Transcript Economics R. Glenn Hubbard, Anthony Patrick O`Brien, 2e.

The Balance of Payments: Linking the
United States to the International Economy
Open economy An economy that has interactions in trade or
finance with other countries.
Balance of payments The record of a country’s trade with
other countries in goods, services, and assets.
Current account The part of the balance of payments that
records a country’s net exports, net investment income, and
net transfers.
Balance of trade The difference between the value of the
goods a country exports and the value of the goods a
country imports.
The Balance of Payments: Linking the
United States to the International Economy
The Current Account
Trade Flows for the United
States and Japan, 2006
The Balance of
Payments of the
United States,
2006 (billions of
dollars)
Don’t forget net
compensation of
nationals working
abroad
(= Labor Services)
The Balance of Payments
balances:
Current Account
+
Financial Account
+
Capital Account
CURRENT ACCOUNT
Exports of goods
$1,023
Imports of goods
−1,861
−838
Balance of trade
Exports of services
423
Imports of services
−343
Balance of services
Income received on investments
Income payments on investments
80
650
−614
Net income on investments
−36
Net transfers
−90
−812
Balance on current account
FINANCIAL ACCOUNT
Increase in foreign holdings of assets in the
United States
1,860
Increase in U.S. holdings of assets in foreign
countries
−1,055
+
Balance on Financial Account
Statistical Discrepancy BALANCE ON CAPITAL ACCOUNT
=
Statistical discrepancy
ZERO
Balance of payments
805
-4
11
0
The International Sector and National
Saving and Investment
U.S. Imports and Exports,
1970–2006
Current account Records payments for currently produced
goods and services, including capital and labor services.
•Mostly exports and imports of goods and services.
• Also includes net int’l earnings of country’s labor and capital resources.
•Unilateral transfers (exports and imports not paid for) are netted out.
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.
Net foreign investment The difference between capital
outflows from a country and capital inflows.
Also equal to net foreign direct investment (fdi) plus net
foreign portfolio investment.
Capital account The part of the balance of payments that
records relatively minor transactions, such as migrants’ transfers,
and sales and purchases of nonproduced, nonfinancial assets.
The Foreign Exchange Market and Exchange Rates
Currency
appreciation An
increase in the
market value of
one currency
relative to another
currency.
Nominal exchange rate
The value of one country’s currency in
terms of another country’s currency.
EXCHANGE RATE BETWEEN THE DOLLAR AND THE INDICATED
CURRENCY
CURRENCY
Canadian dollar
UNITS OF FOREIGN
CURRENCY
PER U.S. DOLLAR
U.S. DOLLAR PER UNIT
OF FOREIGN CURRENCY
1.067
0.937
Japanese yen
122.650
0.008
Currency
depreciation A
Mexican peso
10.919
0.092
decrease in the
British pound
0.507
1.972
market value of
Euro
0.752
1.330
one currency
relative to another Some currencies have fixed exchange rates that do not
currency.
change over long periods.
The country’s central bank buys and sells the currency at
the fixed rate of exchange.
The Foreign Exchange Market and Exchange Rates:
The Operation of Supply and Demand for a Currency
Equilibrium in the Market for Foreign Exchange
Foreign demand for US dollar:
•Buy US stuff
•Currently produced goods
and services
•Buy US assets
•Stocks
•Bonds
•Real estate
•Hotels and factories (fdi)
•Hold $ in US banks
•Transactions demand
•Speculative demand
12 Month Average Unemployment by Category
http://www.nytimes.com/interactive/2009/11/06/business/economy/unemployment-lines.html?hp
State and local rates: http://www.bls.gov/Lau/
The Foreign Exchange Market and Exchange Rates:
Shifts in Demands and Supplies
An increase in the supply of
dollars in exchange for yen:
•Americans buying more
Toyota cars
•Americans buying more
Toyota stock
•Americans fearing dollar
depreciation buy yen now.
An Increase in Supply of Dollars on Foreign
Exchange Market…Americans buy more
Japanese cars….
… and An Increase in Demand for Dollars:
Japanese buy a lot more US bonds & hotels
$ Depreciates
(Get fewer yen/dollar)
But a bigger
Increase in the
Demand for Dollars:
•Japanese buying more US bonds
•Japanese buying more US factories
Dollar Appreciates on net
How Movements in the Exchange Rate Affect
Exports and Imports
If the economy is currently below potential GDP, then, holding all other
factors constant including prices at home and abroad, depreciation of the
domestic currency should increase net exports, aggregate demand, and
real GDP.
An appreciation in the domestic currency should have the opposite effect:
Exports should fall, and imports should rise, which will reduce net exports,
aggregate demand, and real GDP.
It’s the real exchange rate, the nominal rate adjusted for prices, that matters:
Real exchange rate The price of domestic goods in
terms of foreign goods.
 Domestic price level 
Real exchange rate = Nominal exchange rate × 

 Foreign price level 
Real exchange rate = [Yen/$] x [$/Bourbon]/[Yen/Suntory]
= Suntory/Bourbon
The International Sector and National
Saving and Investment
U.S. Imports and Exports,
1970–2006
Balance of Payment Arithmetic
Current Account Balance + Financial Account Balance = 0
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) + NFI
Private saving finances domestic and foreign investment and
the government’s deficit
Public Saving = Taxes – Gov’t Spending = Spublic = T – G
National Saving = Private Saving + Public Saving
S = Sprivate + Spublic
S = [I + (G - T) + NX] + (T - G) = I + NFI
A country that saves a lot has positive NX and invests abroad
-NFI = I - S = I - Sprivate - (T - G) = (I - Sprivate) + (G - T) = - NX
Twin Deficit: G-T up  NX down
The Effect of a Government Budget Deficit
on Investment
The Twin Deficits, 1978–2006
Why Is the United States
the “World’s Largest Debtor”?
Large current account
deficits have resulted in
foreign investors purchasing
large amounts of U.S. assets.
Can the U.S. Current Account
Deficit Be Sustained?
Sustaining the Unsustainable
U.S. trade-weighted exchange index: Major currencies.
Key Terms
Balance of payments
Net foreign investment
Balance of trade
Nominal exchange rate
Capital account
Open economy
Closed economy
Real exchange rate
Currency appreciation
Saving and investment equation
Currency depreciation
Speculators
Current account
Financial account