Unit 7

Unit 7

Balance of payments

• measure of money inflows and outflows between the U.S. and the world
• Inflows are referred to as credits
• Outflows are referred to as debits
• divided into:
• Current account
• capital / financial account
• official reserve account

Double Entry Bookkeeping

• every transaction in the balance of payments is recorded twice in accordance with standard accounting practice
• Ex: U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland
• Credit of $50 million to current account
• Debit of $50 million to capital/financial account
• balances equal each other

Current Account (Net investments and transfers)

• balance of trade or Xn (balance on goods and services)
• exports(inflow/credit) - imports(outflow/debit)
• Net Foreign Income
• income earned by U.S. owned foreign assets - Income paid to foreign held U.S. assets
• Ex: Interest payments on U.S. owned Brazilian bonds - Interest payments on German owned U.S. treasury bonds
• Net transfers (tend to be unilateral)
• foreign aid = a debit to the current account
• Ex: Mexican immigrant workers send money to family in Mexico

Capital/ Financial Account (Stocks and bond, assets)

• Balance of capital ownership
• Includes purchase of real and financial assets
• Direct investment in the U.S. us a credit to the capital account
• Ex: Toyota factory in San Antonio
• Direct investment by U.S. firms/ individuals in a foreign country are debits to the capital account
• Ex: Intel factory in San Juan, Costa Rica
• Purchase of foreign financial assets represents a debit to the capital account
• Ex: Warren Buffet buys stock in Petrochina
• Purchase of domestic financial assets by foreigner's represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchase a large stake in the NASDAQ

What causes Capital/Financial Flow?

• Differences in rates of return on investment
• Ceteris Paribus, savings will flow toward higher return

Relationship Between Current and Capital Account

• The current account and capital account should zero each other
• If current account has a negative balance(deficit), capital account should have a positive balance(surplus)

Official Reserves

• foreign currency holding of U.S. Fed Reserve System
• When there is a balance of payments surplus the Fed accumulates forgeign currency and debits the balance of paymetns
• When there is a balance of payments defivit the Fed depletes its reserves of foreign currency and credits the balance of payments
• The official reserves zero out balance of payments

Credits

• additions to a nation's account

Debits

• subtractions to a nation's account

How to calculate the following:

1. Balance on trade: goods and service exports - goods and service imports
2. Trade deficit occurs when the balance on trade is negative (imports > exports). Trade surplus occurs when the balance on trade is positive (Exports > Imports)
3. Balance on current account: Balance on trade (Exports and Imports) + Net Investment Income + Transfer payments
4. Official Reserves: Change in Current Account - Change in Capital Account + Change in Official Reserves = 0

Foreign Exchange

• The buying and selling of currency
• Ex: In order to purchase souvenirs in France, it is first necessary for Americans to sell (supply) their dollars and buy (demand) Euros
• The exchange rate(e) is determined in the foreign currency markets
• Ex: The current exchange rate is approx. 77 Japanese Yen to 1 U.S. dollar
• The exchange rate is the price of a currency
• Do not try to calculate the exact exchange rate

Changes in Exchange Rates

• Exchange rates(e) are a function of the supply and demand for currency
• increase in supply of currency will decrease the exchange rate of currency
• decrease in supply of currency will increase the exchange rate of currency
• increase in demand of currency will increase the exchange rate of currency
• decrease in demand of currency will decrease the exchange rate of currency

Appreciation and Depreciation

• Appreciation of currency occurs when exchange rate of that currency increases
• Depreciation of currency occurs when exchange rate of the currency decreases

Exchange rates determinates

• Consumer tastes
• Relative income
• Relative price level
• Speculation (expectation)

• Demand $- exports and capital inflows. When the U.S. exports goods/services to other countries  they need our $ to complete the transaction. They demand our money. First they need to supply their.
• Supply $- imports and capital outflows. When we import goods/services from other countries, we need their money to complete the transaction. So we demand their money. We need to supply our money.

Tips

• Always change D line on one currency graph, the S line on the other currency graph
• move the lines of the two currency graphs in the same direction (right or left) and you will have the correct answer
• If D on one graph increases, S will increase on the other graph
• If D moves left, S moves left on the opposite graph

Flexible exchange rate (floating)

• Set by market forces with little or no government intervention

Fixed exchange rate

• determined by government policies

Absolute Advantage v. Comparative Advantage

• Absolute Advantage- faster, more, more efficient
• Comparative Advantage- lower opportunity cost
• Same country can have the same absolute advantage with two products
• Only one country cane have a comparative advantage in one product