Topic 4

Balance of Payments: A
Macroeconomic View of
Trade Balances

Textbook: Chapter 12
 Learning objectives
• See how saving, domestic investment are
related to balances of current account.
• Understand the inherent linkage between
current account and foreign
indebtedness.
• Learn basic structures of balance of
payments accounts.

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 How different Part II is from
Part I in this course?
• Part II considers unemployment problem while
Part I assumes full employment.
• Part II explores the role of saving in affecting
employment and national wealth while Part I
assumes zero saving.
• Part II studies trade imbalances while Part I
assumes trade balance.
• Part I studies money and the price level while
part II considers barter and relative prices.

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 Two Accounts
• National income accounts
– Records all the expenditures that contribute
to a country’s income and output.

• Balance of payment accounts

– Tracks changes in a country’s indebtness to
foreigners and the performance of
international trade.
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Gross National Product (GNP)
• GNP is the market value of all final goods and
services produced by its factors of production
in a given time period.
– Consumption (C): spending by households
– Investment (I): spending by firms for future
production
– Government purchases (G): spending by the
government
– Current account balance (EX-IM): net exports of
goods and services to foreigners

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Figure 12-1 U.S. GNP and Its
components, 1997

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 GNP v.s. GDP
• GNP=GDP+(Domestic factor income
earned from abroad-Foreign factor
income earned from the U.S.)
=C+I+G+{(EX’-IM’)+(DFI-FFI)}
=C+I+G+{(EX’+DFI)-(IM’+FFI)}
=C+I+G+{EX-IM}
=C+I+G+CA
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 Current account and foreign
indebtedness
• The bills-must-be-paid principle

When a country’s imports of goods and

services exceed its exports, the country has
to either run up its foreign debts
(borrowing) or run down its net foreign
wealth (reserves).
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 Saving and current account
• National saving (S) is the income left
after paying for consumption and
government purchases.
• A country can use its current savings to
make either domestic investment and
foreign investment.
S=I+CA

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Figure 12-2 The U.S. Current Account and
Net Foreign Wealth Position, 1977-1996

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Private saving v.s. government
saving
• Private saving (Sp) is households income
left after paying for taxes and
consumption: Sp =Y-T-C.
• Government saving (Sg) is the tax
revenue left after paying for government
spending: Sg =T-G.

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Private saving v.s. government
saving
• Private saving (Sp) can be used to finance
domestic capital investment (I), foreign
investment (CA), and the domestic
government budget deficit (G-T):
Sp =I+CA+(G-T)

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Balance of Payments Accounts
• Current account records the difference
between exports and imports of goods
and services.
• Capital account records the difference
between exports and imports of assets.

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Balance of Payments Accounts
• Every international transaction
automatically enters the BOP twice, once
as a credit and once as a debit.
• Any transaction resulting in a payment
to foreigners is entered as a debit (-); any
transaction resulting in a receipt from
foreigners is entered as a credit (+).

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 Examples of paired transactions

• Example 1: Import of automobile

A U.S. auto dealer imports a Swedish auto and
pays $20,000, which the auto manufacturer
deposits in its U.S. account.
• Example 2: A foreign purchase of T-bill
A foreigner purchases a $10,000 U.S. T-bill
from a U.S. brokerage firm.

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 Fundamental balance of
payment identity
• Current account+Capital account=0
• Therefore,
Current account
=-Capital account
=Capital outflow-Capital inflow
=Change in net international investment
position (NIIP)
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 Capital transactions
Capital Outflow Capital Inflow (+)
(-)
$ €

U.S. Euro Area U.S. Euro Area

IOUs IOUs

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 More on the U.S. NIIP
• U.S. Net International Investment
Position (NIIP)
= U.S. claims on the rest of the world
(ROW)- foreign claims on the U.S.
= Aggregate capital outflow - Aggregate
capital inflow

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 Official reserve transactions
• Official settlements balance (also known
as the balance of payments) indicates the
payments gap that official reserve
transactions need to cover, i.e.,
Official settlements balance (OSB) =
(balance on current account + balance on
non-reserve portion of capital account +
statistical discrepancy)
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 Official reserve transactions
• Official reserve transactions refer to
central banks’ purchases or sales of
official reserve assets such as gold, U.S.
T-bills, and main foreign currencies.
• Balance of official reserve transactions
=Changes in U.S. official reserve assets
held abroad + Changes in foreign official
reserve assets held in U.S. = -OSB
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 An example
• Current account=40, Non-reserve capital
account=-30, Statistical discrepancy=0.

What is official settlement balance? Will

the net international investment position
(net foreign wealth) improve (increase)
or deteriorate (decrease)?

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 Summary
• Current account deficit reflects a shortage of
saving over investment; current account
surplus reflects an excess of saving over
investment.
• Current account deficits either run down net
foreign wealth or run up foreign debts.
• Any current account deficit must be matched
by an equal capital account surplus, and vice
versa.
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