Unit 7 - The Balance of Payments

Def: A measure of money inflows and outflows between the United States and the rest of the world (row)

-Inflows are referred to as CREDITS

-Outflows are referred to as DEBITS

The balance of payments is divided into three accounts:

1. Current account
2. Capital/financial account
3. Official reserves account

Double entry bookkeeping:

-Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice.  

Ex: US manufacturer john Deere exports 50 million worth of farm equipment of Ireland 

-A credit of 50 million to the current account

-Debit of 50 million to the capital financial account

-Notice that the two transactions offset each other(should theoretically equal zero) 

Current account :

-Balance of trade or net exports

Exports of goods services- imports of good/services

Exports create a credit to the balance of payment 

Imports create a debit of the balance of payments 

-Net foreign income 

Incomes earned by us owned foreign assets- income paid to foreign held us assets

-Net transfers

Foreign aid-a debit to the current account 

Ex: Mexican migrant worker send back money 

Capital/financial account:

The balance of capital ownership: Includes the purchase of both real and financial assets

-Direct investment in the U.S is a credit to the capital account

Ex: The Toyota factory in San Antonio 

 -Direct investment by us firms/individuals in a foreign country are debits to the capital account

-Purchase of foreign financial assets represents a debit to the capital account 

Ex: Warren buffet buys stock in Petro china.

-Purchase of domestic financial assets by foreign represents a credit to the capital account

Ex: The United Arab emirates sovereign wealth fund purchases at large stake. 

Relationship between current and capital account:

-The current account and the capital account should zero each other out

That is if the account has a negative balance (deficit) then the capital account should then have a positive balance (surplus)

Official reserves:

-The foreign currency holdings of the U.S federal reserve system.

-When there is a balance of payments surplus the fed accumulates foreign currency and debits the balance of payments.

-When there is a balance of payments deficit the fed depletes its reserves of foreign currency and credits the balance of payments.

-The official reserves zero out the balance of payments.

Active vs. Passive official reserves:

-The U.S is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate

-The people’s Republic of China is active in its use of official reserves. It actively buys and sells dollars in order to maintain a steady exchange rate with the U.S.

Balance of Trade:

Goods and services exports - goods and services imports

-Deficit- imports is greater than exports

-Surplus- exports is greater than imports 

Unofficial way of calculating trade: 

Goods exports + goods imports

Balance of goods and services:       

Goods imports + service imports 

Current account:

Balance of trade + net investment + net transfers 

Capital account:

Foreign purchases of U.S assets + U.S purchases of assets abroad 

Official reserve:

Capital account balance + current account balance