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International Financial Management Chapter 3 Prepared by Wikrom Prombutr

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Chapter 3: The Balance of Payments
Chapter Objective:
This chapter serves to introduce the student to the balance of payments. How it is constructed and how
balance of payments data may be interpreted.
The Balance of Payments is the statistical record of international transactions between the residents of
a given country and the residents of the rest of world over a certain period of time presented in the
form of double-entry bookkeeping.
Example:
Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle
frames from Mercian Bicycles in Darby England.
- There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewoods
bank account.
- This will lead to a rise in the supply of dollars and the demand for British pounds.
Logic: demand of English product what do you need to be able to get the product? () increase in
demand for what do you have to use to get ? ($) increase in supply of $.
What can we learn from the BOP? As you can see from the example above
1. BOP provides detailed information about the supply and demand of the countrys currency.





2. BOP data can be used to evaluate the performance of the country in international economic
competition. For example, if a country is experiencing persistent BOP deficits, it may signal that the
countrys industries lack competitiveness.


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International Financial Management Chapter 3 Prepared by Wikrom Prombutr
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BOP accounts are composed of
1. The current account (CA) includes all purchases (-) and sales (+) of goods and services. (i.e. import
and export)
2. The capital account (KA) includes all purchases (-) and sales (+) of assets such as stocks, bonds, bank
accounts, real estate, and businesses.
3. The official reserve account (RA) includes all purchases (-) and sales (+)of international reserve assets
such as, foreign exchanges, gold, and special drawing rights (SDRs).
4. Statistical Discrepancy (SD)
Theres going to be some omissions and misrecorded transactionsso we use a plug figure to get
things to balance in the residual manner.

2009 U.S. Balance of Payments Data
Credit (+, money inflow ): receipt (of foreign currency) from foreigners this creates demand for $.
Debit (-, money outflow ): payment to foreigners (using $) this creates supply of $.

Credits Debits
Current Account (CA)

1
Exports
2116

2 Imports

-2405.6
3 Unilateral transfer 19.2 -149.4

Balance on CA

-419.8
Capital Account(KA)

4
Direct Investment
152.1
-221
5 Portfolio investment 376.6 -549.4
6 Other investment
616.3
-93.5
Balance on KA 281.1

7 Statistical Discrepancies (SD) 190.9

Overall Balance 52.2

Official Reserve Account (RA)

-52.2

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International Financial Management Chapter 3 Prepared by Wikrom Prombutr
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U.S. BOP in 2009 shows that
Current Account (CA):
U.S. exports were $2,116.0 billion
U.S. imports were $2,405.6 billion.
CA includes (items 1,2) trade account (all imports and exports of goods and services)
(item 3) unilateral transfers of foreign aid.
If the debits (from Imports) exceed the credits (from Exports), then a country is running a trade
deficit.
If the credits (from Exports) exceed the debits (from Imports), then a country is running a trade
surplus.

The current account balance, which is defined as exports minus imports plus unilateral transfers, that is,
(1 ) + (2) + (3), was negative, $41 9.8 billion.
The United States thus had a balance-of-payments deficit on the current account in 2009.
The current account deficit implies that the United States used up more output than it produced.
Since a country must finance its current account deficit either by borrowing from foreigners or by
drawing down on its previous accumulated foreign wealth.

Capital Account (KA):
(4) U.S. direct investment overseas was $221.0 billion.
Foreign direct investment in the United States was $152.1 billion.
(5) Foreigners invested $376.6 billion in U.S. financial securities whereas Americans invested $549.4
billion in foreign securities, realizing a deficit, $172.8 billion.
(6) Other investments
Inflow = 616.3
Outflow = -93.5
Net Inflow = 522.8
International Financial Management Chapter 3 Prepared by Wikrom Prombutr
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International Financial Management Chapter 3 Prepared by Wikrom Prombutr
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Official Reserve Account (RA):
When the United States and foreign governments wish to support the value of the dollar in the foreign
exchange markets, they sell international reserve assets to buy dollars. These transactions, which
give rise to the demand for dollars, will be recorded as a positive entry under official reserves. On the
other hand, if governments would like to see a weaker dollar, they sell dollars and buy gold, foreign
currencies, and SDRs. These transactions, which give rise to the supply of dollars, will be recorded as
a negative entry under official reserves. The more actively governments intervene in the foreign
exchange markets, the greater the official reserve entry.
The table shows that to accommodate a $52.2 billion balance-of-payment surplus, the U.S. increased its
external reserve holdings by the same amount. When the U.S. increases its reserve holdings by either
adding to its reserve holdings or retiring debts, it will spend funds, which will be recorded under debits.
The official reserve account includes transactions undertaken by the authorities to finance the overall
balance and intervene in foreign exchange markets.

BOP Identity
Theoretically, BCA + BKA + BRA = 0

Note: Under a pure flexible exchange rate regime, BCA + BKA = 0
No BRA No intervention No control over the exchange rate

Practically, BCA + BKA + SD + BRA = 0
(-419.8) + (281.1) + (190.9) + (-52.2) = 0
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