1Topic 7-1Circular Flow (Sectors and Markets)- how we-- as a country-- react with the rest of the world Balance of Payments Accounts- summary of the country’s transactions with other countries Micro Example: The Costa Family’s Artichoke FarmWhat we know:- They made $100,000 by selling artichokes- They spent $70,000 on running the farm including purchases of new farm machinery - They spent another $40,000 buying food, paying utility bills for their home, replacing their worn out car etc. - They received $500 in interest on their bank account but paid $10,000 in interest on their mortgage- They took out a new $25,000 loan to help pay for farm improvements, but didn’t use all the money immediately. So they put the extra in the bank. Summarize the Costa family’s year by filling in the chart below:Sources of Cash Uses of Cash NetPurchases or sales of g/s 100,000 70,00040,000-10000Interest Payments 500 10,000 -9500Loans and deposits 25,000 5,500 19,500Total 125,500 125,500 0 The first row shows sales and purchases of g/sThe second row shows interest paymentsThe Third row shows cash coming in from new borrowing vs money deposited in bankIn each row we show the net inflow of cash from each transaction. Row one- net is -10,000Row two- net is -9,500Row three- net is -19,500Total- These sums are equal. By definition, every dollar has a source and every dollar received gets used somewhere.2Macro Example: Simplified US Balance of Payments Accounts 2008\ What we know:The table below shows sources of cash for US as a whole and payments. Payments fromForeignersPayments to Foreigners Net1.Sales and purchases of g/s $1,827 $2,523 -$6962. Factor income 765 646 1193. Transfers - - -128Current Account(1+2+3)-7054. Official asset sales and purchases487 530 -435. Private sales and purchases of assets 47 -534 581Financial account(4+5)538Total - - $-167The first row shows: payments that arise from sales and purchases of goods and services Ex. The value of US wheat exports and the fees foreigners pay to US consulting companies appear in second column. The value of US oil imports and the fees American companies pay to Indian call centers appear in the third columnThe second row shows: factor income payments for the use of factors of production owned by residents of other countries - Ex.1 Profits of Euro-Disney, owned by US Disney Company appear in second column - Ex.2 Profits earned by the US operations of Japanese auto companies appear in the third column. Factor income include labor income - Ex. Wages of an American engineer who works temporarily on a construction site in Dubai are counted in the second column The third row shows: international transfers, funds sent by residents of one country to residents of another - Ex. The main element here is remittances that immigrants such as the millions of Mexican born workers employed in the US send to the families in their country of originThe third column only shows the net value because the US government provides only an estimate of that value and not a break-down of those payments3 The fourth and fifth row show: payments resulting from sales and purchases of assets, broken down by the people doing the buying the sellingThe fourth row shows- government or government agencies (like central banks) Ex. Most of the US sales in this category involved the accumulation of foreign exchange reserves by central banks of China and oil exporting countries. The fifth row shows- private sales and purchases of assets Ex. 2008 purchase of Budweiser, an American brewing company by the Belgian corporation InBev or purchases of European stocks by US investorsWhy do we separate rows 1+2+3 and rows 4+5? This reflects a fundamental difference in how these two groups of transactions affect the future. One set creates liabilities, the other does not. When a US resident sells a good to a foreigner, that is the end of the transaction. A financial asset such as a bond is different A bond is a promise to pay interest and principal in the future,. When a US resident sells a bond to a foreigner that sale creates a liability. The US resident will have to pay interest and repay principal in the future. .Balance of payments on the current account (Current Account): transactions that don’t create liabilities or the balance of payments on g/s+ factor income and net international transfer payments (row1+row2+row3) Balance of payments on g/s. the difference between the value of exports and the value of imports during a given period Ex. Balance of Row 1 (net)Merchandise trade balance (trade balance): difference between a country’s exports and imports of goods alone (not service) Balance of payments on financial account (Financial Account) - create liabilities (row 4 + row 5)What we can learn from the Balance of AccountsIn official data, the US current account deficit and financial account surplus almost offset each other (the financial account surplus was $167 billion smaller than the current account deficit. But that is just a statistical error reflecting the imperfection of official data. ($167 billion error when you are measuring inflows and outflows is not bad!) Current account (CA) + Financial account (FA) = 0 - If it does not equal zero, it is a technical discrepancy4Why is this equation true? We already saw the fundamental explanation in the Costa family example. In total, the sources of cash must equal the uses of cash. The same applies to the balance of payments accounts. Circular Flow of Balance Accounts: This shows the money flow between national economies. Money flows into the US from the ROW as payment for US exports of g/s, as payment for the use of US owned factors of production, and as transfer payments. These flows (indicated by the lower green arrow) are the positive components of the US current account. Money also flows into the US from foreigners who purchase US assets (lower red arrow) the positive component of the US financial account. At the same time, money flows from the US to the rest of the world as payment for US imports of g/s, as payment for the use of foreign owned factors of production, and as transfer payments. These flows (indicated by the upper green arrow) are the negative components of the US current account. Money also flows from the US to purchase foreign assets (as shown by the upper red arrow) the negative component of US financial account. As in all circular flow diagrams, the flow into a box and the flow out of a box must