1. Balance of Payments
The balance of
payments is the score sheet for all economic transactions during a given
period between one country and its residents
(including the governments) and all other countries. Transactions are
reported using double entry
bookkeeping with credit entries balanced on the debit side, and vice versa. The
balance of payments thus necessarily balances. There can be no
surplus or deficit in a country's balance of payments as a whole.
balance of payments
is divided into two major sections: the
current account and the capital account.
The current account, in turn, is subdivided into goods and
services and transfer payments.
The capital account is subdivided into
and monetary sectors.
overall balance of payments comprises the current account (merchandise and
services), unilateral transfers (gifts, grants, remittances, and so on), and the
capital account (long-term and short-term capital movements). If payments due in
exceed those due out, a country is said to be in overall surplus; and when
payments due out exceed payments due in, it is in overall deficit. The surplus
or deficit must be balanced by a monetary movement in the opposite direction,
and consequently the overall balance including monetary movements must always be
is important not to confuse the 'trade balance' and the balance of payments.
The trade balance refers to trade in goods. An export surplus or deficit
in goods may be matched by net sales of services. There would then
be no deficit in goods and services as a whole. Thus the balance
of payments is a broader
and more significant measure than is the balance of trade in goods alone.
Often the balance of
goods and services is confused with the current account balance.
The current account as a whole has always had a basic importance. A nation with a deficit on total current
account is ipso facto decreasing its capital assets abroad (including gold) or
increasing its capital liabilities to foreigners. A nation with a
current-account surplus is gaining foreign assets or reducing its foreign
A deficit in the
balance of goods and services does not necessarily affect a
country's exchange rate. There may be a matching inflow of investment capital
that strengthens the immediate exchange position and builds up a country's
future exporting capacity. Similarly, a surplus in the balance of goods and
services may not assure a strong exchange rate.
For another explanation see: The Economist
Balance of Payments; Government of Canada
Balance of Payments
Balance of Payments;
Exchange Rate (MKM C/12 286-291: 268-272)
'exchange rate' is the price of a country's money in relation to another
country's money. An exchange rate is "fixed" when countries use gold
or another agreed-upon standard, and each currency is worth a specific measure
of the metal or other standard. An exchange rate is "floating" when
supply and demand (including speculation) sets exchange rates.
when Canada's exports increase, the
exchange rate increases (i.e. fewer Canadian dollars buy a unit of foreign
currency). Increased foreign demand for Canadian currency makes
Canadian goods more expensive. As Canadian goods become more expensive,
exports decline. Decreased demand for the Canadian dollar then
tends to lower the exchange rate making Canadian goods cheaper and so on
and so on in a floating exchange rate system. It important to note
that the foreign exchange market is, in the main, binary, i.e.,
there is market for the $Cdn and the $US and a separate market for the $Cdn
and the British £ and yet another for the $Cdn and the Europeann €.
Demand for Dollars (P&B 7th
Ed Fig. 25.2)
Change in Demand for Dollars (P&B
Ed Fig. 25.5; R&L 13th Ed
Supply of Dollars (P&B
Ed Fig. 25.3; R&L 13th Ed
Change in Supply of Dollars (P&B
Ed Fig. 25.6)
Equilibrium Exchange Rate (P&B
Ed Fig. 25.4; R&L 13th Ed
Foreign Exchange Market Intervention (P&B
Ed Fig. 25.7)
trade now depends on a managed floating exchange system. Governments act to
stabilize their countries' exchange rates by limiting imports, stimulating
exports, or devaluing currencies.
economy is self-contained. Central banks must therefore pay attention to
trading and financial relationships with other countries. If goods are bought
abroad, there is a demand for foreign currency to pay for them. Alternatively,
if goods are sold abroad, foreign currency is acquired that the seller
ordinarily wishes to convert into the home currency. These two sets of
transactions usually pass through the banking system, but there is no necessary
reason why in the short-term they should balance. Sometimes there is a surplus
of purchases and sometimes a surplus of sales. Short-term disequilibrium is not
usually significant, but it is important that there be a tendency to balance in
the long term. It is difficult for a country to be a permanent borrower or
to continue building up a command over goods and services that it does not
disequilibrium can be handled by increasing or decreasing balances of foreign
exchange. If a country has no balances to diminish, it may borrow, but normally
it carries working balances. If the commercial banks find it unprofitable to
hold such balances, the central bank will usually carry them; indeed, it may
insist on concentrating the bulk of the country's foreign-exchange resources in
its hands or in those of an associated agency.
equilibrium is more difficult. It may be achieved in three ways: price
movements, exchange revaluation (appreciation or depreciation of the currency),
or exchange controls.
levels may be influenced by expanding or contracting the money supply. If
the central bank wants to stimulate imports, for example, it can induce a a rise
in domestic prices by increasing the money supply. If additional exports are
required, the central bank can force down domestic prices by decreasing the
objective may be achieved directly by revaluing a country's exchange rate.
Depending on the circumstances, the rate may be increased or decreased, or
allowed to "float." Appreciation means that the domestic
currency becomes more valuable in terms of the currencies of other countries and
exports consequently become more expensive for foreigners. Depreciation involves
decreasing the value of the domestic currency thus lowering the price of export
goods in the world's markets. In both cases, however, the effects are usually
only temporary, and for this reason the central bank usually prefers
relative stability in exchange rates even at the cost of fluctuation in domestic
governments resort to exchange controls (sometimes combined with import
licensing) to allocate foreign exchange more or less directly in payment for
specific imports. At times, a considerable apparatus has been assembled for this
purpose, and, despite "leakages" of various kinds, the system has
proved reasonably efficient in achieving balance on external payments account.
Its chief disadvantage is that it interferes with normal market processes,
thereby encouraging rigidities in the economy, reinforcing vested interests, and
restricting the growth of world trade. On the other hand, some countries,
Argentina, will impose an export tax to keep domestic prices low.
method is chosen, the process of adjustment is generally supervised by some
central authority -- the central bank or some institution closely associated with
it -- that can assemble the information necessary to ensure that the proper
responses are made to changing conditions.
Also see: The Economist Glossary -
Exchange Rate; Wikipedia -
3. Trade & The
So far in the AD/AS model for an open
economy we have employed an implicit assumption: Sd = Id
but in open economy some domestic savings are invested abroad and some investment
at home is financed from abroad. This opens up the question of
loanable funds, a disputed alternative to Keynesian theory.
Loanable funds are not testable in this course.
How does such short and long run capital
flows affect the AD/AS short- and long-run equilibrium, the exchange
rate, the interest rate, the inflation rate ? What are the
effects on the national factor endowment and LAS? What tools are
available to a national government and its central bank?
P&B 7th edition
policies, inter alia.
domestic money and foreign currency market interventions,
in defense of the domestic
and foreign exchange value of the $Cdn
Net Capital Outflows is the
relationship between foreign assets bought by Canadians and Canadian assets
bought by foreign citizens in a given time period. If we buy more foreign
assets than we sell Canadian assets then net capital outflow is positive and
vice versa. This means, in the binary exchange market, if Canadian net
capital outflow to country A is positive then country A's net capital outflow to
Canada is reduced in a given time period.
To buy foreign assets we
sell Canadian dollars to buy the appropriate foreign currency in which the
foreign asset is valued. To buy Canadian assets foreigners must by
Canadian dollars. Effects?
Interest Rate: nominal rate, e.g., 6% minus the inflation rate, e.g., 3% equals
a real rate of 3%. Monetary transmission mechanism. Effects?