Zara Mahmood Oct 29 2013 EC102 Lecture 12 Accounts Balance of Payments THE BALANCE OF PAYMENTS Linking the US to the International Economy Open Economies An economy that has interactions in trade or finance with other countries Interact by trading goods and services and making investments in each other s economies Closed Economy Has no interaction in trade or finance with other countries No country completely closed today North Korea has limited interaction Balance of Payments The record of a country s trade with other countries in goods services and assets Current Account and Financial Account Current Account The part of the balance of payments that records a country s net exports net income on investment and net transfers Trade in goods and services X IM o Net Exports NX Income received by US resident positive numbers in current account Income paid by US resident negative numbers in current account Balance of Trade The difference between the value of the good a country exports and the value of the goods a country imports Largest item in the currency account Exports imports trade surplus Exports imports trade deficit Net exports the sum of the balance of trade and the balance of services Net exports component of aggregate expenditures o Adding balance of trade and balance of services Balance of Services The difference between the value of the services a country exports and the value of the services a country imports Financial Account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country Long term flow of funds into and out of the country Trade in assets Capital coming in capital leaving o Net capital flows Capital outflow when US investor buys a bond issued by a foreign company or government or when US firms builds a factory in another country Zara Mahmood Oct 29 2013 EC102 Capital Inflow Foreign investor buys a bond issued by a US firm government or when foreign firm builds a factory in the US Hypothetical Example of a Positive Financial Account Investors from the rest of the world buy 350B worth of US bonds 250 worth of US stocks o 600B total foreign purchases of US financial assets US investors buy 300B worth of bonds in other countries 100B worth of stocks in other countries o 400B total US purchases of financial assets in other countries Financial Account Capital in Capital out 600B 400B 200B Hypothetical Example of a Negative Financial Account Investors from the rest of the world buy 200B worth of US bonds 100 worth of US stocks o 300B total foreign purchases of US financial assets US investors buy 400B worth of bonds in other countries 200B worth of stocks in other countries o 600B total US purchases of financial assets in other countries Financial Account Capital in Capital out 300B 600B 300B Relationship Between Current Account and Financial Account Current Account Financial Account 2012 Current account 440B o Exports were 440B less than imports Financial account 440B Capital in Capital out 440B o Net capital Flows 440B same as financial account Eg Best Buy imports 1 000 Lenova laptops from China Cost of laptops 1 000 000 X IM Current Account 1 000 000 Best Buy pays for the laptops with dollars Lenovo now has a dollar deposit in their bank in China worth 1 000 000 o They don t need to buy any goods or services from the US what will they do with the dollars Invest it in some US asset Zara Mahmood Oct 29 2013 EC102 Lenovo s Options Buy a 1 000 000 worth of US T Bonds portfolio investment o Financial Account 1 000 000 Buy 1 000 000 worth of stock in Facebook portfolio investment o Financial Account 1 000 000 Open a Lenovo Store on Newberry Street Foreign direct Investment o Financial Account 1 000 000 Sit with 1 000 000 deposit for a while holding foreign cash portfolio investment o Financial Account 1 000 000 Regardless of what Lenovo does the financial account is 1 000 000 and current account is 1 000 000 The Flow of Capital Net Foreign Investment NFI NFI Foreign Direct Investment Foreign Portfolio Investment o Domestic residents purchases of foreign assets foreigners purchases of domestic assets The flow of capital abroad takes two forms Foreign Direct investment Foreign portfolio investment Net Foreign Investment The difference between capital outflows and inflows from a country Net foreign direct investment net foreign portfolio investment Is another measure of the imbalance in a country s trade in assets o Domestic purchases of foreign assets exceed foreign purchases of When Net Foreign Investment 0 domestic assets When Net Foreign Investment 0 o Foreign purchases of domestic assets exceed domestic purchases of foreign assets Variables that Influence Net Foreign Investment Real interest rates paid on foreign assets Real interest rates psaid on domestic assets Perceived risks of holding foreign assets Government policies affecting foreign ownership of domestic assets The Equality of NX and Net Foreign Investment NFI An Accounting identity NFI NX o Current account financial account o Financial account NFI Every transaction that affects NX affects NFI by the same amount vice versa When a foreigner purchases a good from the US Zara Mahmood Oct 29 2013 EC102 o US exports and NX increase o The foreigner pays with currency or assets so the US acquires some foreign assets o NFI increases Why is the Balance of Payments Always Zero Balance of payments sum of Current account balance Capital account balance disregard Financial account balance o Balance of payments is ALWAYS ZERO The Macroeconomics of Saving and Investment In a closed economy NX 0 o Y C I G In an open economy o Y C I G NX Investment o I Y C G NX o S Y C G o S I NX Loanable Funds Market Supply Private savings S Public savings T G Demand Net Foreign Investment NFI Investment I Supply Demand S r T G I r NFI r S I NFI