Balance of Payments.

1. International Economics
BoP
jhuato.sfc@gmail.com
SFC 7005
Spring 2012

2. Questions
• What’s the BoP? What is it for?
• What are the main categories in which the country’s
international monetary transactions are organized in
the BoP?
• What’s the BoP’s current account and what are its
main subcategories?
• What’s the BoP’s capital account and what are its
main subcategories?
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3. • What’s the official settlement balance? What kind
of information does it convey?
• What happens when a country runs a BoP deficit
under a fixed exchange rate regime? What happens
under a pure flexible exchange rate regime?
• What’s the relation between the BoP and the na-
tional income accounts?
• What are typical BoP problems and how do affected
countries face them?

4. BoP
Statistical record of a country’s international transac-
tions over a given period of time. Any transaction that
results in a nationals’ receipt from foreigners is recorded
as a credit (plus sign) while any transaction resulting
in a payment by nationals to foreigners is recorded as
a debit (minus sign).
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5. BoP’s categories
1. Current account: (goods & services) trade balance,
factor income, unilateral transfers
2. Capital account: purchase/sale of assets (stocks,
bonds, bank accounts, real estate, businesses)
3. Official reserve account: Purchases/sales of inter-
national reserve assets (USD, FX, gold, SDRs,∗ re-
serves in the IMF) by central bank
∗ TheSpecial Drawing Right is an IMF internal accounting cur-
rency defined as a weighted average of USD (.43), EUR (.35),
JPY (.11), and GBP (.11). Some countries use it to peg their
currency and as an international reserve asset.
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6. http://www.imf.org/

7. Current account
1. Merchandise trade (tangibles)
2. Services (legal, engineering, consulting, tourism, etc.)
3. Factor income (payments/receipts of interest, divi-
dends, other income from prior foreign investments)
4. Unilateral transfers (gifts, remittances, foreign aid,
reparations)
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8. Capital account
1. Direct investment (acquires controlling interest)
2. Portfolio investment (in foreign stocks and bonds
with no control)
3. Other investment (bank deposits, currency invest-
ment, trade credit, etc.)
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9. BoP’s identity
BCA + BKA + BRA ≡ 0∗
∗ BCAis the balance on the current account. BKA is the balance in
the capital account. BRA is the balance in the reserves account
or change in the official reserves.
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10. Official settlement balance
BCA + BKA + Statistical discrepancy = BRA
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11. It indicates the country’s BoP gap (deficit or surplus) that needs to
be accommodated by official reserve adjustments. When there’s a
deficit, the country needs to pay foreigners somehow, by running
down the official reserve assets (gold, FX, SDRs) or borrow anew
from foreigners. (When there’s a surplus, the country will receive
assets and build up its reserves.)

12. Fixed exchange rate regime
CA + KA = −Change in official reserves∗
∗ Assuming the statistical discrepancy is zero.
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13. Flexible exchange rate regime
If “pure,” the central bank doesn’t need reserves since the ex-
change rate adjusts to induce the match of supply and demand
for FX. A current account deficit (suplus) is matched by a corre-
sponding surplus (deficit) in the capital account.
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14. Flexible exchange mechanism
In general, if the demand for home currency exceeds supply, there’s
a surplus in the BoP. If the exchange rate adjusts, then the home
currency value in terms of FX will go up. That should discourage
exports and stimulate imports, which – other things constant –
will lead to balancing the BoP.
Vice versa, if the demand for home currency is lower than supply,
then there’s a BoP deficit. If the exchange rate adjusts, the home
currency value will drop in terms of FX. That should induce more
exports and less imports, which – other things constant – balances
the BoP.
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15. J effect
However, this adjustment mechanism may have a perverse dy-
namics. The J effect is the case when, at first, when a currency
depreciates, the BoP deficit gets worse. If the home currency
continues its drop though, the BoP will eventually improve.
Why?
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16. J effect
Why?
The BoP is not only the CA. There’s also the KA (FDI, portfo-
lio investment, etc.). Suddenly expensive imports may contract
the economy, making it less attractive to foreign investors. Also,
exports may take a while to grow. Thus, the KA inflows of FX
may go down while the reduction in imports and the stimulus to
exports may not be large enough. As a result, the deficit may get
worse!
Much depends on expectations. What’s the nature of the BoP
deficit? Is it structural or temporary? Different responses. If it is
temporary, then expectations may help. You may be able to borrow
your way out of the temporary problem. If it’s structural (and
perceived as such), then you may need a large, painful adjustment
in the economy.
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17. National income accounts and the BoP
The national income identity:
Y ≡C+I +G+X −M (1)
S ≡Y −C−T (2)
S =I +G+X −M −T
Rearranging terms:
(S − I) + (T − G) = (X − M ) = BCA (3)
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18. External shocks on the BoP
1. World business cycle led by rich countries
2. Commodity price cycle (oil, raw materials, foodstuffs)
3. Exchange rates
4. Inflation & interest rates
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19. International goods market shocks
PX
Sudden, adverse changes in the ToT (= PM
) usually summarize
the impact of these schocks:
1. Export shocks (demand in rich countries fluctuates with busi-
ness cycle) [prices (ToT) may not tell whole story, since some
prices are sticky]
2. Import shocks (supply shortfalls, oil shocks for non-oil coun-
tries, harvest failures)
3. Exchange rate changes between rich countries may have strange
effects on developing countries’ BoP
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20. International capital market shocks
Sudden increases in the cost of borrowing determined by interest
rate, inflation rate, and institutional constraints:
1. Interest rate shocks (e.g. the late 1970s & early 1980s) [struc-
ture of the debt matters: terms, fixed vs. floating rates]
2. Inflation & debt [what matters is debt in real terms]
3. Real interest rate (nominal interest rate minus inflation rate)
4. Institutional constraints on borrowing (crisis of confidence
may compound the BoP problem)
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21. Policy responses to external shocks
In poor countries, letting the exchange rate adjust may be brutal.
Lower income in export sectors (usually the most dynamic sector
in the economy) has repercussions in whole economy.
Three choices must be made:
1. Financing or adjusting?
2. Extent of adjustment
3. Lowering spending (reducing aggregate spending via fiscal/monetary
policy) or switching spending (by devaluing or via trade poli-
cies, e.g. import quotas, export subsidies, etc.)?
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22. Financing or adjusting?
It depends on availability of foreign capital.
First, stop the drain of FX reserves.
Is it temporary or structural? (How can we know?)
If temporary, borrow and use counter-cyclical measures domesti-
cally to foster domestic consumption & investment. If structural,
adjust. This is choosing the lesser evil. Don’t adjust if shock
temporary, because you hurt your long-term growth chances.
What if the shock is favorable (and temporary)? Don’t get used
to it. Save, invest in assets that will sustain growth in the future,
even in the face of BoP problems. Build reserves for the bad times.
(Mexico in the late 1970s, early 1980s.)
Role of IMF. To use its credit line, the IMF often dictates that
the country should adjust. That may be very stupid, but that’s a
hard institutional constraint.
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23. Lower spending or switching spending?
How to improve the trade balance?
• Tax increases (LS)
• Cuts in government spending (LS)
• Restrictions to credit in banking system (LS)
• Export subsidies (SS)
• Import controls (SS)
• Devaluation (SS)
See Paul Krugman’s paper (handout).
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