IB Economics/International Economics/Balance of payments

4.5.1 Current Account

  • External equilibrium is concerned with the Balance of Payments: An account of the transactions between domestic and foreign economies.
  • The current account includes the trade account which records the goods and services imported and exported from the home country.
    • A deficit on the trade account means that imports are larger than exports.
  • Those items which lead to Europeans receiving money from abroad are counted as positive items in the balance of payments.
    • A more technical definition: those items which lead to more Euros being purchased are counted as a positive item on the Balance of Payments.
  • The current account:
    • Records all international transactions involving goods and services.

The Balance of Trade

  • Merchandise account: also called the visible account in Britain, which records all transactions involving goods.
  • The Traded Service account which records all transactions involving services.
  • The Capital Servicing account:
    • Includes the interest, profits and dividends paid to and by foreigners.
    • For developing countries, this section is usually negative. More is paid out to foreign investors than is received as interest and dividends.
    • For industrialized countries like the US and Japan, this account is typically positive because of the large amount earned on foreign investments.

Invisible Balance

  • Consists of the Capital Servicing account plus the Traded Services account.

4.5.2 Capital Account

  • The capital account records financial transactions involving short term and long term capital movements into and out of the country.
  • When financial capital flows into a country, that country is exporting a security to the foreigner.
    • The security can consist of a money market instrument, a bond, a stock or a joint venture agreement or some kind of contractual arrangement.
    • When those securities are exported, financial capital flows into the domestic economy and counts as a plus in the Balance of payments.
  • Capital account: if the Japanese invest in US treasury bills, it is the US that gets the money, and the Japanese that get the TB's.
    • It counts as negative on the Japanese balance of payments (and their GDP).

This is how the balance of payments is always balanced: if there are negatives on the current account, they must be balanced by a plus on the capital account.

  • Short term capital is held mainly in money market instruments such as treasury bills or bank accounts (portfolio as opposed to direct investment).
  • Long term capital movements:
    • Portfolio: generally involve the purchase of stocks or bonds.
    • Direct: investments in capital in the country or joint venture agreements.
  • As an alternative to short term and long term, the Capital account is divided by:
    • Direct investments: which includes direct investment in a branch plant or a subsidiary for a large multinational company or a joint venture agreement
    • Portfolio investments: which includes transactions involving securities such as money market instruments or stocks and bonds.

Official Reserves

  • If we include official reserves, the balance of payments is always in balance.
  • One of the easiest ways to think about it is to ask who gets the money.
    • Current account: if Japan imports apples from China, the Chinese get the money, the Japanese get the apples. It counts as a minus in the Japanese balance of payments (and for the GDP).
    • If the Chinese buy cars from Japan, the Chinese get the cars and the Japanese get the money: a plus on Japan’s balance of payments.
    • For services: if the Japanese go skiing in Switzerland, the Swiss get the money, and the Japanese get the tourism experience. It enters as a negative on the Japanese balance of payments.
  • Factors influencing the balance of payments include:
  • Income: as national income rises the demand for imports rise shifting the current account toward a deficit.
    • Changes in relative prices: as domestic prices rise relative to foreign prices, imports appear cheaper and exports more expensive and the current account will move toward a deficit.
    • Changes in relative investment prospects: as return on investment rises, foreign capital will be attracted into the country and the capital account will move toward a surplus.
    • Changes in relative interest rates: as domestic interest rates rise, short term capital is attracted moving the capital account toward a surplus.
  • If the foreign exchange rate is rising (domestic currency appreciating), the central bank may intervene by selling more domestic currency.
  • If the foreign exchange rate is falling (domestic currency is depreciating), the central bank may intervene by buying domestic currency with the reserve of foreign currency.
Last modified on 10 January 2010, at 17:34