Macroeconomics Unit VII: Balance of Payments

BALANCE OF PAYMENTS

• measures the money inflows and money outflows between the U.S. qand the rest of the world
• outflows from the U.S. are debits
• inflows are credits

Balance of Accounts

• three parts
• 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

Current Account

• balance of trade or net exports
• (exports of goods and services - imports of goods and services)
• net foreign income: (income earned by U.S. owned foreign assets - income paid to foreign held U.S. assets)
• net transfers (unilateral): foreign aid is a debit to the current account

Capital/ Financial Account

• balance of capital ownership
• includes the purchase of both real and financial assets
• direct investment in the U.S. is a credit to the capital account 
• direct investment by U.S. firms/individual in a foreign country are debits to the capital account
• purchase of foreign financial assets by a foreign country represents a credit to the capital account

Relationship Between Current and Capital/Financial Account

• should zero out each other
• if current account has a negative balance (deficit) then the capital account should have a positive balance (surplus)

Official Reserves

• foreign currency holding of U.S. Federal Reserve System 
• with the balance of payments surplus, the FED accumulates foreign currency and debits the balance of payments
• with balance of payments deficit, the FED depletes its reserves of foreign currency and credits balance of payments 
• zero out the balance of payments
• active vs. passive: the U.S. is passive in its use of official reserves and does not seek to manipulate the exchange rate

Balance of Trade

• (goods and services exports - goods and services imports)
• surplus: imports > exports
• deficit: exports > imports

Current Account

• (balance of trade + net investments + net transfers)

Capital Account

• (foreign purchases of U.S. assets + U.S. purchase of assets abroad)

Official Reserves

• (capital account balance + current account balance)

Foreign Exchange (FOREX)

• buying or selling of currency
• exchange rate (e) is determined in the foreign currency markets
• exchange rate is price of a currency

Four Tips

• change the demand line on one currency graph and the supply line on the other currency's graph
• move the lines of the two currency graphs in the same direction (right or left) 
• if demand on one graph increases, supply on the other will also increase
• If demand moves left, supply moves left on other graph

Changes in Exchange Rates

• exchange rates (e) are a function of the supply and demand for currency
• increase in supply of currency makes it cheaper to buy one unit of it, vice versa for a decrease in supply
• increase in demand of currency will make buying one unit more expensive, vice versa for decrease in demand

Determinants of Exchange Rate

• Consumer Tastes
• Relative Economy
• Relative Price Level
• Speculation