ADDIS ABABA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT of Economics

1. G/hiwot Woretaw……………………….BEE/2905/13
2. Getahun Amiha………………………..BEE/7888/13

Submission date;sep10, 2023

In the context of international finance,write short note on each of the following .give example ,where
necessary

1) balace of payments ana purposes

2) the current account component of the balance of payments

3)the capital account component of the balace payments

4) the possible causes for"Net Errors and omissions"in the balance payment

5) the J-curve effect of currency devaluation and the possible reasons the shape of the curve

1. Balance of Payments (BoP) and Its Purposes

Definition: The BoP is a record of all economic transactions between a country and the rest of the world
during a specific period (quarter or year). It tracks the flow of money in and out, including:

Exports and imports of goods and services

Investment income (interest, dividends)

Transfers (foreign aid, remittances)

Purposes:

Assessing a nation's international trade position: A surplus indicates more money is flowing in (exports +
investment income) than flowing out (imports + transfers). A deficit means the opposite.

Formulating economic policies: The BoP helps policymakers understand trade imbalances and devise
strategies to manage them (e.g., import quotas, currency adjustments).

Analyzing economic trends: Trends in the BoP can reveal patterns in a country's foreign trade and
investment activity, aiding in forecasting and risk assessment.

2. Current Account

Focus: The current account records a country's net trade in goods and services, investment income, and
current transfers.

Components:

Goods balance: Exports (money coming in) minus imports (money going out) of physical products.

Example: A country exporting more cars than it imports would have a positive goods balance.

Services balance: Exports of services (tourism, consulting, etc.) minus imports of services.

Submission date;sep10, 2023

Example: A country attracting more tourists than its citizens traveling abroad would have a positive
services balance.

Investment income balance: Income earned on foreign investments (dividends, interest) minus payments
made for foreign investments in your country.

Example: A country with more investments abroad than foreign investments domestically might have a
positive investment income balance.

Current transfers balance: Unilateral transfers (gifts, foreign aid) received minus those given.

Overall balance: The sum of the four components. A current account surplus indicates a net inflow of
money, while a deficit indicates a net outflow.

3. Capital Account

Focus: The capital account tracks non-monetary (real) asset transactions between residents and non-
residents. It includes:

Foreign direct investment (FDI): Purchases or sales of businesses or controlling interests in businesses by
foreign entities.

Example: A foreign company building a factory in your country would be considered FDI.

Portfolio investment: Cross-border purchases and sales of stocks, bonds, and other financial assets.

Example: You investing in a foreign stock market would be portfolio investment.

Reserve assets: Changes in official foreign exchange reserves held by the central bank.

Impact: Capital account transactions can influence exchange rates and economic growth.

4. Net Errors and Omissions

Definition: This component accounts for discrepancies in the BoP due to:

Statistical errors: Inaccuracies in data collection and reporting.

Unrecorded transactions: Illegal activities, unreported income, etc.

Challenges: Since it represents unknown or unrecorded transactions, it makes achieving a perfectly

balanced BoP difficult.Here are a few more examples to illustrate the concept of Net Errors and
Omissions in a country's balance of payments:

Example 1: United States

In the United States, the Net Errors and Omissions item has been consistently negative, indicating a net
unrecorded outflow of funds from the country. For example, in 2021, the U.S. balance of payments

Submission date;sep10, 2023

showed a Net Errors and Omissions of -$221.1 billion. This suggests that the recorded inflows and
outflows did not fully capture all international transactions, and there were likely unrecorded outflows of
capital from the U.S.

Example 2: China

China's balance of payments often shows a positive Net Errors and Omissions, indicating a net
unrecorded inflow of funds. For instance, in 2020, China's Net Errors and Omissions was recorded as
$105.6 billion. This could be attributed to factors such as unrecorded capital flight, unreported trade
transactions, or inaccuracies in data collection.

5. J-Curve Effect and Currency Devaluation

J-Curve Effect: This theory suggests that when a country devalues its currency (makes it cheaper relative
to other currencies), its trade balance (exports minus imports) might initially worsen before eventually
improvingThe J-Curve Effect of Currency The J-Curve Effect of Currency

Devaluation and the Possible Reasons for

the Shape of the Curve:The J-Curve effect describes thephenomenon where a country's tradedeficit
initially worsens after a devaluation of its currency before eventually improving. Immediately after
devaluation,the price of imports rises while the volume remains roughly stable becausecontracts and
supply chains cannot adjust instantaneously. Conversely, export gains from competitiveness take time as
contracts and markets adjust to the new pricing. Hence, the trade balance first deteriorates before
improving, forming the shape of a "J." This effect was observed in the UK following the Brexit vote when
the pound weakened significantly but export volumes took time to respond effectively.

Here are some examples to illustrate the J-Curve Effect of currency devaluation and the possible reasons
for its shape:

1. Example: Devaluation of the Thai Baht in 1997

- In 1997, the Thai government was forced to devalue the Thai baht due to a financial crisis.

- In the short-term, the trade balance initially deteriorated as Thailand's imports became more
expensive, while the demand for its exports remained relatively inelastic.

- This was due to existing contracts and the time it took for consumers and businesses to adjust their
purchasing patterns.

- Over time, however, the trade balance improved as Thai exports became more price-competitive, and
domestic consumers shifted towards cheaper domestic goods instead of imports.

- The J-Curve shape was observed, with an initial deterioration followed by an eventual improvement in
the trade balance.

Submission date;sep10, 2023

2. Example: Devaluation of the Chinese Yuan in 2015

- In 2015, the Chinese government devalued the yuan to boost its slowing economy.

- Initially, the trade balance worsened as China's imports became more expensive, and its exporters
were slow to pass on the full price reduction to foreign buyers (pricing-to-market behavior).

- However, over time, the trade balance improved as Chinese exports became more price-competitive,
and foreign demand for Chinese goods increased.

- The J-Curve shape was observed, with an initial deterioration followed by an eventual improvement in
the trade balance.

Submission date;sep10, 2023