11

Balance of Payment

Biswa Swarup Misra

The Balance of Payments: Linking the
Domestic Economy to the International
Economy

Open economy An economy that has interactions

in trade or finance with other countries.

Closed economy An economy that has no

interactions in trade or finance with other countries.

Balance of payments The record of a country’s

trade with other countries in goods, services, and
assets.

slide 1
LEARNING OBJECTIVES

▪ Measuring Macroeconomic Activity: Overview

▪ Identify the relationship between the national
income and product accounts, and the balance
of payments account using the circular flow.
▪ Define the key components of the national
income and product accounts, and the balance
of payments account.
▪ Understand how each component of the balance
of payments accounts affects the flow of income
and spending in the circular flow.
slide 2
Flow of Payments in a Closed Economy
▪ Gross national expenditure (GNE): total national
spending on final goods and services.
▪ It can be divided into three components.
▪ Personal consumption expenditures C (“Consumption”).
▪ Total household spending on final goods and services.
▪ Gross private domestic investment I (“Investment”)
▪ Total spending by firms and households on final goods and
services that add to the nation’s capital stock.
▪ Government consumption expenditures and gross
investment G
▪ Government spending on final goods and services, including
additions to the capital stock.
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Flow of Payments in a Closed Economy

▪ Where does expenditure go?

▪ Total spending (GNE) is total payments for final
goods and services in the market.
▪ In a closed economy, this must equal total sales
by firms of goods excluding sales to other firms.
▪ This measure is known as value added.
▪ Firms sell intermediate goods and services to
other firms. These are excluded to avoid
double counting.

slide 4
Flow of Payments in a Closed Economy

slide 5
Flow of Payments in a Closed Economy

▪ Where does value added go?

▪ Firms use revenues in two ways:
▪ Payments for intermediate goods and services.
▪ Income payments to factors of production, such as wages and
salaries to labor, dividends and interest to capital, and rent to
landowners.
▪ The latter is just value added since it is what is leftover
once intermediate purchases are deducted from total
sales.
▪ Value added avoids double-counting and is considered the “true”
measure of production in the economy, and is also called gross
domestic product (GDP).

slide 6
Flow of Payments in a Closed Economy

slide 7
Flow of Payments in a Closed Economy

▪ Where do factor payments go?

▪ Gross national income (GNI) is the sum of factor
income payments received by national entities.
▪ As with other flows, we neglect taxes and transfers, so these
entities can be thought of as the aggregate of households, firms,
and government.
▪ These income resources are the only resources
available from which the closed economy can finance
expenditure.
▪ The income flow GNI is spent as the expenditure flow GNE.

slide 8
Flow of Payments in a Closed Economy

slide 9
The Circular Flow in a Closed Economy
GNE = GDP = GNI

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Flow of Payments in an Open Economy

▪ The balance of payments account records

international transactions in the open economy.
▪ In the flow of payments for an open economy,
the transactions in the balance of payments
affects the flow of spending, income, and
production.
▪ GNE, GDP, and GNI need not be equal.
▪ The macroeconomic plumbing is more
complicated.
▪ Modifications are need at five points.
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Flow of Payments in an Open Economy
▪ Point 1:
▪ Some home spending is on foreign goods; and
some foreign spending is on home goods.
▪ International payments result.
▪ We must deduct imports (IM) and adds
exports (EX) to GNE to calculate the total
payments received by home firms.
▪ Total spending on final goods and services is
the sum of GNE and the trade balance (TB).
GNE + TB = GDP
TB = EX – IM
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Flow of Payments in an Open Economy

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Flow of Payments in an Open Economy
▪ Point 2:
▪ Some home GDP might be produced using “imported”
foreign factors and some foreign GDP might be
produced using “exported” home factors.
▪ International payments result (e.g., wages, rents).
▪ We must subtract factor service imports (IMFS) and
add factor service exports (EXFS) to GDP to
calculate the income received by the home nation.
▪ The difference between factor service exports and
imports is net factor income from abroad (NFIA).
GDP + NFIA = GNI
NFIA = EXFS – IMFS

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Flow of Payments in an Open Economy

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Flow of Payments in an Open Economy
▪ Point 3:
▪ Country’s disposable income may differ from
income earned due to unilateral transfers paid
to (UTOUT) and received from abroad (UTIN),
e.g. aid.
▪ Net unilateral transfers (NUT) is the net
amount the country receives from the rest of the
world.
▪ Gross national disposable income (GNDI) is
income available including transfers.
GNI + NUT = GNDI
NUT = UTIN – UTOUT slide 16
Flow of Payments in an Open Economy

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Flow of Payments in an Open Economy
▪ Point 4:
▪ Income is not the only resource by which an
open economy can finance expenditure.
▪ The economy can increase/decrease its
spending power by exporting/importing assets
internationally.
▪ These transactions are recorded on the
financial account (FA).
▪ The financial account is equal to asset exports
(EXA) less asset imports (IMA).
FA = EXA – IMA
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Flow of Payments in an Open Economy
▪ Point 5:
▪ A country may transfer/receive assets as gifts.
▪ Like income transfers, these must be recorded
properly.
▪ Asset imports which are gifts (KAIN) do not
reduce resources, so we must add those.
▪ Asset exports which are gifts (KAOUT) do not
increase resources, so we must subtract
those.
▪ These transfers of assets are recorded in the
capital account (KA).
KA = KAIN – KAOUT slide 19
Flow of Payments in an Open Economy

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The Big Picture

slide 21
 Flow of Payments: Quick Summary
Key Issue Number 1
▪ International transactions appear in two places
▪ In the National Income & Product Accounts
▪ Because they account for the differences between measures
of expenditure, product, and income.
▪ In the Balance of Payments Accounts
▪ Where they are broken down by concept and presented in
much more detail.
– Transactions in goods & services TB, factor services NFIA, and
income transfers NUT go in the current account CA.
– Transactions in assets are recorded elsewhere. The financial
account FA records all asset movements. The capital
account KA records transfers of assets.

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Flow of Payments: Quick Summary

Key Issue Number 2

▪ International transactions complete the circular
flow and add up to zero
▪ As we saw the transactions from the balance of
payments are added to GNE at each step.
▪ But the end result is still GNE.
▪ So the balance of payments adds up to zero.
▪ A positive entry in the balance of payments must be
offset by a negative entry elsewhere in the account.

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Three Approaches to
Measuring Economic Activity
▪ Expenditure approach: GNE = C + I + G
▪ Demand for goods and services
▪ GNE = total expenditure on all final goods and
services.
▪ Product approach: GDP = GNE + TB
▪ Supply of goods and services
▪ GDP = value of all goods and services produced
by firms, less intermediate goods purchased.
▪ Income approach: GNI = GDP + NFIA
▪ Payments to factors of production
▪ GNI = value of all payments earned by factor
residents in the economy. slide 24
 Balance of Payments Accounts

▪ A country’s balance of payments accounts

accounts for its payments to and its receipts
from foreigners.
▪ An international transaction involves two parties,
and each transaction enters the accounts twice:
once as a credit (+) and once as a debit (-).

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Balance of Payments Accounts
(cont.)
▪ The balance of payments accounts are
separated into 3 broad accounts:
▪ current account: accounts for flows of goods and
services (imports and exports).
▪ financial account: accounts for flows of financial
assets (financial capital).
▪ capital account: flows of special categories of
assets (capital): typically non-market, non-
produced, or intangible assets like debt
forgiveness, copyrights and trademarks.

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Broad Components of different
Accounts
▪ Current Account = Balance on Trade(exports of
goods-import of Goods) + Balance on services(export
of services-import of services)+ Investment Income
and dividends + net transfers
▪ Financial Account = net direct investment + net
portfolio flows+ other investment + change in
reserve assets

slide 27
The BOP records two types of transactions:
1. Transactions that involve exports or imports of goods
and services or transfers are registered in the current
account
▪ When a Jordanian resident buys a US made
product this is recorded as a debit in the BOP
of Jordan and as a credit in the US BOP.
2. Transactions that involve the purchase or sale of
assets are registered in the Financial account
▪ When a company from Jordan buys a US
company (building, bond, ..), the transaction is
recorded in the Jordanian BOP as a debit in
the financial account and is recorded in the
US as a credit in the Financial account
▪ Why debit, because Jordan is "importing" the
Asset

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 Guidelines for Classification of Credit
and Debit Items in Financial Account

▪ 1. Purchase of assets - Debit and sale of assets

– Credit
▪ 2. Purchase of asset is just like importing the
asset (Krugman)
▪ 3.Every increase in liability or decrease in asset
is a credit and every decrease in liability or
increase in asset is a debit.(Moss)

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 The Balance of Payment
▪ Double-entry bookkeeping, every transaction enters
into the BOP twice, once as a credit and once as a
debit
▪ Example: A US company buys Jordanian
phosphates for USD20,000 and pays with a cheque
▪ Debit in US current account (import) credit in the
Jordanian Current account (export)
▪ Credit in US financial account (The dollars are
liabilities of US Fed. An increase in liability is a
credit entry) and debit in the Jordanian Financial
account as there is an increase in assets(Increase
in Asset is a debit entry)
▪ Financial Account + Current Account + Capital
Account=0
▪ So, what does a Balance of Payment deficit mean?

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The Balance of Payment
▪ The BOP keeps track of a country's payments to
foreigners and receipts from foreigners

▪ Transactions resulting into a payment to

foreigners are entered in the BOP as a debit and
is given (-).

▪ Transactions resulting into a payment from

foreigners are entered in the BOP as a credit
and is given (+).

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 Balance of Payments Accounting

▪ In practice, measurement problems, recorded as a

statistical discrepancy, prevent CA + KFA = 0 from
holding exactly.

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Nearly all economies of the world are:
a. Open economies.
b. Closed economies.
c. Closed economies about to become open in
today’s global economy.
d. Open to trade but closed to investment and
finance interactions with other economies.

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Nearly all economies of the world are:
a. Open economies.
b. Closed economies.
c. Closed economies about to become open in
today’s global economy.
d. Open to trade but closed to investment and
finance interactions with other economies.

slide 34
The Balance of Payments: Linking the
Domestic Economy to the
International Economy

The Current Account

Current account The part of the

balance of payments that records a
country’s net exports, net investment
income, and net transfers.

The Balance of Trade

Balance of trade The difference

between the value of the goods a
country exports and the value of the
goods a country imports.

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A country has a trade surplus when:
a. exports are greater than imports.
b. imports are greater than exports.
c. government revenues are greater than
government expenditures.
d. the balance on the current account must be
positive.

slide 36
A country has a trade surplus when:
a. exports are greater than imports.
b. imports are greater than exports.
c. government revenues are greater than
government expenditures.
d. the balance on the current account must be
positive.

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The Balance of Payments: Linking the Domestic
Economy to the International Economy
The Current Account
Net Exports Equals the Sum of the Balance of Trade
and the Balance of Services
CURRENT ACCOUNT
Illustrative Exports of goods $52,308
Example: Imports of goods −62,326
The Balance of Balance of trade −10,017
Payments of Exports of services 46,807
India, April-
Imports of services −26,304
June 2020
Balance of services 20,503
(Millions of
dollars) Income received on investments 5,070
Income payments on investments −12,768
Net income on investments -7,698
Net transfers 17,010
Balance on current account 19,798

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In the Illustrative Example, the trade position of
India was:
a. A trade surplus of $10.48 billion.
b. A trade surplus of $10.01 billion.
c. A trade deficit of $10.48 billion.
d. A trade deficit of $10.01 billion.

Trade considers tangible goods and not intangible

services

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In the Illustrative Example, the trade position of
India was:

a.A trade surplus of $10.48 billion.

b.A trade surplus of $10.01 billion.
c.A trade deficit of $10.48 billion.
d.A trade deficit of $10.01 billion.

slide 40
The Balance of Payments: Linking the Domestic
Economy to the International Economy
The Current Account
Net Exports Equals the Sum of the Balance of Trade
and the Balance of Services
Illustrative Example:
The Balance of
Payments of India
during Apr-June
2020,(Millions of
dollars) (continued)
FINANCIAL ACCOUNT

Increase in foreign holdings of assets in India 1,26,703

Increase in Indian holdings of assets in foreign
countries −1.45241
Balance on Financial Account -18,538
BALANCE ON CAPITAL ACCOUNT -780
Statistical discrepancy -480
Balance of payments 0
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The Balance of Payments: Linking the Domestic
Economy to the International Economy
The Financial Account
Financial account The part of the
balance of payments that records
purchases of assets a country has made
abroad and foreign purchases of assets
in the country.

Net foreign investment The difference

between capital outflows from a country
and capital inflows, also equal to net
foreign direct investment plus net
foreign portfolio investment.

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Purchases of assets a country has made abroad
and foreign purchases of assets in the
country are recorded in:
a. The current account.
b. The financial account.
c. The capital account.
d. All of the above.

slide 43
Purchases of assets a country has made abroad
and foreign purchases of assets in the
country are recorded in:
a. The current account.
b. The financial account.
c. The capital account.
d. All of the above.

slide 44
The Balance of Payments: Linking the Domestic
Economy to the International Economy

The Capital Account

Capital account The part of the balance of payments

that records relatively minor transactions, such as
migrants’ transfers, and debt forgiveness
Migrant’s transfer means the assets that migrants take
with them when they move into or out of a country

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 Current versus Capital Transfers
Current Transfers Capital Transfers
▪ Current transfers consist of all ▪ A capital transfer should result in a
transfers that are not transfers of change in the stocks of assets.
capital.
▪ Capital transfer can be in cash
▪ Current transfers directly affect the or in kind
level of disposable income and
should influence the consumption of ▪ First, a transfer in kind is a capital
goods or services. transfer when it consists of
▪ Current transfers reduce the ▪ (i) the transfer of ownership of a
income and consumption fixed asset. Investment grants in
possibilities of the donor and kind consist of transfers of
increase the income and transport equipment, machinery,
consumption possibilities of the other equipment, and the direct
recipient. provision of buildings or other
▪ Current transfers are classified, structures by governments to
according to the sector of the nonresident units.
compiling economy, into two main
categories: general government
and other sectors.
BoP and NSI Biswa Swarup Misra slide 46
 Current versus Capital Transfers
Current Transfers
▪ General government transfers comprise
current international cooperation, which
covers current transfers-in cash or in
kind-between governments and
international organizations.
▪ Included are cash transfers effected
between governments for the purpose of
financing current expenditures by the
recipient government. Takes the form of
gifts of food, clothing, other consumer
goods, medical supplies, etc. associated
with relief efforts in the wake of famine,
earthquakes, other natural disasters,
war, or other actions.
▪ Payments by governments or
international organizations to
governments for salaries of technical
assistance staff and for related costs and economy to another. The transfers to be
expenses.
BoP and NSI Biswa Swarup Misra
Capital Transfers
▪ Second, a transfer of cash is a capital
transfer when it is linked to, or conditional
on the acquisition of a fixed asset (for
example, an investment grant).
Investment grants in cash are for
purposes of gross fixed capital formation,
and the grants are often tied to specific
investment projects, such as large
construction projects.
▪ Capital transfers also include migrants’
transfers and debt forgiveness.
▪ In the strictest sense, migrant transfers
are not transactions between two parties
but contra-entries to flows of goods and
changes in financial items that arise from
the migration (change of residence for at
least a year) of individuals from one
recorded are thus equal to the net worth
of the migrants.
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 Current versus Capital Transfers
Current Transfers Capital Transfers
▪ Other current transfers, in cash or in ▪ All the household and personal effects
kind, between resident and nonresident of migrants, together with any movable
entities include those (such as food, capital goods actually transferred from
clothing, other consumer goods, the old to the new economy, are
medical supplies, etc.) for distribution to included under goods-general
relieve hardships caused by famine, merchandise.
other natural disasters, war, etc. and
regular contributions (including ▪ Enterprises (including those that utilize
membership dues) to charitable, land, structures, and movable capital
religious, scientific, and cultural goods not actually transferred) in which
organizations. migrants retain ownership after
departure become foreign claims of the
▪ Workers’ remittances covers current migrants and, consequently, of the
transfers by migrants who are economies to which they have
employed in new economies and migrated.
considered residents there.
▪ A migrant is a person who comes to an
economy and stays, or is expected to
stay, for a year or more.

BoP and NSI Biswa Swarup Misra slide 48

Which of the following is a less important
component of the balance of payments?
a. The current account.
b. The financial account.
c. The capital-account.
d. None of the above. All three components are
equally important.

slide 49
Which of the following is a less important
component of the balance of payments?
a. The current account.
b. The financial account.
c. The capital-account.
d. None of the above. All three components are
equally important.

slide 50
The Balance of Payments: Linking the Domestic
Economy to the International Economy
Why Is the Balance of Payments Always Zero?
The sum of the current account balance, the financial
account balance, and the capital account balance
equals the balance of payments.

To make the balance on the current account equal the

balance on the financial account, the balance of
payments includes an entry called the statistical
discrepancy.

Don’t Confuse the Balance of Trade, the Current Account Balance, and the
Balance of Payments

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Which of the following statements about the
balance of payment is correct?
a. Foreign investment in the United States
shows up as positive entry in the U.S.
financial account.
b. Additions to foreign holdings of dollars show
up as positive entries in the U.S. financial
account.
c. A current account deficit must be exactly
offset by a financial account surplus, leaving
the balance of payments equal to zero.
d. All of the above statements are correct.

slide 52
Which of the following statements about the
balance of payment is correct?
a. Foreign investment in the United States
shows up as positive entry in the U.S.
financial account.
b. Additions to foreign holdings of dollars show
up as positive entries in the U.S. financial
account.
c. A current account deficit must be exactly
offset by a financial account surplus, leaving
the balance of payments equal to zero.
d. All of the above statements are correct.

slide 53