Wesley. All Rights Reserved. 12-1

Copyright © 2007 Pearson Addison-
Wesley. All rights reserved. 12-1

Balance of Payments
Components of the Balance of Payments:
◦ Current Account
◦ Financial Account
Financing the Current Account
Saving, Investment, and Current Account
Other Balance of Payments Measures
Balance of Payments Equilibrium
Topics to be Covered
Balance of payments issues such as trade
deficits and foreign indebtedness are
controversial topics.
Balance of payments accounts provide
insights into the country’s economic
performance relative to the rest of the world.
The study of the economics of balance of
payments allows proper evaluation of the
various arguments and government policies
recommended to eliminate trade imbalances.
Why Study
the Balance of Payments?
Balance of Payments (BOP)—is an
accounting record of a country’s trade in
goods, services, and financial assets with
the rest of the world during a particular
time period (year or quarter).
Balance of Payments
BOP follows the accounting procedure of
double-entry bookkeeping (debits
& credits).
◦ A credit entry records an item or transaction
that brings foreign exchange into the country.
◦ A debit entry represents a loss of
foreign exchange.
Features of the BOP

BOP will always balance.
A BOP deficit (surplus) means that the
debit entries exceed (are less than) the
credits. This imbalance applies only to
a particular account or component of
the BOP.
Features of the BOP (cont.)

Current Account
Capital Account
Financial Account
Components of the BOP

 Thecurrent account includes the value of trade in
merchandise, services, income from investments,
and unilateral transfers (refer to Table 12.1).
 Merchandise—tangible goods.
 Services—include travel and tourism, royalties,
transport costs, and insurance.
 Income from investments—interest and dividends.
 Unilateraltransfers—include foreign aid, gifts, and
retirement pensions.
Current Account
Refer to Figure 12.1
From 1946 to 1970, the U.S. had a
merchandise trade surplus.
The merchandise trade balance has been in
deficit since 1971 (except 1973 and 1975).
U.S. income receipts from investments
abroad have had sizable surpluses that the
current account experienced surpluses in
1973–76 and 1980–81.
U.S. Current Account

Historical Trends
 If we draw a line at the current account
balance, then:
1. Items “above the line” refer to the current
account trade in goods, services, income,
and unilateral transfers.
2. Items “below the line” are the capital and
financial account transactions (purchases
and sales of financial assets).
Drawing a Line in the BOP

Since the BOP always balances, then a
current account deficit (above the line)
implies that the country is running a net
surplus below the line, so that the country is
a net borrower from the rest of the world.
The U.S. became a net borrower in 1985 for
the first time since World War I because of
the huge current account deficits in the
1980s (refer to Item 12.1).
Drawing a Line in the BOP

(cont.)
This line is relatively small for the U.S.
and includes primarily transactions
involving debt forgiveness and financial
assets accompanying migrant workers as
they enter or leave the country.
Capital Account
Refer to Table 12.1 (lines 40–69)
The financial transactions include:
◦ Direct Investment
◦ Purchases of Equity and Debt Securities
◦ Bank Claims and Liabilities
◦ U.S. Government Assets Abroad
◦ Foreign Official Assets in the U.S.
Financial Account
 Given the national income accounting identity:
where Y is national income or GDP, C is

consumption spending, I investment, G
government spending, and X is net exports or the
current account, we can rearrange this identity as:
where Y – C – G is national income less

consumption less government spending, which we
National Saving,
can call national Investment,
saving S. Thus, saving equals the
sum of investment and the current account.
and the Current Account
Rearranging further, we get:
This states that if domestic saving exceeds

investment, there will be a current
account surplus.
A country that spends more than its
income
(I > S) will experience a current account
deficit. This overspending must be financed
by foreign
National investment,
Saving, so there will be a
Investment,
financial account surplus to match the
and current
the Current Account (cont.)
account deficit.
Copyright © 2007 Pearson Addison- 12-
Wesley. All rights reserved. 19
Given two kinds of saving (private
and government):
where private saving equals income less

taxes (T) less consumption, and
government saving equals taxes less
government spending.
More on the Link between

Saving and the Current Account
If government spends more than its tax
revenues (i.e., budget deficit or
government dissaving) and private saving
stays constant, then the current account
will run a deficit. This was the twin-deficit
problem of the 1980s and early 1990s.
When the U.S. budget turned surpluses in
late 1990s, the current account deficit
continued to grow. This was due to a
substantial drop in private saving along
with a rise in investment.
Saving and Current Account

(cont.)
Lesson: Reducing the current account
deficit requires increasing private saving
relative to investment, and expanding
domestic output or income relative to
domestic spending.
Saving and Current Account

(cont.)
Balance of Trade—the value of
merchandise exports minus imports
(line 3 plus line 20 in Table 12.1).
Official Settlements Balance—the
value of the change in financial assets
held by foreign monetary agencies and
official reserve asset transactions
(lines 41 and 56 in Table 12.1).
Additional BOP Summary

Measures
Statistical Discrepancy (Line 70
in Table 12.1) refers to the measurement
errors and omissions resulting from
problems of incomplete
or inaccurate data.
Statistical Discrepancy
Itis impossible for every country in the
world to have a trade surplus.
If international trade is voluntary, then
it is difficult to argue that deficit countries
are harmed and surplus countries benefit.
Deficitsare not inherently bad, nor are
surpluses necessarily good.
Economic Implications of the BOP

BOP equilibrium is the situation
where credit items equal debit items
for a particular sub-account, such as
the current account or official settlements
account, of a country’s balance of
payments.
Balance of Payments
Equilibrium
What happens if the country has a current
account deficit?
◦ The country must borrow (sell domestic
securities) to the rest of the world to finance
the current account deficit.
◦ As foreigners accumulate domestic securities,
the domestic currency value falls which, in
turn, raises net exports and consequently
income.
Movement Towards
BOP Equilibrium
What happens if the country has a current
account deficit? (cont.)
◦ In addition, domestic interest rates rise which,
in turn, lowers consumption and investment
spending.
◦ The increase in national income relative
to spending will reduce the current
account deficit.
Movement Towards
BOP Equilibrium (cont.)

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Features of the BOP

Features of the BOP (cont.)

Components of the BOP

U.S. Current Account

Drawing a Line in the BOP

Drawing a Line in the BOP

where Y is national income or GDP, C is

where Y – C – G is national income less

This states that if domestic saving exceeds

where private saving equals income less

More on the Link between

Saving and Current Account

Saving and Current Account

Additional BOP Summary

Economic Implications of the BOP

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