The Balance of Payments: Linking the United States to the International Economy

1. The Balance of Payments: Linking the United States to the International Economy Balance of payments The record of a country’s trade with other countries in goods, services, and assets. • Current accountrecords a country’s net exports, net income on investments, and net transfers... That is, payments for currently produced goods and services including labor services (paid wages) and capital services (paid “investment income”) • Balance of merchandise trade (sometimes called “balance of trade”) • Balance of trade in goods and service • Financial account records a country’s sales of domestic asset to foreign residents and purchase of foreign assets by domestic residents. • Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.

2. The Balance of Payments of the United States, 2008 (billions of dollars) The Current Account

3. Trade Flows for the United States, 2006

4. U.S. Imports and Exports, 1970–2006

5. So how do we pay for the excess of current account payments to foreigners over what they pay to US? We sell them our IOUs and other assets (stocks, bonds, real estate deeds) Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment, FDI, (in “factories”) plus net foreign portfolio investment (stocks and bonds). • The “Balance of Payments” (BoP)is always zero (statistical discrepancy makes it so) • Sometimes BoP refers to net private transactions in goods, services, and assets (China’s “BoP” surplus  Bank of China buys US bonds)

6. Exchange Rates in the Financial Pages That was then…this is now http://www.bloomberg.com/markets/currencies/fxc.html

7. The Foreign Exchange Market and Exchange Rates Sources of demand for the U.S. dollar: • 1 Foreign firms and households who want to buy goods and services produced in the United States. • Foreign firms and households who want to invest in the United States either through foreign direct investment — buying or building factories or other facilities in the United States — or through foreign portfolio investment — buying stocks and bonds issued in the United States. • People doing international business transacted in dollars. • 3 Currency traders who believe the value of the dollar will increase. Sources of supply of the U.S. dollar are analogous: US residents who want to buy foreign stuff or paper or hold foreign currencies

8. Equilibrium in the Market for Foreign Exchange Currency appreciation An increase in the market value of one currency relative to another currency. Currency depreciation A decrease in the market value of one currency relative to another currency.

9. How Do Shifts in Demand and Supply Affect the Exchange Rate? Factors that cause the demand and supply curves in the foreign exchange market to shift: 1Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign-produced goods and services 2 Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries 3 Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies

10. How Do Shifts in Demand and Supply Affect the Exchange Rate? Adjustment to a New Equilibrium Shifts in the Demand and Supply Curve Resulting in a Higher Exchange Rate

11. Some Exchange Rates Are Not Determined by the Market The Foreign Exchange Market and Exchange Rates Some currencies have fixed exchange rates that do not change … until they are forced to: a payments deficit drains Central Bank foreign exchange holdings; Ms declines; i rises  capital inflows; Y and P fall  Im decline  Balance of Payments balances at the fixed exchange rate. How Movements in the Exchange Rate Affect Exports and Imports • For economy below potential GDP, real depreciation/devaluation of the currency should increase net exports, aggregate demand, and real GDP. • Real appreciation/revaluation of the domestic currency should have the opposite effect . Real exchange rate The price of domestic goods in terms of foreign goods.

13. Some international monetary arithmetic Current Account Balance + Financial Account Balance = 0 or: Current Account Balance = -Financial Account Balance or: Net Exports = Net Foreign Investment … NX = NFI • Private Saving = National Income – Consumption - Taxes • Sprivate = Y – C – T = (C + I + G + NX) - C - T = [I + (G - T) + NX] • Private saving finances domestic and foreign investment and a government deficit • Public Saving = Taxes – Gov’t Spending = Spublic = T – G • National Saving = Private Saving + Public SavingS = Sprivate + Spublic • S = [I + (G - T) + NX] + (T - G) = I + NFI • Capital In = - NFI= I - S=I - Sprivate - (T-G)= (I - Sprivate) + (G - T)

14. The Effect of a Government Budget Deficit on Investment The Twin Deficits, 1978–2006

15. MakingtheConnection • Why Is the United States Called the “World’s Largest Debtor”? Large current account deficits have resulted in foreign investors purchasing large amounts of U.S. assets.

16. Exchange Rate: Can the US Current Account Deficit be Sustained?

17. K e y T e r m s Net foreign investment Nominal exchange rate Open economy Real exchange rate Saving and investment equation Speculators Balance of payments Balance of trade Capital account Closed economy Currency appreciation Currency depreciation Current account Financial account