The Balance of Payments, Exchange

Rates, and Trade Deficits

International Financial Transactions
• There are two major types of international transactions:

• International trade is the sale of goods between countries

• International asset transactions involve changes of ownership

of real assets (factories, real estate, etc) or financial assets
(stocks, bonds, etc) between people in different countries. In
both cases, something (a good or an asset) is
swapped/exchanged for money.

• But since different countries often use different currencies,

these currencies must be exchanged before the transaction can
occur. A company sells study guides in return for US dollars. If
you have Euros to spend you must convert them to dollars first
 The Balance of Payments
• The balance of payments accounts show all
international transactions for a certain country. For
the US, this data shows all of the purchases and
sales that Americans make with other countries. It
shows the net inflow and outflow of dollars as a
result of certain types of transactions.

• The balance of payments is separated into the

current account and the capital and financial
account.
Current Account
• The current account shows US international trade in goods and services.
Purchases of imports are called “debits” because dollars are spent
(transferred to foreigners). Export sales are “credits” because dollars are
earned from other countries.

Balance on Goods
• The balance on goods is the dollar value of all exported goods minus the
value of imported goods. The US is currently running a trade deficit in
goods, because US imports more than exports.

Balance on Services
• The balance on services is the same this as the balance on good except
that is tracks the imports and exports of services. The US is running a trade
surplus in services (exports are greater than imports).

• The balance on goods and services is the sum of the two sub-balances we
talked about
 Balance on Current Account
• Two other items are also included in the current account:

• Net investment income is money paid to Pakistanis on

investments minus payments paid to foreigners for their
investment activity.
• Net transfers are funds that move into the PAK minus funds
that leave without any purchasing activity. Sending a birthday
check to your aunt in Germany is an outgoing transfer. Also
included are pension payments, foreign aid and so forth.
• The balance on the current account is found by adding the
balance on goods and services to net investment income and
net transfers.
 Capital and Financial Account
Capital Account
The capital account tracks international forgiveness of debt. If
you forgive a debt you are basically saying “you don’t have
to pay that loan back any more.” If we forgive $10 billion of
foreign debt and $4 billion of our debt is forgiven, the
capital account balance will be -$6 billion.

Financial Account
The financial account lists foreign purchases of Pakistani
assets (dollars flow into the country) and Pakistani
purchases of foreign assets (dollars flow out of the country).
Why the Balance of Payments Balances
• The current account balance plus the capital and
financial account balance will always add to zero.
This is because the balance of payment accounts
are really tracking the number of dollars
bought(when we sell goods or assets abroad) and
dollars sold (when we buy foreign goods and
assets).
• The number of dollars bought always has to equal
the number of dollars sold. That’s why the balance
of payment accounts balance.
 Payments, Deficits and Surpluses
• Foreign reserves are accumulated because of a
balance of payment surplus.

• The real problem for the PAK is that we are running a

significant current account deficit, which has to be
compensated for by an equally large capital and
financial account surplus.

• In short, ownership of PAK assets is being transferred

abroad.
 Two major types of exchange rate systems

Flexible exchange rate system – Exchange rates are

set by supply and demand. The government is not
involved.
Fixed exchange rate system – The government sets an
exchange rate and works to maintain that rate. We
will first consider flexible exchange rates and then
later turn to fixed exchange rates.
If exchange rates are flexible then the rate will be set
by the intersection of standard supply and demand
curves.
 Determinants of Exchange Rates
• Exchange rates are determined by a few broad factors.

• A general increase in demand for a currency causes the currency to

appreciate. A reduction in the supply of the currency does the same
thing. Finally, if another country’s currency appreciates, your currency
(by definition) has depreciated.

Changes in any of the following factors can alter exchange rates:

• Tastes – If people in other countries develop a taste for your products,
then demand for your currency will increase, causing it to appreciate.

• Relative income – If your economy is expanding quickly your citizens will

demand more foreign imports, causing your currency to depreciate.
Determinants of Exchange Rates
• Relative price levels – Under the theory of purchasing-power parity, if the
exchange rate is $1 = €1.5, then you should be able to buy the same goods
in the US for $1 that you could buy in Europe for €1.5. However, this
relationship has not always held historically.

• Relative interest rates – If real interest rates in your country are relatively
high foreigners will invest in other countries where money is “cheaper.”
Higher relative interest rates cause your currency to depreciate.

• Relative expected returns – By the same logic, if people can earn expect
to earn a higher rate of return with you they will move money to your
country. Your currency appreciates as a result.

• Speculation – People buy and sell currencies because they expect future
appreciation or depreciation. If a large number of investors think that your
currency is going to appreciate in the future they will buy a lot of it. This
itself causes your currency to appreciate.
 Disadvantages of Flexible Exchange Rates
Uncertainty and Diminished Trade
One of the main disadvantages of flexible exchange rates is that currency prices
become volatile and may change dramatically in short periods of time. Since
movements in currencies can wipe out a manufacturer’s export profit, firms
have less incentive to sell goods in countries that use other currencies. This
reduces international trade, which is very bad for everyone.
Terms-of-Trade Changes
Changes in currency prices force countries to export more or less to keep
purchasing the same goods from another country.
Instability
Because export industries are dependent on favorable exchange rates,
fluctuations in those exchange rates can increase macroeconomic instability.
If the dollar suddenly appreciates our exported aircraft, for example,
become much more expensive to foreign buyers. Fewer aircraft will be sold
as a result. This change may cause layoffs in the aircraft industry and weaken
the economy overall.
 Fixed Exchange Rates
• Countries can instead set fixed exchange rates. The problem with this system is that
if the market equilibrium isn’t equal to your pre-determined rate the government
will have to purchase excess supply or sell to boost demand in order to maintain the
target exchange rate.
Use of Reserves
Trade Policies
A country can also fix its exchange rates by restricting or encouraging international
trade. The problem with this policy is that trade restrictions slow economic growth
and reduce output and income for both countries.
Exchange Controls and Rationing
Another option is the use of exchange controls, in which foreign currency obtained by
export sales must be sold to the US government. This fixed supply could then be
rationed among US importers in such a way that the target exchange rate is
achieved. Problems with this approach include:
• Reduced (or distorted) international trade
• The government may favor specific importers
• This strategy reduces the ability of consumers to purchase imports
• If the government offers artificially high or low exchange rates people may form
black markets and swap currency illegally
 Domestic Macroeconomic Adjustments
• Finally, the government could use fiscal and monetary policy to set the desired
exchange rate. Contractionary monetary policy, for example, will lower the price
level and may cause the dollar to appreciate.
• The Current Exchange Rate System:
• The Managed Float
• Today most countries use a managed float exchange system, in which the market is
free to determine exchange rates but the government will sometimes intervene.
• In Support of the Managed Float Supporters of the managed system point out that
it has been relatively successful and has withstood events that probably would have
caused a fixed exchange system to break apart.
• Concerns with the Managed Float Other people point out that managed exchange
rates are still very volatile, and may encourage speculation. They also argue that
the nations that agree on currency policy are still relatively free to do whatever
they want.
• Recent US Trade Deficits The US has run large (and growing) trade deficits for some
time. These deficits must be financed by the sale of American assets to foreigners.
 Causes of the Trade Deficits
• One of the causes of the trade deficit is the fact that the US
economy has been growing very quickly, giving people more
money to buy foreign imports. We also import a large
quantity of goods from China, but Chinese citizens often
don’t have enough money to afford American exports.
Making matters worse, the Chinese currency is somewhat
fixed to the dollar, and therefore cannot appreciate to reduce
the trade imbalance. In addition, the US saving rate has
declined, forcing firms to borrow more money abroad or sell
assets. Actually, the financial and capital account surplus
gives Americans more money to spend on goods (including
imports), further increasing their demand for imports
 Implications of the US Trade Deficits
• Increased Current Consumption Americans can consume more
today because they are selling assets. The problem is that Americans
will not earn money from those assets in the future, reducing their
ability to consume in the coming years.

• Increased US Indebtedness The US is forced to take on debt to

finance its spending. As a result, foreign claims on US assets are
accumulating. On the other hand, if this borrowed money is used to
develop more assets and increase our productive capacity that might
not be a bad thing.

• Overall, the trade deficit has costs and benefits. We’re not really
sure exactly what the final consequences of the trade deficit will be,
and that uncertainly can be worrying.