Capital flows that take place to help bring equilibrium in the balance of payments are called

The balance of payments registers all the international transactions of a country, and it is part of the National Accounts system, which registers economic activity based on a standardized accounting system between nations. This chapter describes the balance of payments and the main aggregates of the National Accounts. We show that the current-account balance results from the difference between the economy’s aggregate savings and investment. We discuss the notion of equilibrium of the balance of payments as well as the condition for sustainability of current account deficits. Finally, we discuss the main hypothesis of different open economy models regarding the functioning of the goods, assets, and money markets.

5.3.3 Balance of Payment

A BOP is the statistical record of a country’s international transactions over a certain period of time. In this double-entry bookkeeping system, any receipt from a foreigner is recorded as a credit and payments to foreigners are recorded as debits. The three major divisions of a BOP are the current account, capital account, and official reserves account. The current account includes the exports and imports of goods and services. The current account is further subdivided into merchandise trade, services, factor income, and unilateral transfers. Merchandise trade represent exports and imports of tangible goods. Trade in services include payments and receipts for service-related activities such as financial services, transport services, law, accountancy, management consultancy, and tourism. Factor income consists of payments and receipts of interest, dividends, and the like. Unilateral transfers include payments such as gifts and foreign aids.

The capital account measures all the short-term and long-term monetary transactions between a country and the rest of the world. The capital account consists of direct investment, portfolio investment, and other investments. Direct investment refers to money that follows across national boundaries for investment purposes. Portfolio investment refers to investments in foreign stocks and bonds. Other services include bank deposits, currency investments, and net government borrowings from foreigners.

Official reserves consists of a country’s reserve assets such as gold, foreign exchange reserves, and SDRs.

Because a BOP is based on double-entry bookkeeping, the sum of all debits or payments must be equal to the sum of all credits or receipts. A country with a current account deficit will have a capital account surplus and the country with a current account surplus will have a deficit in its capital account.

Shifting the BP Curve

In deriving the BP curve, we assumed that higher interest rates in the domestic economy would attract foreign investors and decrease the capital account deficit. If capital is perfectly mobile for any income level, then any deviation of the domestic interest rate from the foreign rate would cause investors to attempt to hold only the high return assets. Therefore, the BP curve becomes perfectly horizontal in the case of perfectly mobile capital. If foreign capital is not perfectly available then the BP curve will be upward sloping. If there are many restrictions to capital mobility then the BP curve will become close to vertical. Figure 13.5 illustrates a perfectly horizontal BP curve, and an upward-sloping BP curve.

It is also important to realize that the BP curve can shift whether it is upward sloping or horizontal. For example, a changing foreign perception of the substitutability shifts the BP curve. This is an intercept change, and thus the entire schedule shifts. For example, in Figure 13.6 one can see how an increase in the perception of riskiness of a country’s assets causes the BP curve to shift upward. Thus, interest rates are not equal across countries even with perfect capital mobility. For example, Indonesia may have a positive risk premium, so that investors demand a certain added premium for financing Indonesia’s trade deficits. However, as long as that particular risk premium is paid, investors are willing to finance the trade deficit.

Summary

1.

The balance of payments records a country’s international transactions: payments and receipts that cross the country’s border.

The balance of payments uses the double-entry bookkeeping method. Each transaction has a debit and a credit entry.

If the value of the credit items on a particular balance of payments account exceeds (is less than) that of the debit items, a surplus (deficit) exists.

The current account is the sum of the merchandise, services, investment income, and unilateral transfers accounts.

Current account deficits are offset by capital account surpluses.

The balance of trade is the merchandise exports minus the merchandise imports.

The official settlements balance is equal to changes in financial assets held by foreign monetary agencies and official reserve asset transactions.

An increase (decrease) in the U.S.-owned deposit in foreign bank is a debit (credit) to the U.S. capital. While an increase (decrease) in foreign-owned deposit in the U.S. bank is a credit (debit) to the U.S. capital.

The United States became a net international debtor in 1986.

Deficits are not necessarily bad, nor are surpluses necessarily good.

With floating exchange rates, the equilibrium in the balance of payments can be restored by exchange rate changes.

With fixed exchange rates, the balance of payments will not be automatically restored. Thus, central banks must either intervene to finance current account deficits or impose trade restrictions to restore the equilibrium.

Currency Crises

Currency crises may also be called balance-of-payments crises as they generally result from serious current or anticipated payment imbalances at the reigning exchange rates. Typically, they reflect market anticipations that domestic policies will not be adjusted sufficiently so that changes in exchange rates can be avoided. Adjustably pegged exchange rates are frequent contributors to such currency crises, generating one-way speculative options. This has given rise to the unstable middle hypothesis which argues, with considerable empirical support, that regimes at the two ends of the exchange rate spectrum – hard fixes like currency boards and common currencies at one end and floating rates at the other – are much less prone to currency crises than intermediate regimes with flexibility that is substantially limited.1 The European crises of 1992–93 provide examples of this problem.

Within a currency union, such as the Eurozone, changes in exchange rates are unlikely, but concerns about persistent deficits and/or fears about the credit worthiness of borrowers can lead to an increase in outflows of private capital and a decline in inflows, resulting in a higher risk premium in interest rates and an increase in the payments deficit. Unless offset by policy corrections and/or official financing, the result will be a decline in the money supply within the country with subsequent adverse effects on economic activity.

Exercises

1.

“Monetary disequilibrium leads to balance of payments problems under fixed exchange rates, and a currency problem under floating exchange rates.” Discuss this statement with reference to the monetary approach.

What are the assumptions underlying the MABP? Explain.

According to the MABP, what type of economic policies would help a country to resolve a balance of trade deficit?

Using the MABP, explain how the Bretton Woods system could break down after the United States increases its money supply too fast.

In a perfectly floating exchange rate regime, use the MAER to explain the effect on the dollar price of a Swiss franc ($/SFr) of the following scenarios:

The output in the United States decreases by 3%.

The price level in Switzerland decreases by 2%.

Assume that Mexico and the United States are in a fixed exchange rate agreement. Suppose that the Fed increases the money supply by 40%. What would happen to the international reserve position for the United States? Assume that the United States has to intervene to peg the exchange rate; how could they accomplish the intervention?

Appendix 3.A Reserve currency status and balance of payments

This note shows how the global demand for reserves affects the balance of payments of the reserve currency country. Special reference is made to the balance sheet of the reserve currency providing central bank.

According to the balance of payments constraint, the sum of current account balance (CA) and capital and financial account balance (KA) equals the change in international reserves (R). The capital account may be further divided into private and official capital flows where official capital flows are defined as changes in assets and liabilities held by foreign official institutions, mostly foreign central banks and governments. Hence, the balance of payments constraint can be written as:

(3.14)CA+KA PR+KAOF=ΔR

where the capital account balance is divided into the balance of private capital flows ( KAPR) and the balance of official capital flows (KAOF).

All central bank transactions with foreign entities are recorded in the balance of payments. Accordingly, ΔR corresponds to the change in a central bank's foreign assets and liabilities.37

(3.15)ΔR=ΔAf−ΔLf

where Af are foreign monetary assets and Lf denote foreign monetary liabilities.

For an ordinary central bank ΔR equals the change in its monetary assets, namely the change in its international reserve holdings because Lf=0.38 A deficit in the current-cum-capital account in this country has to be balanced by a sale of central bank reserves, which contracts its balance sheet. The central bank of the reserve currency country, however, features the particularity that part of its currency in circulation is held by foreigners. Domestic currency circulating in foreign countries is part of the central bank's foreign liabilities. Consequently, a deficit in the current-cum-capital account in a reserve currency country can additionally be financed by an equal increase in the central bank's liabilities without affecting its foreign assets: The central bank increases money supply and extends its balance sheet.

Whereas deficit financing in an ordinary country comes to a natural end when reserves are exhausted, the reserve currency country can finance a current-cum-capital account deficit through an increase in its foreign liabilities as long as these are accepted by the rest of the world.

Assume without loss of generality that the reserve currency country holds its stock of foreign monetary assets – which equals the stock of reserves for a non-reserve currency country – constant (ΔAf=0). Then the following identity holds:

(3.16)ΔR=−ΔLf

The change in its reserves equals the change in its foreign liabilities.39

An increase in foreign central banks' dollar reserves can take either of two forms: The central bank amounts dollar cash or in dollar denoted assets. In the balance of payments notation of the reserve currency country, the first transaction enters as a change in the central bank's liabilities with respect to foreigners (ΔLf) and the second appears in the capital account as an official capital inflow. Accordingly, the accumulation of reserves by the rest of the world ΔRROW can be expressed as

(3.17)Δ RROW=KAOF+ΔLf

After plugging (3.16) and (3.17) in (3.14) we get

(3.18)CA+KAPR=−ΔRROW

This formulation shows that any demand for reserves from the rest of the world may be satisfied by one of the following two counterbalancing operations: (1) a current account deficit or (2) private capital outflows. It is true that the US has to run a current account deficit when the rest of the world wants to accumulate net dollar assets since private capital outflows increase the liabilities of the rest of the world toward the US. If the accumulation of reserves is financed by foreign private capital inflows [−KAPR=ΔR], net foreign asset positions are unaffected.

The Mechanics of Operation of a Strict Fixed Exchange Rate Mechanism and Its Impact on the Domestic Monetary Base

We have assumed that the people of Lakeland like the way the country of Westland runs its monetary policy and they have decided that its central bank should follow Westland’s monetary policy by fixing Lakeland’s exchange rate to that of Westland. This is accomplished by the following intervention mechanism: whenever Lakeland’s exchange rate appreciates relative to Westland’s currency, Lakeland’s central bank is forced to intervene in the open market. It will buy Westland’s currency and sell or print Lakeland’s currency. In the process, it increases the supply of pesos in the economy, that is, Lakeland’s currency. The increase in the monetary base is registered as an improvement in the BOP. Notice that if the rule is strictly adhered to, the monetary base will include the international reserves of the country and the sum of all current and previous BOP flows.

That is:

(23.41) BOP=ΔIR

and

(23.42)IR=ΣBOP

where BOP denotes the Balance of Payments, ΔIR denotes the change in the international reserves of the central bank, IR the total of international reserves held by the central bank, and ∑BOP the sum of all past BOP flows. As Lakeland is the country fixing its exchange rate and the country holding the other country’s currency as reserves, we call Lakeland the NRCC and Westland the Reserve Currency Country or RCC.

The monetary base will therefore be defined as:

(23.43)B=D+IR

where B denotes the monetary base and D denotes the domestic component of the monetary base. By this we mean that D is the number of pesos not backed by International Reserves. Thus if the central bank has a policy of 100% backing, then D will be zero at all times and the base will consist solely of international reserves.

The growth rate of the monetary base can be expressed as:

(23.44)ω=δ*κ+(1−δ)*Ω

where κ denotes the growth rate of the domestic component of the monetary base. Ω is the growth rate of the international reserves, that is the BOP divided by the stock of international reserves held by the central bank and δ denotes the domestic component of the monetary base as a percent of the monetary base. The discussion in the previous section suggests that δ is a critical variable, it may denote the viability of a speculative attack against a currency. The larger its value, the higher the viability and thus the higher the likelihood of a speculative attack. Again if the central bank adheres to a policy of 100% coverage of the monetary base, then the domestic component of the monetary base will be zero:

(23.45)δ=0

And Eq. (23.44) simplifies to

(23.44’)ω=Ω

The equation shows that under this assumption, the growth of the monetary base will consists solely of the growth of international reserves.

The equilibrium conditions in the NRCC are determined by the equality of the demand for and supply of money:

(23.6)Md=Ms

Substituting for the percentage changes in money demand and money supply, we obtain the following equilibrium condition:

(23.46)πl+ηl−υl=ωl+μl

However as we know that under a fixed exchange rate system, the NRCC inflation rate, πl, is the same as that of the RCC, πw, and that the growth in the monetary base is a weighted average of the domestic money creation and the growth of the international reserves, Eq. (23.46), the equilibrium condition can be written as:

(23.46’)πw+ηl−υl=δ*κ+(1−δ)*Ω+μl

Finally, we know that,

(23.46)Ω=BOP/IR

These two equations can be combined to yield an expression for the country’s BOP:

(23.47)BOP=(πw+ηl-υl-δ*κ−μl)*IR(1−δ )

Notice that the higher the world inflation, πw, and the higher the real GDP growth, ηl, all else the same, the larger will be the BOP inflow. The larger the increase in money velocity, that is, a decline in domestic money demand, and the larger the increase in the money multiplier, an increase in domestic money supply and the larger the domestic money creation the smaller the money inflow, the smaller the BOP.

The previous sets of equations provide us with insights regarding the NRCC BOP, Eq. (23.47):

The higher the global inflation rate, the larger will be the BOP surplus and the larger the money growth in the NRCC. The reason for this is that as the inflation rate erodes the purchasing power of money, people need to replenish their cash balances to replace the loss of purchasing power. If the NRCC is unhappy with the RCC monetary policy, the NRCC can unhinge its currency or delink its currency from that of the RCC. One issue that we may discuss later is whether there is a mechanism that forces some discipline on the RCC central bank.

The larger the real GDP growth rate in the NRCC country, the larger is the demand for money. The excess demand for money is satisfied in the NRCC country by importing money, thus the BOP surplus.

The third term captures the shifts in the velocity of money and the banking system money multiplier, that is, the ability to leverage the banking system in the creation of loans and deposits. We summarize these effects as variables that impact the “money-ness” of money, the attractiveness of the local currency, and domestic financial system.

The last term measures changes in the money multiplier, the ability of the banking system to generate endogenous domestic money. The greater the domestic money creation ability, the lower the need to import money to satisfy a rising domestic demand.

The fourth term in the equation captures the domestic money creation, and as we have already mentioned, the larger the amount of domestic money creation, the lower will be the net excess demand for money that has to be satisfied by importing money, that is, a BOP surplus. The equation also gives us the precise conditions beyond which additional growth in the domestic component of the money supply results in a BOP deficit. That turns out to be:

(23.48)κ=(πw+ηl-υl−μl)/δ

Hence the higher the world inflation, the faster the economy grows, and combined with any decline in the velocity of money and banking sector money creation ability, the larger the amount of high-powered money that the domestic or NRCC central bank can print without causing a BOP deficit.

2.6 Economic Development and Reform

Early development theory emphasized ‘macroeconomic accounting aggregates such as savings and the balance of payments, and the relative balance between broadly defined “sectors” such as “industry” and “agriculture”’ (Lal 1983, p. 5). When that prescription proved disappointing, the pendulum swung in the opposite direction. The new imperative was to activate the market and ‘get the prices right’ (Lal 1983, p. 107), but that too was overly simple.

‘Getting the property rights right’ seemed more responsive to the pressing needs for reform in Eastern Europe and the former Soviet Union. But while ‘an essential part of development policy is the creation of polities that will create and enforce efficient property rights, … we know very little about how to create such polities’ (North 1994, p. 366). As discussed in Sect. 3.2.2, privatization is important but is not a panacea.

Equilibrium

Equilibrium for the economy requires that all three markets—the goods market, the money market, and the balance of payments—be in equilibrium. This occurs when the IS, LM, and BP curves intersect at a common equilibrium level of the interest rate and income. In Fig. 13.1, point e is the equilibrium point that occurs at the equilibrium interest rate ie and the equilibrium income level Ye. Until some change occurs that shifts one of the curves, the IS-LM-BP equilibrium will be consistent with all goods produced being sold, money demand equal to money supply, and a current account surplus equal to a capital account deficit that yields a zero balance on the official settlements account.