The Balance of Payments

In this section, we begin with a look at the balance of payments, followed by a discussion of exchange rate determination, and in the next section at policy implications.

The balance of payments is used to record the value of the transactions carried out between a country’s residents and the rest of the world. The balance of payments is composed of two accounts:

1. The current account comprises:

1. net exports of goods and services, (the difference in value of exports minus imports, which can be written as) NX. (1)
2. net investment income,and
3. net transfers.

(1) Since the large majority of the current account deals with trade of goods and services we will only discuss this component of the current account.

The balance of payments sums to zero because of the symmetry of the current and capital accounts.

Consider the purchase of a Japanese-made VCR by an American. This is considered an export from Japan and an import into the United States. When the U.S. consumer purchases the VCR, he pays in dollars (which increases the value of imports in the current account). However, the producer in Japan receives yen. The exchange of dollars for yen takes place in the foreign exchange markets. The important point is that the Japanese producers do not want dollars; instead they need yen to pay their employees, suppliers, and dividends to shareholders. The dollars return to the U.S. through the capital account.

We end up with a circular flow of currency. In the example given here, the dollars spent on a Japanese VCR will:

• increase the value of imports into the U.S.,
• reduce the value of the current account surplus ($exports -$ imports > 0) or increase the value of the current account deficit ($exports — $imports< 0).
• increase the supply of dollars in foreign exchange markets (we will soon see the effect on the yen/$ exchange rate), and
• eventually return to the U.S. through the capital account.

Consider an example. Assume that initially both the current account and capital account are in balance; NX = 0. Now you, rush out and buy a new $200 Toshiba VCR made in Japan and imported into the United States. The result is a $200 current account deficit (exports = 0, imports = $200). Back in Japan, Toshiba’s bank statement shows a $200 credit, but Toshiba needs to withdraw yen to pay for manufacturing costs. As a result, Toshiba’s bank uses the foreign exchange market to convert the dollars into yen, so Toshiba’s bank credit is actually denominated in yen.

As a result of your purchase, the supply of dollars in the foreign exchange markets has increased by $200. Now let us assume that a Japanese saver wants to buy $200 worth of stock shares of a U.S. company, fast growing Sun Microsystems for example. She will deposit $200 worth of yen (2) in her brokerage account. Her investment bank will convert the yen into $200 and execute the stock purchase of Sun Microsystems shares. Consequently, your $200 has made its way back into the U.S. through the capital account.

(2) If we assume an initial exchange rate of Ґ 100/$1, the Japanese saver deposits Ґ 20,000 in her Tokyo account

Although this example is simplistic, it shows the basic linkage between the current and capital accounts. In general, deficits or surpluses in either account will show up as the opposite in the other account. Later in this topic we will show the linkage between changes in the capital account in Mexico and swings in the current account. Thus the linkages can work either way: from the current account to the capital account or the capital to current account.

There are exceptions to the one-to-one tradeoff. For example, the dollar is used throughout the world as an alternative to transactions in the domestic currency. As a result, some dollars may remain in Russia, as goods may be paid for in either rubles or dollars in the markets of Moscow. This is a relatively minor factor which will have no impact on our analysis.

Important Factors That Determine the Current Account

When considering a nation’s current account surplus or deficit, we need to consider some determinants of the level of its total imports and exports of goods and services. For now, let us assume that its trade is not influenced by trade barriers such as tariffs and quotas; we will look at these effects later.

There are four primary considerations when examining activity in a nation’s current account:

1. Changes in economic growth rates and national income will have a significant influence on the amount of goods and services that a country imports. As GDP growth and consumer incomes rise, purchases of goods and services also increase. Part of this increased consumption will be composed of foreign imports. For example, for every dollar that U.S. consumers spend on goods and services, about 10%, or 10 cents, is spent on imported goods. Thus we can expect a positive correlation between economic growth and the level of imports.

We also need to consider the GDP growth of a nation’s trading partners. High growth rates abroad will lead to increases in the demand for another country’s exports as foreign consumers increase their purchases of goods and services. Therefore, relative economic growth rates is the key variable. If a nation’s economy is growing relatively faster than its trading partners, then the value of imports will increase faster than exports and net exports will decline.

The basic rule is higher domestic inflation rates relative to other trading countries lead to a decrease in net exports. Higher inflation rates increase the relative prices of exports and decrease the relative prices of imports.

Lower domestic inflation rates relative to other trading countries lead to an increase in net exports. They decrease the relative prices of exports and increase the relative prices of imports.

Interest Rates and the Capital Account

The capital account deals with monetary flows into and out of a nation’s financial markets. The most important determinant of financial flows are interest rates, which determine the rate of return on savings. In addition to interest rates, we should consider:

• The potential return on direct investment. Foreign firms will consider direct investment in a country the greater the potential return. By direct investment, a foreign firm may make a financial agreement with a domestic firm to provide money for capital expansion and research and development. Or the foreign firm may produce goods and services abroad, bringing in the money to build productive capacity.

Returning to interest rates, the higher a country’s interest rates, the more attractive its financial markets are to both domestic and foreign savers.

As domestic interest rates increase relative to rates in other countries, the relative rate of return in that country’s financial markets rises, which attracts savings and financial capital. This leads to an increased inflow of money through the capital account and less money leaving a country in search of higher foreign interest rates, also through the capital account.

Trade Balances and Exchange Rate Determination

Throughout this course we have examined how equilibrium is determined in various markets. We began with the product market, looking at the supply and demand for a good. When supply equaled demand, the market price was decided. As we progressed, we saw how the equilibrium of the supply of labor and labor demand set the wage rate and how equilibrium in the market for loanable funds (the capital market) determined the rate of interest. Next we examined macroeconomic markets where the interaction of aggregate demand and aggregate supply changed macroeconomic prices (inflation) and output (GDP). Using the same basic analysis of supply and demand, we will now see how exchange rates are determined.

Exchange rates give us the price of one currency in relation to another. As with any good, the relative price of two currencies is determined by the supply and demand of the currencies in exchange rate markets. We can use basic fundamentals to explain how a domestic currency’s price changes in relation to another. For a floating currency, its price in relation to another currency is determined by conditions of supply and demand for the currency.

Before we begin with our analysis of floating exchange rates, consider two other ways in which a currency’s value can be determined.

• Fixed: a currency may be fixed at a value that will not change in relation to other currencies throughout the world.

Determining Floating Exchange Rates

Figure 12-1 shows the demand and supply of dollars in foreign exchange markets. We label the horizontal axis with the quantity of dollars in the foreign exchange markets. We will measure the value of the dollar in relation to the Japanese yen, so we label the vertical axis as the yen/$ ratio, or the price of the dollar in relation to the yen. The dollar’s value is determined by the equilibrium of the demand for the dollar in foreign exchange markets with the supply of dollars in the same markets. In this case one dollar is worth 100 yen (Ґ 100/$1). Or equivalently, it takes 100 yen to buy one dollar.

Now that we see how the demand and supply of dollars in foreign exchange markets determine its value relative to other currencies, let us consider changes in the dollar’s value. We will first examine how current account conditions impact the U.S. dollar, and then we will examine the capital account.

First, let’s examine how a change in economic growth affects the current account. Throughout this section it will be important to emphasize the ceteris paribus condition, or holding everything else constant. In this case let us assume that a tax cut increases U.S. GDP growth. Importantly, we hold everything else constant such as inflation rates and the rate of Japanese GDP growth.

Accelerating economic growth in the U.S. increases incomes and consumption. As U.S. consumers increase their consumption, part of this will include additional spending on imports. Over 10 cents out of every dollar spent by U.S. consumers is on imported goods. As economic growth increases in the U.S. so does spending on imports, reducing the value of net exports.

Remember what happens when a U.S. consumer buys an import. In Baltimore, the consumer pays for a Japanese good in dollars. The dollars make their way over to Japan through the foreign exchange markets where they are converted to yen. The result is to increase the supply of dollars in foreign exchange markets, which we will show below, and also increase the demand for yen (which we will not show).

As U.S. consumers increase their consumption of imports, the supply of dollars in foreign exchange markets rises. Figure 12-2 shows a rightward shift in the supply of dollars from S _$ 0 to S _$ 1 as U.S. consumers increase their purchases of imports. As a result, the price or value of the dollar falls from P _$ 0 to P _$ 1 in relation to the yen. This is also known as a depreciation of the dollar.

This also means that the yen has appreciated, which could also be shown by looking at the demand for yen using the demand and supply for yen and the $/yen ratio.

The depreciation of the dollar could be expressed numerically. For example, the original yen/dollar ratio was Ґ 100/$1, and after the dollar depreciates let us say the new yen/dollar ratio is Ґ 90/$1. Originally, one dollar would buy the equivalent of Ґ 100 worth of Japanese goods and services. At the new value, the purchasing power of one dollar has fallen to Ґ 90 worth of Japanese goods and services.

Now consider the capital account. Let us construct a scenario where the U.S. Federal Reserve uses restrictive monetary policy to raise U.S. interest rates. Importantly, we hold all other economic variables constant, such as foreign interest rates.

In the previous example, changes in the level of imports affected the amount of dollars in the foreign exchange market through the current account, which measures trade in goods and services. Movements in interest rates impact the number of dollars in foreign exchange markets through the capital account. The capital account measures currency flows of savings and financial capital (or the supply of loanable funds). In the current account, dollars end up in the foreign exchange markets as a result of a purchase or sale of a tangible good or service. Money moves in the capital account seeking more favorable rates of return (e.g. higher interest return) or greater stability. No transactions of goods and services occur in this case; only the movement of money. Money that moves either through the capital or the current account still ends up in the same foreign exchange market ; it just takes a different route (via accounting definitions) getting there.

With an increase in U.S. interest rates (holding all foreign interest rates constant), money from foreign savers enters the U.S. seeking a higher relative return. Consider the Japanese saver in Yokosuka making a purchase of U.S. Treasury Bills because he seeks a higher rate of return than he can earn domestically. The saver deposits his money with his brokerage in Japan and the broker takes the yen deposit and exchanges the yen for dollars in the foreign exchange market. The dollars are then used to buy a U.S. T-bill in America. The Japanese saver becomes the owner of the U.S. T-bill. Importantly, this transaction has increased the demand for dollars in the foreign exchange market. The demand for dollars increases as yen are exchanged for dollars in the foreign exchange market in order to make the T-bill purchase.

Figure 12-3 shows the impact of higher U.S. interest rates. As foreign savers send their money over to the U.S. to purchase American financial assets, the demand for dollars increases from D _$ 0 to D _$ 1. This raises the price or value of the dollar relative to the yen from P _$ 0 to P _$ 1. This is known as an appreciation of the dollar.