Tutorial1 Studentnotes

Summaryoflecture1
1.Nationalsavingminusdomesticinvestmentequalsthecurrent account(exportsminusimports). 2.

Thecurrentaccountequalsthecountrysnetforeigninvestment,i.e., CA =S I.Thisisalso
thenetflowsoffinancialassets=netacquisitionoffinancialasset net incurrenceoffinancialliabilities,eg.IfCA>0(credit(+)),domesticresidentsor CBboughtmoreforeignassetsthanforeignersboughtdomesticassets(debit()) whichisfinancialoutflowwhenapaymentor: Intermsofassets,netforeignassets=netacquisitionofdomesticresidentsof foreignassets netacquisitionofforeignresidentsofdomesticassets.Hence, CA=NFAsoCA>0meansNFA>0andviceversa

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Summaryoflecture1(cont.)
3.Thebalanceofpaymentsaccountsrecordsflowsofgoods&servicesand fl flows of ff financial lassetsacrosscountries.
Ithas3parts:currentaccount,capitalaccount,andfinancialaccount(non reserveandreservetransactions),whichbalanceeachother. Transactionsofgoodsandservicesappearinthecurrentaccount; transactionsoffinancialassetsappearinthefinancialaccount. Eachcredit(+)hasacorrespondingdebit()andviceversainthebalanceof payment taccount t

4.Officialinternationalreserveassetsareacomponentofthefinancial account,whichrecordsofficialassetsheldbycentralbanks. 5.Theofficialsettlementsbalance(whichisalsoknowninthemediaasthe balanceofpayment)isthenegativevalueofofficialinternational reserveassets,anditshowsacentralbanksholdingsofforeignassets relativetoforeigncentralbanks banks holdingsofdomesticassets. assets

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Question1a
ThenationofPecunia hadacurrentaccount deficitof$1billionandanonreservefinancial accountsurplusof$500millionin2008. 2008 a) WhatwasthebalanceofpaymentofPecunia inthatyear?Whathappentothecountrys country s netforeignassets?

Suggestedanswer
Sincenoncentralbankfinancialinflowsfellshortof thecurrentaccountdeficitby$500million,thebalance ofpaymentsorofficialsettlementbalanceofPecunia (officialsettlementsbalance) ( )was$500million.
Onpage343ofKOM,itstatesthattheOSBormore informally,BOP,isthesumofthecurrentaccountandthe capitalaccountlessthenonreserveportionofthe financialaccountbalance.

Thecountryasawholesomehowhadtofinanceits$1 billioncurrentaccountdeficit, ,soPecunias netforeign g assetsfellby$1billion. NotethatCurrentAccount= netforeigninvestment=netforeignasset.

Q1b
b Assumethattheforeigncentralbanksneither b. buynorsellPecunia assets.Howdidthe Pecunia centralbank banks sforeignreserveschange in2008?Howwouldthisofficialintervention showupinthebalanceofpaymentsaccounts inPecunia?

Suggestedanswer
Thus Thus,Pecunia Pecunias s centralbanksold$500million inforeignreserves,whichwouldappearasan officialfinancialinflow(ofthesame magnitude)inthecountrysbalanceof paymentsaccounts accounts.
Inotherwords,theCBwouldhavesold$500m worthofforeigncurrencyofwhichitwould receiveanequivalentamount(officialfinancial inflowwhichiscredit).

Q1c
Howwouldyouranswerto(b)changeifyou learnedthatforeigncentralbankshad purchased$600millionofPecunia assetsin 2008?Howwouldtheseofficialpurchases enterforeignbalanceofpaymentsaccounts?

Suggestedanswers
thecountryneededonly$1billiontocoveritscurrent accountdeficit,but$1.1billionflowedintothecountry(500 millionprivateand600millionfromforeigncentralbanks). banks) Notethatforeigncentralbankspurchasesofdomesticassets donotnecessarilyaffecttheOfficial(international)reserve assetaccount(seeexampleinthetextofNissanandBankof JapantransactionsinUSdollars,thirdparagraphpage342 and3rd paragraph,page343). Thebalanceofpayments(orOSB)isnow100million, million comprising500incurrentaccounttransactions,500million inprivateand600millioninforeigncentralbankspurchasing Pecunia assets(orPecunia sellingitsassets).Theofficial (international)reservetransactionoftheCBinvolves100 millionwhichisapurchaseofforeignassets.Pecunias centralbanksp purchaseofforeign g assetsincreasestheofficial reserveassets.

Question2
Canyouthinkofanyreasonswhyagovernment mightbeconcernedaboutalargecurrent accountdeficitorsurplus?Whatmighta governmentbeconcernedaboutitsofficial settlementbalance(i (i.e., e itsbalanceof payments)?

Suggestedanswer
Acurrentaccountdeficitorsurplusisasituationwhich maybeunsustainableinthelongrun. Thereareinstancesinwhichadeficitmaybe warranted,forexampletoborrowtodaytoimprove productivecapacityinordertohaveahighernational incometomorrow.Butforanyperiodofcurrent accountdeficittheremustbeacorrespondingperiod inwhichspendingfallsshortofincome(i.e.,acurrent accountsurplus)inordertopaythedebtsincurredto foreigners. foreigners Intheabsenceofunusualinvestmentopportunities, thebestpathforaneconomymaybeoneinwhich consumption relativetoincome, consumption, income issmoothedoutover time.

Suggestedanswer
Thereservesofforeigncurrencyheldbyacountrys centralbankchangewithnonzerovaluesofitsofficial settlementsbalance.Centralbanksusetheirforeign currency yreservestoinfluenceexchange g rates.A depletionofforeignreservesmaylimitthecentral banksabilitytoinfluenceorpegtheexchangerate. Forsomecountries(particularlydevelopingcountries), centralbankreservesmayanimportantasawayof allowingtheeconomytomaintainconsumptionor investmentwhenforeignborrowingisdifficult. difficult Ahigh levelofreservesmayalsoperformasignalingroleby convincingpotentialforeignlendersthatthecountryis creditworthy. creditworthy