Understanding the Balance of Payments

• The balance of payments tracks a country's international transactions.
• Transactions that involve a flow of money into a country are credit items, marked with a plus sign e.g. exports.
• Transactions involving a flow of money out of a country are debit items, marked with a minus sign e.g. imports.

The Current Account

• The current account measures a country's trade in newly produced goods and services, as well as net transfers between countries.
• Three components of the current account:
  • Net exports of goods and services
  • Investment income earned from assets held abroad
  • Current transfers between countries
• The current account balance is calculated by summing all credits and subtracting all debits.
• A positive balance indicates a current account surplus, while a negative balance indicates a current account deficit.

Table 5.1: Impact on the Current Account Components

• Net exports: impact is determined as export + and import -
• Exports of merchandise: are a credit (+)
• Exports of services: are a credit (+)
• Imports of merchandise: are a debit (-)
• Imports of services: are a debit (-)
• Net income from assets: impact is determined as income + and payments -
• Income from foreign investments: credit (+)
• Investment income paid to foreigners: debit (-)
• Current transfers: impact is influenced by transfers to foreigners + and from foreigners -
• Transfers from foreigners: credit (+)
• Transfers to foreigners: debit (-)

The Capital Account

• The capital and financial account records trades in existing assets, both real (e.g., houses) and financial (e.g., stocks and bonds).
• Referred to as simply the capital account.
• Capital inflow occurs when the home country sells assets to a foreign country and is a credit (+).
• Capital outflow occurs when assets are purchased from a foreign country and is a debit (-).
• A capital inflow into Canada from Japan occurs when someone in Japan buys shares of stock in a Canadian company.
• A country with more capital inflows than outflows will have a capital account surplus.
• Official settlements balance/balance of payments is net increase (domestic less foreign) in a country's official reserve assets.
  • These assets are utilized in international payments, including gold, foreign government securities, foreign bank deposits, and Special Drawing Rights (SDRs) at the IMF.

Relationship between the Current Account and the Capital Account

• Represented by CA (Current Account) and KA (Capital Account).
• The balance must sum to zero at each period: CA + KA = 0
• Measurement issues recorded as a statistical discrepancy prevent this condition from being exact.
• A current account surplus implies a capital account deficit, leading to a net increase in foreign asset holdings (capital outflow) and the country is a net foreign lender.
• A current account deficit implies a capital account surplus, leading to a net decline in foreign asset holdings (capital inflow) and the country is a net foreign borrower.
• Equivalent measures of a country's international trade and lending:
  • Current account surplus
  • Capital account deficit
  • Net acquisition of foreign assets
  • Net foreign lending
  • Net exports (NFP and net transfers are zero)

Net Foreign Assets and the Balance of Payments Account

• Net foreign assets are the difference between foreign assets held by residents and a country's foreign liabilities, forming part of national wealth.
• The total value of net foreign assets can shift if:
  • The value of existing foreign assets or liabilities changes.
  • New foreign assets/liabilities are acquired/incurred.
• The net increase in foreign assets equals a country's current account surplus.
• A current account surplus leads to a capital account deficit, implying a net increase in foreign asset holdings with the country as a net foreign lender.
• A current account deficit leads to a capital account surplus, implying a net decrease in foreign asset holdings with the country as a net foreign borrower.

Goods Market Equilibrium in an Open Economy

• The open economy national income identity: S = I + CA
• The uses-of-saving identity shows savings can be used to:
  • Fund domestic investment (I)
  • Increasing a country’s capital stock
  • Lend to foreigners (CA)
  • Increasing a country’s net foreign assets
• Current account consists of net exports plus net factor payments so the open economy income identity can be written as:
  • S=I+NX+NFP
• The goods market equilibrium in an open economy: national saving and investment equal their desired levels, yielding condition:
  • Sd=Id+NX+NFP
• At equilibrium, the desired amount of national saving (Sd) must equal the desired amount of domestic investment (Id) plus the amount lent abroad CA.
• If net factor payments are zero, the open economy goods market equilibrium condition becomes: Sd = Id + NX
• In an open economy, net exports (NX) equals total output (Y).
• Minus total spending by domestic residents called absorption: NX = Y - (Cd + Id + G)

Saving and Investment in a Small Open Economy

• Canada does not affect the world real interest rate (rw), and this is fixed in our analysis.
• Three Scenarios for the Trade Position of a Small Open Economy:
  • If rw = r1, then Sd > Id, desired national saving exceeds desired investment. The difference is lent internationally in which net foreign lending is positive and the country has a trade surplus so CA > 0
  • If rw = r2, then Sd = Id, desired national saving equals desired investment, no net foreign lending and trade is balanced and CA = 0
  • If rw = r3, then Sd < Id, desired investment exceeds desired national saving. The difference is borrowed internationally where net foreign lending is negative, and the country has a trade deficit so CA < 0
• Interest rates paid on assets in Canada and the U.S. differ due to other factors impacting the expected rate of return on domestic vs. foreign assets:
  • Transaction costs
  • Tax rates on interest income
  • Exchange rate risk
  • Political risk

The Effects of Supply Shocks in a Small Open Economy

• A temporary negative supply shock shifts the national saving curve to the left due to the decrease in income.
• Investment is unaffected by a temporary supply shock if the MPK is unchanged.
• National saving curve shifts left: current account balance falls, net foreign lending falls, and net exports fall.

Saving and Investment in Large Open Economies

• Saving and investment patterns of a large economy impact the world real interest rate.
• Analysis assumes there are two large economies: domestic and foreign.
• The world real interest rate is where desired international lending equals desired international borrowing.
• Anything that increases desired international lending relative to desired international borrowing causes the world real interest rate to fall.
• Takeaway: For a large open economy, the equilibrium world real interest rate is where its desired international lending equals another country’s international borrowing.
  • Alternatively, equilibrium is where the lending country's current account surplus equals the borrowing country's current account deficit.

The Twin Deficits

• Twin deficits theory applies to Canada in the late 1980s and early 1990s.
• Canada experienced large government budget deficits and current account deficits at that time, with many attributing the former as a primary cause of the latter although not all economists agree with this theory.

The Critical Factor: The Response of National Saving

• The link between the government budget deficit and the current account deficit hinges on how national saving responds to government budget deficit increases.
• Reducing desired national saving raises the current account deficit.
• Raising the saving curve to the left leads to current account declines in this scenario.
• An increase in the government budget deficit has no effect on desired investment, so it affects the current account only if it affects desired national saving
• If desired national saving is influenced, the saving curve shifts to the left raising the world real interest rate and reducing investment in both countries in the analysis.

The Government Budget Deficit and National Saving

• Considerations in the underlying cause of the government budget deficit and whether this can affect the twin deficits theory.
• A budget deficit caused by increased government purchases clearly reduces desired national saving because: Sd = Y - Cd - G
• A budget deficit caused by a current tax cut will cause desired national saving to fall only if it causes desired consumption to rise.
• Impact is Influenced By
  • Ricardian equivalence
  • Consumer response to not foreseeing future taxes
• Empirical evidence for Ricardian equivalence is mixed.

Summary

• International trade introduces a foreign sector in the goods market model.
• International transactions as swaps of goods, services, or assets between countries have offsetting effects on the sum of the current and capital account balances.
• An open economy, goods market equilibrium requires:
  • Desired amount of national saving = desired amount of domestic investment + the amount the country lends abroad
• A small open economy faces a fixed world real interest rate
  • National saving and investment will equal their desired ones
  • Increases or decreases in either affect the small open economy's foreign lending and current account balance at the current world real interest rate.
• Large open economies see effects of their levels of saving and investment affect the world real interest rate.
  • Equilibrium real interest rate in the international capital market is where desired international lending equals desired international borrowing.