Unit 7

Balance of Payments:

• Measure of money inflows and outflows between the US and the rest of the world.
• Inflows are referred to as credits and
• Outflows are referred as debits.
• the balance of payments us divided into three accounts.
• current account
• capital/ financial account.
• official reserve account.

Double Entry Book Keeping:

• Every transaction in the balance of payment is recorded twice in the accordance with standard accounting practice.
• ex: U.S. manufacture 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.

• notice that the two transactions offset each other.

Current Account:

Balance of Trade:

• 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 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) (one-sided)

• Foreign Aid --> a debit to the current account

• Ex. Mexican migrant workers send money to family in Mexico.

Capital Financial Account

• The balance of capital ownership.
• Include the purchase of both real and financial assets.

• Direct investment in the U.S. 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
•  Purchase of foreign financial assets represents a debit to the capital account
• Ex. Warren Buffet buys stock in Petrochina 
•  Purchase of domestic financial assets by foreigners represents a credit to the capital account
• The United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ

Relationship  Between Current and Capital 

Account

• The Current Account and the Capital Account should zero each other out
• If the current account has a negative balance (deficit), then the Capital Account should then have a positive balance (surplus)

 Official Reserves

• The foreign currency holdings of the US Fed Reserve System
• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments
• When there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments
• The Official Reserves zero out the balance of payments

Credits v. Debits

• Credits--Addition to a nation's account
• Debits--Subtractions to a nation's account 

How to Calculate the Following

1. Balance of Trade
• (merchandise & service exports) - (merchandise & service imports)
2. Trade deficit occurs when the balance on trade is negative (Imports > Exports)
• Trade surplus occurs when the balance on trade is positive (Exports > Imports)
3. Balance on current account
•  Balance on trade (goods & services) + Net Investment Income + Transfer Payments
4.  Official Reserves

• Nationally
• Change in CA + Change Capital + change in Official Reserves = 0.

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
• Ex. The current exchange rate is approximately 77 Japanese Yen to 1 US dollar

• Simply put, the exchange rate is the price of a currency
•  Do not try to calculate the exact exchange rate

 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 decrease the exchange rate of a currency
• A decrease in supply of a currency will increase the exchange rate of a currency
• An increase in demand for a currency will increase the exchange rate of a currency
• A decrease in demand for a currency will decrease the exchange rate of a currency

Appreciation and Depreciation

•  Appreciation of a currency occurs when the exchange rate of that currency increases 
• Depreciation of a currency occurs when the exchange rate of that currency decreases
• Ex. If German tourists flock to America to go shopping, then the supply of Euros will rise and the demand for Dollars will increase. This will cause the Euro to depreciate and the dollar to appreciate
• Dollar Appreciate; Prices go up

Exchange Rate Determinants

• Consumer tastes
• Ex. A preference for Japanese goods created an increase in the supply of dollars in the currency exchange market which leads to depreciation of the Dollar and an appreciation of Yen.

•  Relative Income
• Ex. If Mexico's economy is strong and the U.S. economy is is recession, then Mexicans will buy more American goods, increasing the demand for the Dollar, causing the Dollar to appreciate and the Peso to depreciate

•  Relative Price Level
• If PL is up in Canada than U.S., American goods are relatively cheaper than Canadian goods, thus Canadians will import more American goods causing the U.S. dollar to appreciate and Canadian Dollar to depreciate

•  Speculation
• If U.S. 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 $ to appreciate.