Unit 4.5, 4.7 and 4.8 Balance of Payments

Unit 4.5, 4.7 and 4.
8 Balance of Payments
Unit 4.5-4.8: International Economics

Unit Overview
4.5 Balance of payments
• Current account
>>balance of trade Blog posts "Balance of trade"
>>invisible balance
• Capital account
Blog posts: "Current account"
4.7 Balance of payment problems
• Consequences of a current account deficit or surplus Blog posts: "Capital account"
• Methods of correction
>>managed changes in exchange rates
>>reduction in aggregate demand/expenditure-reducing policies
>>change in supply-side policies to increase competitiveness
>>protectionism/expenditure-switching policies
• Consequences of a capital account deficit or surplus
• Higher level extension topics
• Marshall-Lerner condition
• J-curve
4.8 Terms of trade

• Definition of terms of trade
• Consequences of a change in the terms of trade for a country's bop and its domestic economy
>>The significance of deteriorating terms of trade for developing countries
Higher level extension topics

• Measurement of terms of trade
• Causes of changes in a country's terms of trade in the short-run and long-run
• Elasticity of demand for imports and exports
www.welkerswikinomics.com 1
Unit 4.5, 4.7 and 4.8 Balance of Payments
Balance of Payments
Introduction
The Balance of Payments: A nation’s balance of payments is the sum of

all transactions that take place between its residents and the residents of
all foreign nations.
These transactions include merchandise exports and imports, tourist

expenditures, and the sale and purchase of financial and real assets abroad,
including stocks, real estate, government bonds, etc...
The balance of payments account is subdivided into three components:
• the current account

-visible balance
-invisible balance
• the capital (or financial) account
• the official reserves account
Balance of Payments
the Current Account
The current account summarizes a country's trade in currently produced goods and
services.
• "Balance of trade". It measures the is the difference between a country's

expenditures on imports and its income from exports of goods and services.
-The balance of trade in goods is known as "the visible balance"
-The balance of trade in services is known as "the invisible balance"
• Balance on the current account is found by adding all transactions (expenditures

on imports plus income from exports) in the current account.
• If a country spends more on imports than it earns from exports, it is said

to have a "current account deficit" or a "trade deficit".
• If a country earns more from its exports than it spends on imports, it is

said to have a "current account surplus" or a "trade surplus".
For example: US expenditures on laptop computers made in Taiwan count towards a deficit
in the US current account. The export revenue for Taiwan moves its current account towards
surplus.
Taiwan's expenditures on airplanes made in the US count towards a deficit in Taiwan's

current account. The export revenue earned by the US moves its current account towards
surplus
Balance of Payments
the Current Account
Balance of Payments
the Current Account
BoP Case Study: Examine the table below. What does it tell you about trade between the
US and China. Evaluate the situation and the likely impacts on the US and Chinese
economy in the long-run.
Source: http://www.censusbureau.biz/foreign-trade/balance/c5700.html
Balance of Payments
the Current Account
BoP Case Study: Examine the image below. Which countries have trade deficits? surpluses? Are
there common characteristics among red or blue countries? Evaluate the factors that determine
weather a country will have a trade surplus or deficit.
Source: http://en.wikipedia.org/wiki/Balance_of_payments
Balance of Payments
and Floating Exchange Rates
How floating exchange rates can restore balanced trade b/w two nations:
1) Interest rates in the US fall while ECB rates remain stable. Americans investors want to save in
Europe, Demand for euros increases and euro appreciates
2) Strong Euro causes Europeans to demand more American goods, Americans demand fewer
European goods, shifting the US towards BoP surplus, the EU towards deficit.
3) Strong European demand for American goods will drive demand for dollars up, causing
appreciation of dollar. Equilibrium exchange rate of $1.5/Euro is restored.
4) The appreciation of the dollar resulting from new demand for American goods reduces the
incentive for Europeans to buy American, shifting the US towards a BoP deficit and the EU
towards a surplus, restoring balanced trade between the US and Europe.
Market for Euros in the US after Market for Dollar in the Europe after
decrease in US interest rates increase in D for US goods
$/∈
∈/$
S∈ S$
1.6
.67
1.5 .625
D∈1 D$1
D∈ D$
Qe1 Q1 Q∈ Qe1 Q1 Q$
Balance of Payments
Floating exchange rate system:
• Definition: When a country leaves the value of its currency up to the free market.
• Exchange rates will fluctuate as demand for currencies increase and decrease based
on relative exchange rates, relative incomes, relative price levels, consumer tastes, and
currency speculation.
Flexible rates should automatically correct any imbalance in the balance of payments.
WHY?
What happens to demand Americans are buying more imports,

and supply of US$ as the foreigners are buying fewer American
goods. Supply of $ increases, demand
US moves towards a
decreases, depreciating the US$
current account deficit?
With rising exports and As depreciation occurs, prices for goods and
falling imports, the US services from the US become more attractive and
moves towards a trade the demand for them will rise. At the same time,
surplus, restoring balance imports become more costly as it takes more
in the current acount currency to buy foreign goods and services.
Balance of Payments
Blog post: "US balance of payments prophecies"
The extent of the imbalances in the global economy and the fact that normal growth patterns will not correct them has been
underlined by the latest US balance of payments deficit. The current account deficit reached $225 billion in the fourth quarter of
2005, up from $185.4 billion in the third. For the year 2005 the deficit was $805 billion, equivalent to 6.4 percent of gross
domestic product.
The latest figures show that rather than being closed, the payments gap is widening. This was the seventh year out of the last
eight in which the deficit hit a new record.
“The bottom line is that a current account deficit of this unparalleled magnitude is unsustainable and there is no hope of it
being painlessly resolved through higher exports alone,” Paul Ashworth, an analyst at Capital Economic told the Financial
Times.
Total US exports would need to increase by 70 percent to eliminate the payments gap. “This is clearly not going to happen,”
Ashworth continued. “Instead it will require a big dollar depreciation alongside much weaker domestic demand for imports.”
In other words, the only way the deficit would start to fall is through a major recession in the US. On the one hand, “a big
dollar depreciation” would almost certainly lead to a sharp interest rate rise, as international banks and financial institutions
demanded bigger compensation for placing their funds in dollar assets. And a significant interest rate rise would bring a
downturn in the economy.
On the other hand, “weaker domestic demand for imports” could be achieved only by a severe contraction of the US economy.
This is because the very structure of the US economy, in which imports of goods and services are some 59 percent higher than
exports, means that normal economic growth automatically increases the deficit.
Balance of Payments
the Capital Account
Capital Account:
• The capital account summarizes the buying and selling of assets between countries,
including anything that can be owned and that has value such as land, real estate,
companies, bank deposits, stocks and shares, treasury bills, government bonds,
foreign currency.
If foreign ownership of domestic assets increases more quickly than domestic

ownership of foreign assets, then there is more money coming into the country than
going out... this is a capital account SURPLUS.
If domestic owenership of foreign assets increases more quickly than foreign

ownership of domestic assets, then there is more money leaving the country than
coming in... this is a capital account DEFICIT.
For example, a foreign firm may buy a real asset, say an office tower in the U.S., or a
U.S. government bond. This will be counted as a positive on the US capital account.
• Both transactions involve the “export” of the ownership of U.S. assets from the
United States in return for payments of foreign currency (money “capital”inflows).
But if a US investor buys an office building in Shanghai or builds a golf course in

Malaysia, this counts as a negative on the capital account.
• Both transactions involve the "import" of the ownership of a foreign asset from the
foreign country in return for payments of US dollars (money "capital" outflows).
Balance of Payments
the Official Reserves Account
The central banks of nations hold quantities of foreign currencies called

official reserves.
A government's reserves are built up when its income from exports

exceeds its expenditures on imports.
These reserves can be drawn on to make up any net deficit in the

combined current and capital accounts (much as you would draw on
your savings to pay for a special purchase).
BoP Deficits and Surpluses:

• A drawing down of official reserves measures a nation’s balance of payments deficit;
a building up of official reserves measures its balance of payments surpluses.
• Adding to foreign reserves would occur if there is a trade surplus.
• A balance of payments deficit is not necessarily bad, nor is a balance of payments
surplus necessarily good.
• However, persistent deficits would ultimately deplete the foreign exchange reserves.
• To correct its balance of payments deficit, a nation might implement a major
depreciation of its currency or other policies to encourage exports.
Balance of Payments
the Official Reserves Account
BoP Case Study: Examine the table to the right:
1) What has happened to China's foreign reserves

since 1997?
2) What happened in China in 1977 that led to a

build up of its foreign reserves?
3) Where do China's
China's Official
foreign reserves come from? Reserves Account
1977 - 2007
4) What do you think China does with its reserves of
foreign currencies?
Blog post: "Excuse us China, could you lend us
another billion?"
CLICK HERE: Balance of Trade data between US

and every other country in the world
Balance of Payments
Balance of Trade
BoP Case Study: Examine the table below. Calculate US's balance of trade with
each of its top 15 trading partners.
Source: http://www.censusbureau.biz/foreign-trade/balance/c5700.html
Balance of Payments
Consequences of current and capital account imbalances
Consequences of a current account deficit:
• Foreign ownership of domestic assets: such as property, businesses,

stocks and bonds. Threatens economic sovereignty, national security. If
foreigners lose faith in economy and sell off assets, will lead to massive
depreciation of country's currency, destabilizing economy further.
• Foreign indebtedness: Current account deficits must be offset by capital

account surpluses. To attract financial investment in the economy central
banks must keep interest rates high, discouraging domestic investment,
which threatens to further increase current account deficits in the future.
Example: China uses some of its US$ reserves to buy US gov't bonds, financing
US budget deficits. Since it can borrow from China, the US gov't can keep
taxes low, meaning higher levels of disposable income and consumption for
Americans. Since much of US consumption is made up of imports from China,
low taxes mean strong demand for Chinese output. Indirectly, China's
purchase of US gov't bonds is financing America's trade deficit with China.
Balance of Payments
Consequences of a current account surplus:
• Increased ownership of assets abroad: A surplus in the current

account leads to a build-up of foreign exchange reserves and/or
deficit in the capital account. As Country A acquires more of
Country B's assets, the threat of protectionism by Country B grows.
Video: China buying up the United States - CHEAP
• Possible appreciation of currency: Strong demand for a country's

exports puts upward pressure on exchange rate, possibly harming
firms in export sector. Floating exchange rate should restore a more
balanced current account.
Balance of Payments
In 2007 the US current account deficit was about $800 billion.
Causes of the trade deficit
• From 1992 till 2007 the U.S. economy grew more rapidly than the economies of several
major trading nations.
• This growth of income has boosted U.S. purchases of foreign goods.
• In contrast, Japan, some European nations, and Canada suffered recessions or slow income
growth during this period.
• Also, a declining savings rate in the U.S. has contributed to U.S. trade deficits and an
increase in foreign investment in U.S.
Implications of U.S. trade deficits
• A trade deficit means that the U.S. is receiving more goods and services as imports from
abroad than it is sending out as exports. This gain in present consumption may come at the
expense of reduced future consumption.
• A trade deficit is considered “unfavorable” because it must be financed by borrowing from
the rest of the world, selling off assets or dipping into foreign currency reserves.
• In 2004, foreigners owned $2.5 billion more assets in U.S. than Americans owned in foreign
assets. Therefore, the current consumption gains delivered by U.S. trade deficits mean
permanent debt, permanent foreign ownership, or large sacrifices of future consumption.
• But it could also mean higher economic growth as foreign investment expands our capital
base
Balance of Payments
Blog articles to read and comment on
US balance of payments deficit prophecies!
Dominican Republic struggles to find its “comparative advantage” as
it faces new competition from Asia
What’s Korea’s “beef” with the US on trade? Mankiw on free trade in politics
Silver lining of US recession more balanced trade
China: formerly the world’s factory, now a nation of consumers…
Triple threat puts the pinch on Asian garment makers
Could a US recession be good for China?
Exports, good Imports, ALSO GOOD!
The US dollar’s decline in value may cause more harm than good for the US economy
Comparative advantage as the basis for trade oh, what a beautiful concept!
Excuse me, China… could you lend us another billion?
Balance of Payments
the Marshall-Lerner Condition
What will happen to a country's exports as its currency

depreciates or is devalued?
• Exports should increase
or...
• Exports should decrease
WHY?
What will happen to a country's imports as its currency

depreciates or is devalued?
• Imports should increase
or...
• Imports should decrease
WHY?
How should the depreciation or devaluation of a country's
currency affect its current account balance?
• shift towards trade deficit
or
• shift towards trade surplus
Why?
Balance of Payments
How does the price elasticity of demand for exports impact the change in the
current account as a currency depreciates or is devalued?
ELASTIC PEDx: Franc depreciates, exports become cheaper to foreigners,

who are highly responsive to lower price, so income from exports will
increase in Switzerland
INELASTIC PEDx: Franc depreciates, but foreigners are relatively

unresponsive to cheaper Swiss goods. Since they give up less of their
currency to buy Swiss, income from exports will decline in Switzerland
WHY?
How will the price elasticity of demand for imports affect the amount domestic
consumers spend on imports as their currency depreciates or is devalued?
ELASTIC PEDm: Franc depreciates, Swiss are highly responsive to higher price of
imports, so expenditures on imports decrease.
INELASTIC PEDm: Franc depreciates, Swiss are unresponsive to higher price of

imports, must give up more francs to get the same amount of imports,
expenditures on imports may actually increase.
Balance of Payments
The Marshall-Lerner condition tells us how successful a depreciation

or devaluation of a currency's exchange rate will be as a means to
improve a current account deficit in the balance of payments.
How could a depreciation or a devaluation of a nation's currency actually WORSEN a
current account deficit?
1) a country's currency is devalued or depreciates
2) the country's exports become cheaper to foreign consumers, BUT, demand is price inelastic,
SO...
3) foreign expenditures on the country's exports actually decrease (remember the TR test?!)
4) The weaker currency will decrease demand for imports as they become more expensive, BUT,
demand is price inelastic, SO...
5) as the price of imports goes up, consumers don't respond much to the change in price, and
since it takes more domestic currency to buy imports, expenditures on imports actually
INCREASES!
6) A decrease in income from exports and an increase in expenditures on imports actually

WORSENS the current account deficit!
Balance of Payments
The Marshall-Lerner Condition is met if...
PEDexports +PEDimports > 1,

Interpretation: a depreciation in a nation's currency will move
a county's current account towards surplus.
THEREFORE...
if PEDx +PEDm < 1,

then a depreciation in a nation's currency will move a country
towards a current account deficit.
Interpretation:
If the PEDx were inelastic and price fell as a result of depreciation, then the % change in exports
would be less than the % change in price, meaning less export revenue.
If PEDm were inelastic and the price of imports rose as a result depreciation, then the % change
in imports would be less than the % increase in their price, meaning more spending on
imports.
For a current account deficit to become better when a currency depreciates, the PED for exports
and imports combined must be greater than one.
Balance of Payments
the Marshall-Lerner Condition and the J-Curve
PED in the short-run versus the long-run: Over time, consumers are more responsive to
price changes as they can adjust their consumption behaviors to new prices.
The table below shows the SR and LR price elasticities of demand for exports and
imports for several countries. Using the data, determine whether the Marshall-
Lerner Condition is met for each country.
SR PEDx SR PEDm total ML met? LR PEDx LR PEDm total ML met?

Canada .5 .1 .6 ______ .9 .9 1.8 ______
France .1 .1 .2 ______ .2 .4 .6 ______
Germany .1 .2 .3 ______ .3 .6 .9 ______
Italy .3 .0 .3 ______ .9 .4 1.3 ______
Japan .5 .1 .6 ______ 1 .3 1.3 ______
UK .2 .0 .2 ______ 1.6 .6 2.2 ______
US .5 .6 1.1 ______ 1.5 .3 1.8 ______
Surplus
What would it look like if we were
to plot one of these nation's current
account balances over time to
reflect the effect of a currency Deficit Time
depreciation or devaluation?
Balance of Payments
P P P
D for Swiss exports D for Swiss exports Swiss Import D P Swiss Import D
P1 P1 P2 P2
P2 P2 P1 P1
Dexports Dimports
Dexports Dimports
Q Q1 Q2 Q Q2Q1 Q Q2 Q1 Q
Q1Q2
Shade a box in each of the graphs showing the change in export spending or import income
when the deprecation of the Franc causes a change in price from P1 to P2. Describe:
1. the effect of a Franc depreciation on export revenues when the demand for exports is inelastic.
2. the effect of a Franc depreciation on export revenues when the demand for exports is elastic.
3. the effect of a Franc depreciation on spending on imports when the demand for imports is inelastic.
4. the effect of a Franc depreciation on spending on imports when the demand for imports is elastic.
Under which of the conditions above will a current account deficit improve, i.e. become
smaller when the Swiss franc depreciates?
Balance of Payments
The J-curve: Reflects the effect of changing PED

for exports and imports over time on a nation's
Current account Current Account

current account after its currency depreciates the J-Curve
surplus
• If PEDm is inelastic in the SR, then a
weaker currency will lead to an
increase in expenditures on imports
• If PEDx is inelastic in the SR, then a

weaker currency will lead to a fall in
export revenue
Time
• As export revenue falls and spending
et
deficit
m
on imports rises, the country's current
LC
account deficit deepens M
M
LC
• Over time, consumers at home will no
tm
begin to replace their consumption of
et
imports with more domestic goods,
and consumers abroad will begin
buying more of our country's now
cheaper products. Income from
exports will rise and expenditures on
imports will fall, moving the current
account towards surplus.
Balance of Payments
Source: http://www.tutor2u.net
"There is some evidence
for the J Curve effect
shown in the diagram
above which shows the
quarterly balance of
trade in goods and the
average value for the
sterling exchange rate
index between 1990-
2000.
In late 1992 the pound was devalued by nearly 15% following the United Kin gdom's exit
from the European Exchange Rate Mechanism. The sharp fall in the exchange rate
provided a welcome boost to the competitiveness of UK producers - but in the short term,
the balance of trade actually worsened. Import volumes remained steady - but were more
expensive following the decline in the exchange rate. Exports took time to respond to the
more competitive value of sterling.
But in 1993-94 there was a clear acceleration in export volumes and a slower growth of
imported goods and services as the effects of the exchange rate depreciation started to
take effect. The net result was an improvement in the balance of trade in goods - although
not sufficient to take the balance from deficit into surplus."
International Economics
Practice Questions
For what reasons might a country’s exchange rate rise? 10 marks

A basic answer is likely to explain that the exchange rate is determined by the demand for and the
supply of the currency on the foreign exchange market, and that an appreciation would occur due to
an increase in demand and/or a decrease in supply. High scoring answers are likely to progress
beyond this to explain the influence of specific factors on demand and supply, and to relate these to
appreciation; e.g. exports, imports, capital flows, official financing. The influence of such factors as
the level of interest rates and inflation, comparative advantage/competiveness, speculation and
government policy could be examined. Students who distinguish between short run reasons (e.g.
speculation) and long run reasons (e.g. underlying competitiveness) should be rewarded. A few
issues examined in detail, or several in less depth, could gain full marks.
Explain why the depreciation of a country’s exchange rate might not improve
its balance of payments.
Candidates might start by explaining what a depreciation is and the effect of this on export
and import prices. Reasons for not helping the balance of payments might include: Marshall-
Lerner condition not fulfilled; the J curve effect; importance of non-price factors; possibility of
competitive depreciations; rising import costs causing a loss of competitiveness as a result of
inflation.
To earn full marks the Marshall-Lerner condition could be explained fully (although the official
name does not need to be stated), or any two factors could be explained in depth, or several in
less depth. To reach band 4, candidates must make explicit reference to export revenues and
import expenditure in the context of the Marshall/Lerner condition/J curve effect.
Practice Questions
a) “Whether the exchange rate rises or falls there are always losers.”
b) Evaluate this statement from a domestic and/or global perspective.

Candidates can receive full credit for answers based only on domestic perspectives
Definitions that should be included:
• exchange rate
• appreciation/depreciation; revaluation/devaluation
For currency appreciation the following issues could be addressed:
• loss of domestic and international markets as the price of exports
increases and the price of imports falls
• the resulting impact on the Balance of Payments
• the Marshall-Lerner condition
• possible falls in domestic output and employment
• possible effects of policies to deal with Balance of Payments deficits
• hot money/capital flows
• effects of cheaper imports on inflation
• de-industrialisation
For currency deprecation, the following issues could be addressed:
• effect on domestic and international market shares
• the Marshall-Lerner condition, the J-curve and the Balance of Payments
• possible effects on inflation (cost push and demand pull)
• hot money and capital flight
• terms of trade
• debt repayments/debt servicing ratios and the effect of these on
public expenditure and investment
• loss of confidence in the currency
• competitors may devalue to restore competitiveness / possible global instability
• environmental issues
[25 marks]
Practice Questions
Use demand and supply analysis to explain the possible effects of currency speculation on a country’s
exchange rate.
For full marks to be earned it is sufficient to discuss the two aspects of speculation (i.e. buying and
selling of a currency) with appropriate diagrams. Selling shifts supply to the right and lowers the
exchange rate, while buying shifts demand to the right and increases the exchange rate. Implicit in the
answer should be an awareness of why speculation takes place. Candidates who consider only one
aspect correctly should be limited to [5 marks]. In addition, candidates may also be rewarded for
discussing other relevant points such as: the importance of the type of exchange rate regime; whether
the exchange rate rises or falls depends on the magnitude of the speculation; possible central bank
action; the impact of changes elsewhere in the balance of payments.
[10 marks]
Explain how, in theory, balance of payments deficits and surpluses on current account are
automatically adjusted under a system of flexible exchange rates. Illustrate your answer using supply
and demand analysis.
(Total 10 marks)
Answers might usefully start by defining key terms such as current account deficit and surplus, and
flexible exchange rates. If no progress is made beyond this point, a maximum of [3 marks] should be
awarded.
Good responses should explain that a current account deficit should cause the exchange rate to fall,
export prices will fall and import prices will rise. The demand for exports will rise, while the demand
for imports will fall. Balance of payments equilibrium will be restored; and vice versa for a surplus.
A maximum of [6 marks] should be awarded if no diagrams are used. To obtain full marks, at least
some reference to the adjustment of a deficit and a surplus should be made, with one being explained
in reasonable detail.
[10 marks]

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Unit 4.5, 4.7 and 4.

Unit 4.5-4.8: International Economics

4.8 Terms of trade

Higher level extension topics

The Balance of Payments: A nation’s balance of payments is the sum of

These transactions include merchandise exports and imports, tourist

The balance of payments account is subdivided into three components:

• the current account

• the capital (or financial) account

• the official reserves account

• "Balance of trade". It measures the is the difference between a country's

• Balance on the current account is found by adding all transactions (expenditures

• If a country spends more on imports than it earns from exports, it is said

• If a country earns more from its exports than it spends on imports, it is

Taiwan's expenditures on airplanes made in the US count towards a deficit in Taiwan's

Floating exchange rate system:

What happens to demand Americans are buying more imports,

Blog post: "US balance of payments prophecies"

If foreign ownership of domestic assets increases more quickly than domestic

If domestic owenership of foreign assets increases more quickly than foreign

But if a US investor buys an office building in Shanghai or builds a golf course in

The central banks of nations hold quantities of foreign currencies called

A government's reserves are built up when its income from exports

These reserves can be drawn on to make up any net deficit in the

BoP Deficits and Surpluses:

BoP Case Study: Examine the table to the right:

1) What has happened to China's foreign reserves

2) What happened in China in 1977 that led to a

CLICK HERE: Balance of Trade data between US

Consequences of a current account deficit:

• Foreign ownership of domestic assets: such as property, businesses,

• Foreign indebtedness: Current account deficits must be offset by capital

Consequences of a current account surplus:

• Increased ownership of assets abroad: A surplus in the current

Video: China buying up the United States - CHEAP

• Possible appreciation of currency: Strong demand for a country's

In 2007 the US current account deficit was about $800 billion.

Causes of the trade deficit

Implications of U.S. trade deficits

What will happen to a country's exports as its currency

What will happen to a country's imports as its currency

ELASTIC PEDx: Franc depreciates, exports become cheaper to foreigners,

INELASTIC PEDx: Franc depreciates, but foreigners are relatively

INELASTIC PEDm: Franc depreciates, Swiss are unresponsive to higher price of

The Marshall-Lerner condition tells us how successful a depreciation

1) a country's currency is devalued or depreciates

6) A decrease in income from exports and an increase in expenditures on imports actually

The Marshall-Lerner Condition is met if...

PEDexports +PEDimports > 1,

if PEDx +PEDm < 1,

SR PEDx SR PEDm total ML met? LR PEDx LR PEDm total ML met?

The J-curve: Reflects the effect of changing PED

Current account Current Account

• If PEDx is inelastic in the SR, then a

For what reasons might a country’s exchange rate rise? 10 marks

b) Evaluate this statement from a domestic and/or global perspective.

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