Ownership of Domestic Assets.
✦ Boosting the Savings Rate:
Social security benefits.
Tax changes.
IRA and other tax deferred savings ***

Other Issues:
✦ Current Account Deficit and Unemployment
✦ Current Account Deficits / Surpluses: Good or Bad?
✦ Is the Trade Deficit a Subtraction from GDP?
✦ Is the U.S. Spending too Much and Saving too Little?
72
✦ The U.S. current account deficit can be viewed as an efficient
adaptation to different savings propensities and investment
opportunities in the US and the rest of the world.
The real problem, if any, may be either too much consumption and
too little savings or too much investment.
The hard fact is that the situation confronting the US and ROW
since the early 90s is an expression of national preferences to
which trade flows have adjusted in a timely manner .
✦ Long term consequences for a nation that runs a current account
deficit:
✦ (i) If the Current Account deficit and the resulting capital account
surplus finances productive domestic investments, then the nation
is better off as the returns from these added investments will help
to service the foreign debts with income left to improve domestic
living standards.
✦ (ii) If the capital account surplus finances current consumption, it
merely increases a nation's well being today at the expense of
future well being. 73
✦ In popular discussions, the U.S. trade deficit is often referred
to as a subtraction from the GDP.
Economic analysis suggests otherwise.
✦ Some imported goods (e.g. agricultural products, oil)
cannot be produced in the U.S., while other imports provide
low-cost products for consumers and firms.
✦ Production at some firms might even decrease if imported
products were not available.
✦ Furthermore, in a tight labor market, some firms might find it
difficult to hire enough labor to expand output by the size of
the trade deficit.
✦ The basic economics of trade deficit suggests that with
floating exchange rates, a trade deficit can persist only if
foreigners willingly accumulate financial claims issued by
a country’s household and firms (if foreigners continue
to invest in the country). 74
✦ Absent this, the value of domestic currency would fall and
the trade gap would tend to close as import prices increase
and export prices decrease.
✦ At the same time the yields available on domestic investments
must remain attractive especially to foreign investors.
✦ Economists view the trade deficit as part of an overall
general equilibrium involving domestic demand,
production, and investment opportunities, relative to
economic conditions in the rest of the world.
Therefore, the trade deficit is not a subtraction from GDP.

75
 The Case for Free Trade
✦ The case for free trade is based on the theory of
comparative advantage.
When countries specialize and trade based on
comparative advantage, consumers pay less and
consume more, and resources are used more
efficiently.

✦ When tariffs and quotas are imposed, many of the

gains from trade are eliminated.

76
 The Case for Protection
✦ Protection saves jobs.
✦ Some countries engage in unfair trade practices.
✦ Cheap foreign labor makes competition unfair.
✦ Protection safeguards national security.
✦ Protection discourages dependency.
✦ Protection safeguards infant industries.
✦ Protection fights neo-colonialism
77