- Measure of money inflows and outflows between the United States and the rest of the world (ROW)
- Inflows are referred to ad credits
- Outflows are referred to as debits
- The balance of payments is divided into 3 accounts
- Current account
- Capital/financial account
- Official reserves account
Double entry bookkeeping
- Every transaction in the balance pf payments is recorded is recorded twice in accordance with standard accounting practice
- Ex. U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland.
- A credit of $50 million to the current account (- $50 million worth of farm equipment or physical assets)
- A debit of $50 million to the capital/financial account (+$50 million worth of euros or financial assets)
Current account
Balance of trade or net exports
- Exports of goods/services - import of goods/services
- Exports create a credit to the balance of payments
- Imports create a debit to the balance of payments
Net foreign income
- Income earned by U.S. owned foreign assets - income paid to foreign held by 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 migrant workers send money to family in Mexico
Capital/financial accounts
- The balance of capital ownership
- Includes the purchase of both real and financial assets
- Direct investment in the United States is a credit to the capital account
- Ex. The Toyota factory in San Antonio
- Direct Investment by U.S. firms/individuals in a foreign country are debits to the capital account
- Ex. The Intel factory in San Jose, Costa Rica
- Purchases of foreign financial assets represents a debit to the capital account
- Ex. Warren Buffet buys stock in Petrochina
- Purchases of domestic financial assets by foreigners represents a credit to the capital account
- The United Arab Emirates sovereign wealth fund purchases a stake in the NASDAQ
Relationship between Current and Capital account
- Remember double entry bookkeeping?
- The current account and the capital account should zero each other out
- That is...if the current account has a negative balance (deficit), then the capital account should have a positive balance (surplus).
Official reserves
- The foreign currency holdings of the United States Federal Reserve System
- When there is a balance pf payments surplus the Fed accumulates foreign currency and debits the balance of payments
Active vs passive official reserves
- The united states is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.
- The people's republic of china is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the united states.
Foreign exchange (FOREX)
- 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.
- Simply put. The exchange rate is the price of currency.
- Do not try to calculate the exact exchange rate.
Tips
- Always change the demand line on the currency graph, the supply line on the other currency's 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 on the other graph decreases
- If D moves to the left, S will move to the left on the other graph.
Changes in Exchange Rates
- Exchange rates (e) are a function of the supply and demand for currency.
- An increase in the supply of a currency will make it cheaper to buy one unit of that currency.
- A decrease in supply of a currency will make it more expensive to buy one unit of that currency.
- An increase in demand for a currency will make it more expensive to buy one unit of that currency.
- A decrease in demand will make it cheaper to buy one unit of that currency.
- Hypothetical: 100 yen is used to buy $1. Now 200 yen buys $1.
- The dollar is "stronger".
- One hundred yen used to buy one dollar. Now 50 yen buys one dollar.
- The dollar is weaker because it takes fewer yen to buy the dollar.
- Consumer tastes
Ex. A preference for Japanese goods creates an increase in
the demand of yen and an increase in the supply of dollars in the currency
exchange market.
The increase in demand of the yen leads to the appreciation
of the yen.
The increase in the supply of dollars leads to the
depreciation of the dollar.
- Relative income
Imports tend to be normal goods
Ex. If Mexico's economy is becoming stronger and the U.S.
Economy is in recession, then Mexicans will buy more American goods.
- Relative price level
Ex. If the price level is higher in Canada than in the
United States, then American goods are relatively cheaper than Canadian
goods.
This Canadians will import more american goods causing the
us dollar to appreciate.
- Speculation
Ex. If Us investors expect that Swiss interest rates will
climb in the future, then Americans will demand Swiss francs in order to earn
the higher rates of return in Switzerland.
This will cause the Swiss franc to appreciate as demand for
it will increase.
Supply of the dollar will increase causing it to
depreciate.