Balance of payments
Measure of money inflows and outflows between the United States and the rest of the world (ROW) - Inflows are referred to as 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 decrease
- 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.
- Appreciation of a currency occurs when the exchange rate pf that currency increases (e ^)
- Hypothetical: 100 yen is used to buy $1. Now 200 yen buys $1
- The dollar is "stronger"
- Depreciation of a currency occurs when the exchange rate of that currency decreases (e decreases)
- 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.
Exchange rate determinants
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 good
- 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.
