NOTES R

Balance Of Payments (BOP)

It is a bookkeeping system for recording all payments that have a direct

bearing on the movement of funds between a nation and foreign countries.
It has three components:

A. Current Account
B. Capital Account
C. Financial Account

!! In a simple world B. and C. together are often referred as a

Capital Account. So if a Japanese firm sells $1 billion worth of
PlayStations produced in Japan to U.S. consumers and uses the
revenue to buy Columbia Pictures studios. The transaction will show
as U.S. $5B Current Account deficit (U.S. consumers got
PlayStations) and U.S. Capital Account surplus (Japanese got the
Hollywood studio). The two will balance each other and so BOP is
zero.
Three components:
A. Current Account = Trade Balance + Other Current Account Payment
The current account is used to mark the inflow and outflow of goods
and services into a country. Earnings on investments, both public
and private, are also put into the current account.
Within the current account are credits and debits on the trade of
merchandise, which includes goods such as raw materials and
manufactured goods that are bought, sold or given away (possibly in
the form of aid). Services refer to receipts from tourism,
transportation (like the levy that must be paid in Egypt when a ship
passes through the Suez Canal), engineering, business service fees
(from lawyers or management consulting, for example), and
royalties from patents and copyrights. When combined, goods and
services together make up a country's balance of trade (or simply
trade balance). The trade balance is typically the biggest bulk of a
country's balance of payments as it makes up total imports and
exports. If a country has a balance of trade deficit, it imports more
than it exports, and if it has a balance of trade surplus, it exports
more than it imports.
Receipts from income-generating assets such as stocks (in the form
of dividends) are also recorded in the current account. The last
component of the current account is unilateral transfers. These are
credits that are mostly worker's remittances, which are salaries sent

back into the home country of a national working abroad, as well as

foreign aid that is directly received.
Trade Balance = Merchandise Exports Imports
Other Current Account Payments =
net investment income, net services such as
tourism, and net unilateral transfers such as gifts
US Current Account Balance may be in Deficit (US is borrowing
capital to finance the purchases) or Surplus (US is lending)
B. Capital Account
The capital account is where all international capital transfers are
recorded. This refers to the acquisition or disposal of non-financial
assets (for example, a physical asset such as land) and non-produced
assets, which are needed for production but have not been produced,
like a mine used for the extraction of diamonds.
The capital account can be broken down into the monetary flows
branching from debt forgiveness, the transfer of goods, and financial
assets by migrants leaving or entering a country, the transfer of
ownership on fixed assets (assets such as equipment used in the
production process to generate income), the transfer of funds
received to the sale or acquisition of fixed assets, gift and
inheritance taxes, death levies, and, finally, uninsured damage to
fixed assets.
C: Financial Account
In the financial account, international monetary flows related to
investment in business, real estate, bonds and stocks are
documented.
Also included are government-owned assets such as foreign
reserves, gold, special drawing rights (SDRs) held with the
International Monetary Fund, private assets held abroad, and direct
foreign investment. Assets owned by foreigners, private and official,
are also recorded in the financial account.
The Balancing Act
The current account should be balanced against the combinedcapital and financial accounts. However this rarely happens.
We should also note that, with fluctuating exchange rates, the
change in the value of money can add to BOP discrepancies. When

35

there is a deficit in the current account, the difference can be funded

by the capital or financial accounts.
When a country has a current account deficit that is financed by the
capital account, the country is foregoing capital assets. If a country
is borrowing money to fund its current account deficit, this would
appear as an inflow of foreign capital.
Simple rule of double-entry book keeping:
Every international transaction automatically enters the balance of
payments twice, once with plus sign and once with minus sign.
It holds true as every transaction has two sides. If you buy something from
foreigner, you get it but must pay him/her in someway.
Examples:
(1) A U.S. citizen buys a $800 handbag from an Italian company, and the
Italian company deposits the $800 in its account at Citibank in New York.
That is, the U.S. trades assets for goods. This transaction creates the
following two offsetting entries in the U.S. balance of payments:
It enters the U.S. Current Account with a negative sign (-$800).
It shows up as a $800 claim on U.S. banks in the U.S. financial account.
(2) A French citizen pays $200 for dinner at a L.A. restaurant by charging
his Visa credit card. That is, the U.S. trades assets for services.
This transaction creates the following two offsetting entries in the U.S.
balance of payments:
It enters the U.S. Current Account with a positive sign ($200).
It shows up as a negative $200 in other US claims by nonbanks.
(3) A U.S. bank forgives $5000 in debt owed to it by the government of
Afganistan. This transaction creates the following two offsetting entries in
the U.S. balance of payments:
It enters the U.S. capital account with a negative sign (-$5000).
It shows up as a positive $5000 decrease in the U.S. assets abroad
financial account.
Note: U.S Official Reserves include gold, foreign currencies and SDRs.
SDR (Special Drawing Rights) is a paper substitute for money, issued by
IMF (International Monetary Fund). SDR are backed by currencies of
member countries of IMF (US, Europe and Japan back the most of it).

2008 BALANCE OF P AYME NTS, Billions of USD

A. CURRENT ACCO UNT
Receipts
Payments
G oods E xp orts
129 1
G oods Impor ts
-2112
Trade Balance (Balance on Goods)
Se rvices Exports
544
Se rvices Imp orts
-4 05
Income Rece ipts
752
Income Payments
-6 18
Conp . of U.S. Emplo yees
3
Conp ensati on o f For. Emp l.
-10
Unilatera l Tran sfers
-1 20
Current Account Balance [A]
B. CAPITAL ACCO UNT
Net Capita l Acc ount Payme nt s [B]

Balance

-8 21

-6 73

-3

C. FINANCIAL ACCO UNT

US asse ts abroad:
Decrea se
Increa se
Fore ign Sto cks
6
Fore ign Bonds
85
Fore ign Dire ct Investments
-3 18
O the r US Claims by B anks
425
O the r US Claims by n onban ks
284
US Official Rese rve s
-5
O the r US G overnm ent Asset s
-5 30

Balance

-53
Fore ign as sets (from U.S.)
U.S. Treasuri es
U.S. age nci es bon ds
U.S. sto cks
U.S. bon ds
Direct Investmen ts to U.S.
Claims on U.S. b anks
Claims on oth er U.S. en tities
Fore ign O ffic ial Asse ts in U.S.
U.S. Curren cy

Increase
308

Decre ase

Balance

-1 31
7
1
325
-3 37
-29
421
35
599

Fina nial Account Balance [C]

546

Statistical Discrep ancy

BALANCE OF PAY MENTS (A + B + C + Stat .Discr.)

129
0

Impact on market for USD:

Demand

S upply

--

36

NOTES Q
CURRENT ACCOUNT BALANCE AS % OF
GDP IN SELECTED COUNTRIES: 19702003

If to $5.25, importer of 100 worth of tea has two alternatives:

1. Pay $525
2. Buy $500 gold ($500/$20 = 25 ounces of gold), ship to
UK, convert into 100 (= 25 x 4) and buy tea
If shipping cheap, do alternative 2!
More gold flows into the UK => depreciates.
Why? Gold flows from US to U.K.
More gold in UK means more currency in UK,
=> prices in UK => more imports into UK, less exports from UK
Less gold in US means less currency in US,
=> prices in US => less imports into US, more exports from US
=> depreciates back to par, $ appreciates back to par
Two Problems with golden standard
1. Country on gold standard loses control of Ms (gold is the Ms)
2. World inflation determined by gold production
(Liquidity depends on gold discoveries)

Government (central bank) FX intervention

Sales or purchases of foreign reserves can be used to influence the value
of own currency in a floating exchange rate regime

Other Regimes (fixed exchange rates, ):

1. The Gold Standard: (example of a Fixed Exchange Rate regime)
Currencies convertible into gold at fixed values
Example of how it worked:
US: $20 converted into 1 ounce of gold
UK: 4 converted into 1 ounce of gold
=> Par value of 1 = $5.00 => Fixed Exchange Rate

2. Other Fixed Exchange Rate Systems: Bretton Woods (1944 - 1971)

1. US$ convertible into gold for central banks only ($35 per ounce)
2. Other central banks keep exchange rates fixed to $.
( US$ is the reserve currency )
3. International Monetary Fund (IMF) set rules and provides loans to
BOP deficit member countries.
4. World Bank made loans to developing countries.
5. World Trade Organization (WTO) should enforce free trade
Non US central banks must intervene to keep their currencies exchange rates
fixed to US$ - One can increase or decrease value of own one currency by
selling/ buying domestic currency for US$.
Undervalued domestic currency = par FX rate below potential
market rate and there is excess supply for domestic
currency
=> Central bank must sell international reserves ($) to buy
domestic currency and balance the market excess supply of it.

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Overvalued domestic currency: par FX rate above potential market

rate and there is excess demand for domestic
currency
=> Central bank must buy international reserves ($) to sell
domestic currency and balance the market excess demand of it.
Devaluation / Revaluation
If the country cannot/does not support changes in the value of its
currency it must devalue or revalue.
1. Devaluation: the country cannot keep its currency from depreciating (e.g.
doesnt have enough international reserves) so it must reset the par
exchange rate at a lower level
2. Revaluation: the country cannot keep its currency from appreciating (e.g.
central bank doesnt want to acquire more international reserves). Thus,
must reset the par exchange rate at a higher level.
Key weakness of fixed rate system
Asymmetry:
IMF can pressure deficit countries losing international reserves to
decrease Ms or to devalue (countries are willing to do so, since net
importers, so can become more competitive)
IMF has difficulties to pressure surplus countries to increase Ms or
to revalue (these countries are net exporters and they dont want to
lose their competitiveness exportsjobs!)

Exchange Rate Pegs

1. Commit to keep value of currency fixed relative to strong currency
2. Central bank must constantly intervene and can run out of assets (Argentina)
PRACTICE QUIZ
Note: When the exchange rate of the British pound is $1.25, then you can buy 1 pound for
1.25 dollars.
1) When the exchange rate of the British pound changes from $1.25 to $1.50, then
A) the pound has appreciated and the dollar has depreciated.
B) the pound has depreciated and the dollar has appreciated.
C) the pound has appreciated and the dollar has appreciated.
D) the pound has depreciated and the dollar has depreciated.
2) When the exchange rate for the Swiss Franc changes from $0.60 to $0.80, then, holding
everything else constant, in respect to US $, the Swiss Franc has ______ and it become _____
expensive to import Swiss army knifes to U.S.
A) appreciated; more B) appreciated; less C) depreciated; more
D) depreciated; less
3) Assume that the absolute version of PPP theory holds. According to the law of one price, if
the price of textbook on Money and Banking is $100 in the U.S. and 50 Canadian dollars in
Canada, then the exchange rate between the US dollar and the Canadian dollar:
A) 1 Canadian per 2 US dollars.
B) 2 Canadian per 1 US dollar.
4) Assume that the relative version of PPP theory holds. If the 2001 inflation rate in Canada is
2 percent, and the inflation rate in US is 5 percent, then the theory of purchasing power parity
predicts that, during 2001, the value of the Canadian dollar in terms of US dollars will
A) rise by 3 percent.
B) rise by 2 percent.
C) fall by 2 percent.
D) fall by 3 percent.
E) none of the above or left.

Ended by president Nixon in 1971 when US currency was too strong (other
countries did not want to revalue their currencies) and US economy
(exports) too week.

5) Assume that the Interest Rate Parity theory holds. If the interest rate on euro-denominated
assets is 4 percent and the euro is expected to appreciate at a 3 percent rate in respect to US
dollar, what is the interest rate on US dollar- denominated assets?
A) 7 percent.
B) 4 percent.
C) 3 percent. D) 1 percent. E) minus one percent.

1971, return to Gold Standard?

Pros : 1. Would impose monetary discipline, lower inflation
2. Resulting fixed exchange rate reduces uncertainty

6) Assume that the Interest Rate Parity theory holds. Suppose that Bank of England cuts the
interest rate on assets denominated in British pounds, while the Federal Reserve System keeps
the US interest rate constant. As a result of such a cut, US dollar (in respect to British
pound) will immediately____________.
A. appreciate
B. depreciate.
(!!! THIS NOT THE SAME QUESTION AS #5 !!!)

Cons: 1. High volatility of gold price might mean high volatility

of price level
2. Most Gold was produced in Soviet Union and South Africa
Other Fixed Exchange Rate Systems:
European Monetary System
1. Values of currencies fixed to each other (before January 2002)
2. New currency unit: Euro (January 2002)

7) American consumers stop consuming French wine (thus French wine is no longer imported
to the US). Such situation results in __________ of French currency (that is of European
Euro).
A) depreciation
B) deflation C) denomination D) appreciation
Answer to all questions is the first letter of the alphabet..

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