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Balance of Payments

Balance of Payments

THE CURRENT, CAPITAL, AND FINANCIAL ACCOUNTS

THEORIES AND ASSESSMENT OF THE BALANCE OF PAYMENTS

MACROECONOMIC STABILITY

BIBLIOGRAPHY

The balance of payments is an accounting statement that records transactions (trade in goods, services, and financial assets) between a countrys residents and the rest of the world. Those transactions consist of receipts and paymentscredits (entries that bring foreign exchange into the country) and debits (entries that record a loss of foreign exchange), respectivelythat are recorded through the use of double-entry bookkeeping. Balance-of-payments data usually are reported quarterly in national publications and also are published by the International Monetary Fund.

THE CURRENT, CAPITAL, AND FINANCIAL ACCOUNTS

The balance of payments consists of the current account, the capital account, and the financial account (see the illustration). The current account includes trade in merchandise (raw materials and final goods), services (transportation, tourism, business services, and royalties), income (from salaries and direct, portfolio, and other types of investment), and current transfers (workers remittances, donations, grants, and aid). The current account is related to the national income accounts because the trade balance corresponds broadly to the net export value recorded in the national income accounts as one of the four components of the gross national product (GNP), along with consumption, investment, and government expenditures.

The capital account records all international capital transfers. Those transfers include the monetary flows associated with inheritances, migrants transfers, debt forgiveness, the transfer of funds received for the sale or acquisition of fixed assets, and the acquisition or disposal of intangible assets. The financial account records government-owned international reserve assets (foreign exchange reserves, gold, and special drawing rights with the International Monetary Fund), foreign direct investment, private sector assets held abroad, assets owned by foreigners, and international monetary flows associated with investment in business, real estate, bonds, and stocks.

The balance of payments should always be in equilibrium. The current account should balance with the sum of the capital and financial accounts. However, because in practice the transactions do not offset each other exactly as a result of statistical discrepancies, a separate line with those discrepancies is included in the statistical presentation.

If the current account is in equilibrium, the country will find its net creditor or debtor position unchanging because there will be no need for net financing. Equilibrium in the capital and financial accounts means no change in the capital held by foreign monetary agencies and reserve assets. In the case of disequilibrium arising when a country buys more goods than it sells (i.e., a current account deficit), the country must finance the difference through borrowing or sale of assets (i.e., there is an inflow of capital and thus a capital and financial account surplus). In other words, the country uses foreign savings to meet its consumption or investment needs. Similarly, if a country has a current account surplus, the capital and financial accounts record a net outflow, indicating that the country is a net creditor. The exchange rate regime is an important determinant of the adjustment toward the new equilibrium. With fixed exchange rates, central banks must finance the excess demand for or supply of foreign currency at the fixed exchange rate by running down or adding to their reserve assets. Under floating exchange rates, balance of payments equilibrium is restored by movements in the exchange rate.

THEORIES AND ASSESSMENT OF THE BALANCE OF PAYMENTS

A number of theories have been developed to explain the adjustment process of the balance of payments. In a world without capital flows the elasticities approach provides an analysis of how changes in the exchange rate affect the trade balance, depending on the elasticities of demand and supply for foreign exchange and/or goods. An exchange rate depreciation increases the domestic price of imports and lowers the foreign price of exports. However, depreciation reduces imports only if import demand is

United States balance of payments, 1970-2005
(In millions of U.S. dollars)
SOURCE: Bureau of Economic Analysis, International Economics Accounts, U.S. Department of Commerce, http://www.bea.gov/international, Washington, D.C., 2006.
 1970 1980 1990 2000 2005
Current account
Exports of goods and services and income receipts 68,387 344,440 706,975 1,421,515 1,749,892
Exports of goods and services56,640271,834535,2331,070,5971,275,245
Income receipts11,74872,606171,742350,918474,647
Imports of goods and services and income payments 259,901 333,774 759,290 1,778,020 2,455,328
Imports of goods and services54,386291,241616,0971,448,1561,991,975
Income payments5,51542,532143,192329,864463,353
Unilateral current transfers, net 6,156 8,349 26,654 58,645 86,072
U.S. Government grants4,4495,48610,35916,71431,362
U.S. Government pensions and other transfers6111,8183,2244,7056,303
Private remittances and other transfers1,0961,04413,07037,22648,407
Capital account
Capital account transactions, net 6,579 1,010 4,351
Financial account
U.S.-owned assets abroad, net (increase/financial outflow ()) 8,470 85,815 81,234 560,523 426,801
U.S. official reserve assets, net3,3487,0032,15829014,096
U.S. Government assets, other than official reserve assets, net1,5895,1622,3179415,539
U.S. private assets, net10,22973,65181,393559,292446,436
Foreign-owned assets in the U.S., net (increase/financial inflow (+)) 6,359 62,612 141,571 1,046,896 1,212,250
Foreign official assets in the United States, net6,90815,49733,91042,758199,495
Other foreign assets in the United States, net55047,115107,6611,004,1381,012,755
Statistical discrepancy (Sum of above items reversed) 219 20,886 25,211 70,213 10,410

elastic; the same is the case for the behavior of exports after a decline in export prices. Thus, the final impact on the current account balance depends on the elasticity of demand in each country for the other countrys goods and services.

The absorption approach emphasizes the way in which domestic spending on domestic goods changes relative to domestic output: The trade balance is viewed as the difference between what the economy produces and what it spends. In an economy that is operating below its full potential an exchange rate depreciation tends to increase net exports (given the elasticity conditions noted above) and bring about an increase in output and employment. In an economy operating at full potential, in contrast, a depreciation tends to increase net exports, but because it is not possible to increase output, the result is higher prices of domestically produced goods.

In the modern global economy with well-developed financial markets and large-scale capital flows, financial assets play an important role in the analysis of the balance of payments. The lifting of controls on the movement of capital and financial flows has been fundamental to promoting world trade and eventually greater incomes. The unrestricted movement of capital allows governments, businesses, and individuals to invest capital in other countries, thus promoting not only foreign direct investment but also portfolio investment in the capital market.

With perfect capital mobility, monetary and fiscal policies affect the balance of payments through the interest rate channel. Under fixed exchange rates an increase in the money supply will reduce interest rates and lead to capital outflows, tending to cause a depreciation that will have to be offset by sales of foreign exchange by the central bank. This will then reduce money supply until it reaches its original level. Thus, monetary policy is ineffective in increasing output. Fiscal policy, however, is highly effective because a fiscal expansion tends to raise interest rates, leading the central bank to increase the money supply to support the exchange rate, reinforcing the impact of the expansionary fiscal policy. Under floating exchange rates, monetary policy is highly effective and fiscal policy is ineffective in changing output. A monetary expansion leads to depreciation and higher exports and output. Fiscal expansion, in contrast, causes an appreciation of the exchange rate and crowds out net exports.

The introduction of interactions between prices and changes in the exchange rate leads to a model that postulates that price flexibility ultimately moves an economy to full employment. The mechanism involves changes in the domestic money supply that take place as the central bank keeps selling foreign exchange to domestic residents in exchange for domestic currency. A monetary contraction thus reduces prices, improves competitiveness, and increases net exports and employment. Under floating exchange rates, in the short run a monetary expansion increases output and reduces interest rates, causing a depreciation of the exchange rate. In the long run, however, a monetary expansion increases the price level and the exchange rate, keeping real balances and the terms of trade unchanged.

The monetary approach to the balance of payments postulates that disequilibrium in the balance of payments is essentially a monetary phenomenon. It emphasizes the central banks balance sheet identitya change in net foreign assets equals the difference between changes in high-powered money and in domestic creditwhich shows that sufficient contraction of domestic credit will improve the balance of payments. This improvement comes about through higher interest rates and lower domestic income and employment. Finally, the asset market (or portfolio) approach incorporates assets besides money. In recognition of the fact that asset markets across countries are well integrated, changes in the demand for and supply of assets will affect interest rates, exchange rates, and the balance of payments.

MACROECONOMIC STABILITY

Maintaining a favorable balance-of-payments position is important for macroeconomic stability, and countries gear their policies toward achieving that goal. Although current account deficits that are financed through non-debt-creating capital flows may not pose an immediate threat, large and unsustainable deficits can transform into chronically unfavorable balance-of-payments positions that may affect the stability of the currency. Correcting such unfavorable positions is done through the adoption of stabilization programs that sometimes are supported by the International Monetary Fund through the provision of short-term financing to ease the burden of temporary problems.

SEE ALSO Balance of Trade; Capital Controls; Capital Flight; Equilibrium in Economics; Exchange Rates; Exports; Imports; Interest Rates; International Monetary Fund; Mundell-Fleming Model; Policy, Fiscal; Policy, Monetary; Reserves, Foreign; Trade Deficit; Trade Surplus

BIBLIOGRAPHY

Dornbusch, Rudiger, Stanley Fischer, and Richard Startz. 2004. Macroeconomics, 8th ed. Boston: McGraw-Hill.

Frenkel, Jakob, and Harry G. Johnson, eds. 1976. The Monetary Approach to the Balance of Payments. Toronto: University of Toronto Press.

Husted, Steven, and Michael Melvin. 2007. International Economics, 7th ed. Boston: Pearson/Addison-Wesley.

International Monetary Fund. Various years. Balance of Payments Statistics Yearbook. Washington, DC: Author.

Costas Christou

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Balance of Payments

BALANCE OF PAYMENTS


The balance of payments is similar to the balance sheets bookkeepers maintain to keep track of their companies' credits and debits. But it does not focus on the cash flow of a single company. The balance of payments records the credits and debits of the entire U.S. economy with its foreign trading partners. If U.S. consumers, businesses, or the government spend more in foreign economies than those economies spend in the United States, the balance of payments is "in deficit." If the reverse is true, the U.S. balance of payments is "in surplus."

The balance of payments is not the same as the balance of trade. The balance of trade is only one of two major components in the balance of payments. The first component is the "current account." The "current account" is roughly the same as the balance of trade, and includes all short-term imports and exports of goods and services. The second component is the "capital account", which includes long-term investments and loans between the United States and foreign economies.

Before 1933 the United States and most of the industrialized world was on the gold standard. Applying this standard meant that all international currencies were valued in terms of how much gold they represented. Because of the Great Depression, Great Britain abandoned the gold standard in the early 1930s, but it was not until the Bretton Woods Agreement of 1944 that a new system based on the U.S. dollar instead of gold was implemented. Under this system a country could always "devalue" its currency relative to other countries' currencies if its balance-of-payments deficit became dangerously large. This would wipe out much of the deficit. The United States was the only country that could not devalue its currency to lower its balance-of-payments deficit. That restriction was applied because the Bretton Woods system valued all currencies against the U.S. dollar. President Richard Nixon (191394) abandoned the Bretton Woods Agreement in 1973, which enabled the United States to devalue the dollar when necessary. Since then all world currencies including the dollar may be exchanged freely on the world market at whatever rate the market will bear. The United States continues to accumulate balance-ofpayment deficits, when the value of the dollar is strong compared to other currencies. Foreign goods and services are inexpensive relative to U.S. goods and services. The U.S. government offsets these deficits by selling U.S. government bonds to foreign investors attracted to the stable dollar.

See also: Bretton Woods Agreement, Gold Standard, Richard Nixon

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balance of payments

balance of payments, balance between all payments out of a country within a given period and all payments into the country, an outgrowth of the mercantilist theory of balance of trade. Balance of payments includes all payments between a country and its trading partners and is made up of the balance of trade, private foreign loans and their interest, loans and grants by governments or international organizations, and movements of gold (capital account). A chronically unfavorable balance of payments, when debits exceed credits, may affect the stability of the nation's currency, particularly where exchange rates are no longer fixed. After World War II the International Monetary Fund was established to handle problems relating to the balance of payments and foreign exchange.

Since the late 1950s the United States has generally experienced an unfavorable balance of payments because of large-scale foreign aid, sizable U.S. investment in Europe, and major U.S. military investments abroad. In the early 1970s the United States, in an effort to create a more favorable balance of payments, announced (1971, 1973) a devaluation of the U.S. dollar. However, the increase in the cost of petroleum from the Arab states (1973–74) had a negative effect on the balance of payments in the United States and most countries in Western Europe. In addition, tight money policies and high deficits adversely affected the savings rate in the United States in the 1980s and caused the balance of payments to decline even further. As a result, the United States looked to foreign borrowing to fill the gap, but the interest payments only increased the shortfall in the balance of payments. In the late 1990s and subsequent years the U.S. balance of payments reached record negative levels.

See N. Fatemi, Problems of Balance of Payment and Trade (1975); T. De Saint Phalle, Trade, Inflation, and the Dollar (1981); D. Bigman, ed., Floating Exchange Rates and the State of World Trade Payments (1984).

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balance of payments

balance of payments Overall surplus or deficit that occurs as a result of the exchange of all goods and services between one nation and the rest of the world. A country with a balance of payments deficit must finance it by borrowing from other countries or the International Monetary Fund (IMF), or by using foreign currency reserves. Such deficits, if frequent, can pose a serious problem, because they cause a reduction in the reserves. This in turn leads to economic pressure for devaluation in order to correct the imbalance. A country with a surplus is in a favourable position, but may come under international pressure to revalue its currency.

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