Unit 7

Unit 7

Balance of payments

• Measure of $ inflows and outflows between the US and the rest of the world (Row)

     *inflows are referred to as CREDITS
     *outflows are referred to as DEBITS

• The balance of payments is % into 3 accounts

     *current account
     *capital/financial account
     *official reserves account

Current Account

• Balance of trade and net exports

     *exports of goods /services -import of goods and services
     *exports create a credit to balance of payments
     *imports create a debit to the balance of payments

• Net foreign income

     *income earned by US owned foreign assets. Income paid to foreign held US assets
     Ex. interest payments on US owned Brazilian bonds. Interest payments on German owned US                  treasury bonds. 

• Net transfers (tend to be unilateral)

    
Capital/Financial Account

• The balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the US is a credit to the capital account
• Direct investment by US firms/individuals in a foreign country are debits to the capital accounts
• Purchase of foreign financial assets represents a debit to the capital account
• Purchase of domestic financial assets by foreigners represents a credit to the capital account

Official Reserves

• The foreign currency holdings of the US federal reserve system.
• When there is a balance of payments surplus the FED accumulates foreign currency and debits the balance of payments.
• When there is a balance of payments deficit the FED depletes its reserves of foreign currency and credits the balance of payments 
• The official reserves 0 out the balance of payments

Active VS passive official reserves:

The United States is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate

Formula!!
Balance of trade:
     Goods exports + Good imports
Balance on goods and services:
     Goods exports + service exports + goods imports + service imports
Current Account:
    Balance on goods and services + net investment + net transfers
Capital Account:
     foreign purchases + domestic purchases

Foreign exchange (FOREX)

• The buying and selling of currency

     ex: in order to purchase souvenirs in France, it is first necessary for Americans to sell their dollars and buy Euros

• Any transaction that occurs in the balance of payments necessitates foreign exchange

Changes in exchange rates

• Exchange rates (e) are a function of the supply and demand for currency.

1.      An increase in the S of a currency will decrease the exchange rate of a currency
2.      A decrease in S of a currency will increase the exchange rate of a currency
3.      An increase in D for a currency will increase the exchange rate of a currency
4.      A decrease in D for a currency will decrease the exchange rate of a currency

Appreciation and depreciation

• Appreciation of a currency occurs when the exchange rate of that currency increases
• Depreciation of a currency occurs when the exchange rate of that currency decreases

Exchange rate determinants


1. Consumer's taste
2. Relative income
3. Relative price level
4. Speculation

Exports and imports

• The exchange rate is a determinant of both exports and imports
• Appreciation of the $ causes American goods to be relatively more expensive and foreign goods to be relatively cheaper thus reducing exports and increasing imports

Fixed rates

• Based on a country's willingness to distribute currency and to control the amounts
• The US uses a fixed rate the $1 stays $1

Absolute advantage

•      Individual- exists when a person can produce more of a certain good/service than someone else in the same amount of time (or can produce a good using the least amount of resources)
•      National- exists when a country can produce more of a good/service than another country can in the same time period

Comparative advantage

•  A person or a nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner

Specialization and trade

• Gains from trade are based on comparative advantage, not absolute advantage-Examples output:

• tons per acre
• miles per gallon
• words per minute
• apples per tree
• television produced per hour

     Examples input:
-# of hours to do a job
-# of acres to feed a horse
-# of gallons of paint to paint a house