The document discusses the international balance of payments, which records transactions between countries. It has three components: the current account, capital account, and official financing. The current account records trade in goods and services, while the capital account records cross-border investment flows. Official financing shows changes in foreign exchange reserves. A country's balance of payments must always balance, and imbalances are corrected by changes in the exchange rate or official reserves. Trade deficits can be problematic if due to overconsumption rather than investment.

1. THE INTERNATIONAL BALANCE OF
PAYMENTS
NIJIL C V

2. THE INTERNATIONAL BALANCE OF
PAYMENTS
 The components of the balance of payments:
 Current account
 Capital account
 Official financing
 National income determination and foreign trade

3. Economies are becoming more “open” (in terms of trade as % of
GDP), but some countries are more open than others…
Exports and imports as % of GDP
1990 2003
Mauritius 153 121
Zambia 99 76
Chile 64 68
China 29 66
UK 51 54
Argentina 15 40
Bangladesh 20 37
India 17 31
Brazil 14 30
United States 20 23
Source: World Bank World Development Indicators

4.  Higher degree of openness => structure of production and
employment, and economic growth, are more likely to be
affected by external events
 The balance of payments provides and indication of how
international trade and external events feed back
into the macroeconomy
 This presentation describes how balance of payments
accounts are recorded and then explores the link
between the balance of payments and a country’s
exchange rate

5. THE BALANCE OF PAYMENTS (BOP)
ACCOUNTS
A country’s balance of payments accounts record its
international trading position and its lending and
borrowing
=> records transactions between countries

6. Each transaction is classified according to the payment or
receipts that it generates
 Transactions that generate a receipt of a payment from
foreigners are a credit item in the accounts with a + sign
⇒ These represent a supply of foreign exchange ($) and a demand for
the local currency (£)
 Transactions that comprise a payment to foreigners are
reported as a debit item with a - sign
=> These represent demand for foreign exchange ($) and a supply of
the local currency (£)

7. THREE BALANCE OF PAYMENTS (BOP)
ACCOUNTS
a) The balance of payments on Current Account
b) The balance of payments on Capital Account
c) The balance for Official Financing
(International reserves account operated by central
bank)

8. Let us consider two countries:
the United Kingdom:
local or domestic
currency: British pounds (£)
the United States:
foreign
currency: US follars ($)

9. A) THE BALANCE OF PAYMENTS ON
CURRENT ACCOUNT
Records transactions arising from trade in goods and
services
 The visible trade balance
 payments and receipts from the import/export of tangible
goods (cars, food, textiles,…)
 The invisibles trade balance
 payments and receipts for financial services, shipping and
tourism, interest and dividends payments on investments, etc.
…

10. b) The balance of payments on Capital
Account
Records transactions related to international
movements in the ownership of financial assets
 The purchase of foreign investments by UK citizens
brings assets to the UK (in exchange for money) and are
referred to as a capital outflow
 to purchase these foreign assets, locals have to buy $
=> debit (negative) entry in the Capital Account

11. b) The balance of payments on Capital
Account (cont.)
 Foreign investment into the UK increases UK liabilities to
foreigners, and it is a capital inflow
 foreigners have to buy £ to undertake their investments
⇒ credit (positive) entry in the Capital Account
The Capital Account is further divided into short-term and
long-term capital flows

12.  The supply of £s reflects imports to the UK and UK
purchases of foreign assets
=> outflows in the UK balance of payments
 The demand for £s reflects UK exports and sales of UK
assets to foreigners
⇒ inflows in the UK balance of payments

13.  The exchange rate is the price of the £ in terms of other
currencies (e.g. $)
 If the exchange rate is freely floating then it will adjust
to ensure that the demand for £s = the supply of £s 
inflows = outflows in the BoP  BoP is exactly = zero
 Since BoP = Current Account + Capital Account:
 a Current Account surplus => a Capital Account deficit
 a Current Account deficit => a Capital Account surplus

14. c) The balance for Official Financing
 If the exchange rate is fixed, and there is a BoP deficit 
outflows > inflows  supply of £s > demand for £s
 The Central Bank must offset this excess supply of £s by
buying them with foreign currency ($); i.e. runs down its
reserves of foreign exchange

15. c) The balance for Official Financing
(cont)
The balance for official financing shows the net increase
or decrease in a country’s holdings of foreign currency
reserves:
 A decrease in the official reserves is reported as a credit item
(+), since it involves the purchase of £s
 an increase is reported as a debit item (-)
=> If the exchange rate is freely floating,
then the balance for official financing is
zero

16.  The balance of payments must always balance since the
accounts are constructed such that this must be true by
definition
 However, there can be measurement error and unreported
borrowing from abroad and other illegal activities
⇒ The discrepancy represents a combination of unrecorded
current and capital account transactions
 This requires the inclusion of what is referred to as a
balancing item, to ensure the accounts balance in
practice

17. NATIONAL INCOME IDENTITIES
AND THE CURRENT ACCOUNT BALANCE
Recall the aggregate expenditure equation in
our study of macroeconomics:
AE (=AD) = C + I + G + X - M
 Leakages are:
S + T + M
 Injections are:
I + G + X
=> In equilibrium: injections = leakages
S + T + M = I + G + X

18. The balance of payments on Current Account could be re-
written as:
(X - M) = (T - G) + (S - I)
or
(M - X) = (G - T) + (I - S)
trade = government + private
sector
deficit balance balance

19. ⇒ Trade deficit = government deficit + priv. sector deficit
⇒ An increase in govt. expenditure (G), or a reduction in
private saving (S) worsens the trade balance (i.e. raises
trade deficit)

20. ARE TRADE DEFICITS A PROBLEM?
 A trade deficit is not necessarily a bad thing (e.g. when
growing domestic industries attract foreign investments)
 if borrowing is financing investment (which generates
economic growth and income in future) then it is not a problem
 However, if a country persistently runs a trade deficit
this is something to worry about (e.g. vulnerability to loss
of foreign investors’ confidence)
 excessive borrowing on capital account to finance consumption
on current account will incur higher interest payments and
eventually lead to reduction consumption