Balance of Payments Overview

Balance of Payments (BoP)

• The Balance of Payments (BoP) is a record of a country's economic transactions with the rest of the world over a specified period.
• It has two main accounts:
  • Current Account: Records trade in goods, services, income, and unilateral transfers.
  • Capital and Financial Account: Tracks capital transfers, FDI, portfolio investment, and changes in reserve assets.

Current Account Components

• Trade Balance: Difference between exports and imports of goods and services.
  • Surplus: Exports exceed imports.
  • Deficit: Imports exceed exports.
• Primary Income: Earnings from foreign investments (e.g., dividends, interest).
• Secondary Income (Unilateral Transfers): Remittances, foreign aid, and gifts.

Capital and Financial Account Components

• Capital Transfers: Debt forgiveness, asset transfers.
• Financial Account:
  • Foreign Direct Investment (FDI): Long-term investment in foreign enterprises.
  • Portfolio Investment: Short-term investments in stocks or bonds.
  • Reserve Assets: Changes in central bank holdings of foreign currencies or gold.

BoP Accounting Identity

• The BoP must always balance.
• Current Account Balance + Capital and Financial Account Balance + Errors and Omissions = 0
• A deficit in one account must be offset by a surplus in another account.

Exchange Rate Systems

• Fixed Exchange Rate: Currency value is pegged to another currency (or a basket).
  • Central banks intervene in the foreign exchange market to maintain the fixed rate.
  • Pros: Stable international trade, reduced exchange rate risk.
  • Cons: Requires large reserves, limits monetary policy flexibility.
• Floating Exchange Rate: Currency values are determined by supply and demand in foreign exchange markets.
  • Pros: Automatic adjustment to trade imbalances, increased monetary policy flexibility.
  • Cons: Volatility, uncertainty for traders and investors.
• Managed Float (Hybrid System): Primarily market-driven exchange rates with occasional central bank intervention.

Determinants of Exchange Rates

• Interest Rate Differentials: Higher domestic interest rates attract foreign capital, appreciating the currency.
• Inflation Rates: Lower inflation strengthens a currency's purchasing power.
• Trade Balances: Persistent deficits can weaken a currency.
• Political Stability: Stable economies attract investment, strengthening the currency.

Currency Crises

• Occur when a country struggles to maintain a fixed exchange rate due to insufficient reserves or loss of investor confidence.
• Examples include the Asian Financial Crisis (1997) and the Argentine Crisis (2001).

Purchasing Power Parity (PPP)

• Exchange rates adjust so identical goods cost the same across countries (expressed in a common currency), but not always accurate over short periods.
• Formula: E = (Domestic Price Level) / (Foreign Price Level)

Limitations of PPP:

• Transportation costs and trade barriers influence goods prices between countries.

Interest Rate Parity (IRP)

• Explains the relationship between interest rates and exchange rates under arbitrage conditions.
• Formula: Forward Exchange Rate = Spot Exchange Rate × (1 + Domestic Interest Rate) / (1 + Foreign Interest Rate)