Introductory Macroeconomics Lecture 21: Balance of Payments I PDF

Introductory Macroeconomics Lecture 21: Balance of Payments I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Balance of Payments I (1) Saving, investment, and the trade balance (2) Current accoun...

Introductory Macroeconomics Lecture 21: Balance of Payments I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Balance of Payments I (1) Saving, investment, and the trade balance (2) Current account vs. Capital account (3) International capital flows BOFAH Chapter 18 2 Saving, Investment, and the Trade Balance 3 (1) Savings, Investment, and the Trade Balance Savings, investment, and the trade balance are linked By national income accounting identity, in an open economy Y = C + I + G + (X − M ) Recall that private savings S is disposable income less consumption S = (Y − T ) − C Combining these expressions and cancelling common terms we get S = I + (G − T ) + (X − M ) 4  Savings, Investment, and the Trade Balance Rearranging terms S + (T − G) −I = |X − {z M} | {z } total domestic savings trade balance where total domestic savings S equals domestic private savings S plus domestic public savings T − G A country that runs a trade deficit X < M has investment I that is greater than total domestic savings A country that runs a trade surplus X > M has investment I that is less than total domestic savings 5 Current Account vs. Capital Account 6  (2) Current Account Current Account Balance – is (i) trade balance + (ii) net foreign income balance – we disregard net foreign transfers because its a negligible amount (broadest measure of trade balance) (i) Trade balance – balance on merchandise trade (’goods’) – balance on goods and services (’net exports’) (ii) Net foreign income – capital income (interest, dividends, etc) – labor income (wages, salaries, etc) – taxes and transfers (including foreign aid & remittances) 7 Trade in Goods and Services 8 Trade in Goods and Services 9 The Current Account Balance 10  Financing a Current Account Deficit Historically, Australia had large persistent current account deficits. How are such deficits financed? – by borrowing and/or selling assets to foreigners Gives rise to international capital flows, in equity and debt (note: this is ’financial capital’, not ’physical capital’) – foreign direct investment (controlling interest) – portfolio investment (passive interest) * purchases of government securities * purchases of corporate equity or securities * bank and non-bank loans – government transactions These flows are recorded in a country’s capital account 11 International Capital Flows 12  (3) Balance of Payments Current and capital accounts must balance current account + capital account = 0 (up to a statistical discrepency) Current account deficit = capital account surplus ⇔ domestic investment > domestic savings Current account surplus = capital account deficit ⇔ domestic investment < domestic savings 13  For Discussion Are large, persistent current account deficits a problem? Two perspectives – pessimistic: current account deficit because we have low savings, debt burden will grow, consumption will have to fall in future – optimistic: capital account surplus because our economy is good place to invest, large flow of savings from low-growth countries 14  Risk of Sudden Stops Main concern with current account deficits: capital inflows prone to ’sudden stops,’ sudden withdrawal of international lending Many examples in emerging economies Need for sharp adjustment via combination of sudden domestic recession and sharp real exchange rate depreciation Often also associated with domestic banking/financial crisis 15 Historical Balance of Payments 16 But More Recently 17 Net International Capital Flows 18  External Position Current/capital account measures international capital flows Add up current/capital accounts over time to get stocks net foreign liabilities = gross foreign liabilities−gross foreign assets where – gross foreign liabilities are foreign claims on domestic economy – gross foreign assets are domestic claims on foreign economy 19 Add Up Net Flows to Get Net Foreign Liabilities 20 High Proportion of Liabilities in AUD 21  A China Puzzle? For many years, China had both (i) large current account surpluses as well as (ii) large inflows of private investment How can these be reconciled? What has changed in the last few years? 22 China’s Balance of Payments 23 24  Learning Outcomes 1 Understand and explain the relationship between savings, investment and the trade balance. 2 Understand and explain how the current account and capital account are related through the Balance of Payments Identity. 3 Understand and explain how to calculate the external position, summing of net capital flows. 4 Understand trends in Australia’s balance of payments and critically reflect on risks associated with Australia’s external position. 5 Critically reflect on the value of persistent current account deficits. 25  New Formula(s) and Notation None! 26  Next Lecture Balance of Payments II – Determinants of net capital inflows * General principles * Small, open economy setting – eurozone sovereign debt crisis BOFAH Chapter 18 27