Name: Anindya Alifia Putri

NIM: 20200410301

SUMMARY CHAPTER 4

4.1 THE BALANCE OF PAYMENTS: CONCEPTS AND TERMINOLOGY

Important Points about Balance of Payments:

Definition: The Balance of Payments (BOP) tracks the value of transactions between a
country's residents, businesses, and government with the rest of the world over a specified
period, summarizing international flows of goods, services, and asset ownership changes.

Major Accounts: BOP comprises two major accounts: the Current Account and the Capital
Account (often referred to as the Financial Account). The Current Account records
transactions involving goods, services, income flows from foreign assets, and unilateral
transfers. The Capital Account (or Financial Account) tracks purchases and sales of foreign
and domestic assets.

Double-Entry System: BOP uses a double-entry accounting system where each transaction
generates two entries, one credit, and one debit, reflecting equal value. Credits represent
inflows or sources of foreign exchange, while debits represent outflows or uses of foreign
exchange.

Current Account Transactions: Includes imports, exports, income from foreign assets (like
dividends and interest), and unilateral transfers (such as foreign aid and gifts). Credits on the
Current Account correspond to inflows, while debits correspond to outflows.
 Capital Account Transactions: Involve purchases and sales of foreign and domestic assets.
Transactions may lead to capital inflows or outflows depending on whether residents acquire
foreign assets or foreigners acquire domestic assets.

Official Reserves Account: Tracks changes in a country's official international reserves,

typically held by the central bank. Transactions mirror those in the private sector's capital
account, with acquisitions leading to debits and drawdowns leading to credits.

Implications for Fixed Exchange Rates: In countries with fixed exchange rates, the central
bank may intervene directly to maintain the fixed rate. Transactions involving foreign assets
or currency led to corresponding entries in the official reserves account to balance the private
sector's transactions.

Understanding the intricacies of BOP accounting helps analyze a country's economic

relationships with the rest of the world and its financial health.

4.2 SURPLUSES AND DEFICITS IN THE BALANCE OF PAYMENTS ACCOUNTS

Balance of Payments Structure: The balance of payments (BOP) consists of two major
accounts: the current account and the capital account (financial account), which records
international transactions involving goods, services, and assets.

Current Account Components:

- Goods and services transactions: Records imports and exports.

 - Income flows from foreign assets: Includes dividends and interest paid to domestic and
foreign asset owners.

- Unilateral transfers: Involves one-way transfers of money between countries, such as

foreign aid or gifts.

Capital Account (Financial Account) Components:

- Records purchases and sales of foreign assets by domestic residents and vice versa.

- Special attention to transactions involving official international reserve assets, typically

gold or foreign currency.

Double-Entry Accounting System: Follows a system where each transaction results in two
entries: a credit and a debit, ensuring that the sum of credits equals the sum of debits.

Determining Credits and Debits: Credits represent inflows or sources of foreign exchange,
while debits represent outflows or uses of foreign exchange.

Balance of Payments Identity: The sum of the current account and the capital account
(including official reserves account) balances must equal zero, ensuring that total credits
equal total debits.

U.S. Current Account:

- Components include goods trade balance, services trade surplus, investment income, and
unilateral transfers.

- Shows deficits in goods trade but surpluses in services, resulting in an overall current
account deficit.
 U.S. Capital and Financial Accounts:

- The surplus in the capital account finances the current account deficit.

- Involves transactions in U.S.-owned assets abroad, foreign-owned assets in the U.S.,

financial derivatives, and capital account transfers.

Statistical Discrepancy: Occurs due to missed or estimated transactions, necessitating a

balancing item in the balance of payments.

Official Settlements Account: Tracks changes in a country's official international reserve

assets, essential for maintaining fixed exchange rates.

Global Balance of Payments: Countries with current account deficits must borrow from or
sell assets to finance the deficit, while countries with surpluses experience inflows of capital.

Role of Balance of Payments in Developing Countries: Crucial for understanding economic

stability, currency crises, and global imbalances. Emerging markets often experience
fluctuations in current account balances.

4.3 THE DYNAMICS OF THE BOP

Trade Account and Investment Income Account: The balance of payments includes the trade
account (covering transactions in goods and services) and the international investment
income account (relating to income flows from foreign assets).
Net International Investment Position: Represents the difference between a country's
ownership of foreign assets and foreign ownership of its assets. A positive position indicates
a net creditor status, while a negative position indicates a net debtor status.

Impact of Current Account Deficits on Investment Income: Countries with current account
deficits often rely on foreign borrowing, leading to a negative net international investment
position. This results in a deficit on the investment income account, as interest and dividend
payments to foreign investors exceed income earned on foreign assets.

Trade Balance and Investment Income Balance Relationship: A country's trade balance must
be in surplus if there is a deficit on the investment income account. This means the country
must export more goods and services than it imports to cover its debt obligations.

U.S. Net International Investment Position: The United States has a negative net international
investment position, indicating substantial foreign ownership of U.S. assets. Despite this, the
U.S. maintains a surplus on its investment income account due to various factors such as the
composition of foreign investments and yield differentials.

Sustainability Concerns: There are concerns about the sustainability of the U.S. situation,
given the continued deterioration of its net international investment position. However,
factors such as the ratio of the position to total national wealth and the current account deficit
as a percentage of GDP suggest a nuanced view of the situation.

Composition of Foreign Claims: Foreigners, particularly central banks, have primarily

invested in U.S. bonds, leading to a relatively cheap source of borrowing for the U.S. The
potential impact of a shift away from U.S. bonds on the country's borrowing costs is a point
of consideration.
4.4 SAVINGS, INVESTMENT, INCOME, AND THE BOP

National Income and Expenditure Identity: The national income and product accounts
(NIPA) help in understanding the relationship between gross national income (GNI), national
expenditures, and the current account (CA). The identity \(GNI - (C + I + G) = CA\)
illustrates how a current account surplus or deficit is related to national income and
expenditures.

Link between Current Account and Saving-Investment Balance: The current account
represents the difference between national savings and national investment. If a country's
investment exceeds its savings, it will run a current account deficit, which is financed by
borrowing from abroad.

Government Budget Deficits and Current Accounts: There is an identity linking government
budget deficits and current accounts. A government deficit must be financed either by private
saving, reduced private investment, or a current account deficit. However, this does not imply
causality from government deficits to current account deficits.

Ricardian Equivalence: The concept suggests that taxpayers may foresee future tax liabilities
due to government deficits, leading them to adjust their behavior in the present. If taxpayers
fully anticipate future tax increases to finance deficits, it would offset any impact on national
savings and current accounts.

Individual Intertemporal Budget Constraints: Individuals face intertemporal budget

constraints when making consumption and savings decisions. Factors such as interest rates,
 investment opportunities, and expectations about future economic conditions influence these
decisions.

Investment Spending: Investment decisions by businesses and individuals are crucial

determinants of the current account. Investment tends to be pro-cyclical, increasing during
economic expansions and decreasing during downturns.

Assessment of International Capital Market Openness: The correlation between national

savings and investment rates can indicate the openness of international capital markets.
However, interpretations of this correlation vary, with some arguing that common economic
forces or financial frictions may influence the relationship.

Debate on Capital Market Integration: Studies like those by Feldstein and Horioka suggest
limited capital market integration historically, but more recent research questions this
interpretation, considering factors like common economic shocks and incomplete capital
market openness.

Importance of Considering Rates of Return: Frankel emphasizes the importance of assessing

the integration of capital markets by examining rates of return globally, not just focusing on
savings and investment flows.

4.5 SUMMARY

This chapter introduced the concepts associated with a country’s balance of payments and its
net international investment position and examined how these concepts are related to
national income and product accounts. Knowledge of this information is useful in
discussions of the determination of exchange rates. The main points in the chapter are the
following:

1. A country’s balance of payments records the eco- nomic transactions between its
residents and gov- ernment and those of the rest of the world.
2. There are two major accounts on the balance of payments: the current account and the
capital account.
3. The current account records transactions in goods and services, transactions that are
associated with the income flows from asset stocks, and unilateral transfers.
4. The capital account, which is also called the fi- nancial account in some presentations of
the BOP, records the purchases and sales of assets—that is, changes in the domestic
ownership of the assets of other nations and in the foreign ownership of assets of the
domestic country.

5. The balance of payments uses a double-entry ac- counting system. Each transaction gives
rise to two entries—a credit and a debit of equal value.
6. The purchases of goods and assets by foreign residents from domestic residents are
recorded as credits. Credit transactions result in an inflow, or source, of foreign currency.
7. The purchases of goods and assets by domestic residents from foreign residents are
debits. Debit transactions result in an outflow, or use, of foreign currency.
8. Sales of domestic goods and services to foreign residents are domestic exports. Sales of
domestic assets to foreigners are capital inflows to the home country. Both types of
transaction are credits on the domestic balance of payments.
9. Purchases of foreign goods and services by do- mestic residents are domestic imports.
Purchases of foreign assets by domestic residents are capital outflows from the home
country. Both types of transaction are debits on the domestic balance of payments.
10. If the sum of the credits on a particular account is greater than the sum of the debits on
that account, the account is said to be in surplus. If the sum of the debits on a particular
account is greater than credits on that account, the account is said to be in deficit.

11. The current account is sometimes decomposed into the sum of the trade account and the
interna- tional investment income account. The trade ac- count is a broader concept than
 the merchandise trade balance because the former includes trade in economic services
such as education, bank- ing, tourism, shipping, insurance, and transfers, whereas the
latter does not.
12. International reserves are the assets of a coun- try’s central bank that are not denominated
in the domestic currency. Gold and assets denominated in foreign currency are the typical
international reserves.
13. The official settlements account of the capital ac- count measures changes in the
international re- serves that a country’s central bank holds. If a central bank wants to
maintain a fixed exchange rate, it must use its international reserves to fix the price of the
domestic currency in terms of a foreign currency. International reserves will rise and fall
with the surpluses and deficits on the current ac- count and the private capital account.
14. Because many balance of payments entries are estimated, the sum of the current account
and the capital account does not always equal zero as it should in a double-entry system.
If the sum of the current and capital accounts is not zero, statisti- cians add a balancing
item equal to the sum of all the measured items with the sign reversed. This term is called
the statistical discrepancy or errors and omissions.
15. The balance of payments records flows of goods and assets over a period of time, just
like the income statement of a firm. By analogy, just as a firm has a balance sheet, at a
point in time, a country owns a certain stock of foreign assets, and foreigners own a
certain stock of domestic assets. The difference between the values of these two stocks is
called net foreign assets. Consequently, at any given point in time, a country has a net
international investment position; it is either a net creditor or a net debtor with the rest of
the world.
16. The value of all the final goods and services pro- duced within a country is called the
country’s gross domestic product (GDP).
17. The value of what is produced in a country must be purchased either by domestic
residents or foreign residents. Hence, the country’s total consumption purchases, C, plus
its total government purchases, G, plus its total investment purchases, I, plus the value of
its net exports, NX, must equal its GDP: GDP=C+I+G+NX.
18. The value of all the final goods and services must be paid to factors of production. In an
open econ- omy, net factor income from abroad (NFI) from ei- ther labor that works in
 foreign countries or capital that is invested in foreign countries provides a flow of
resources that separates gross national income (GNI) from GDP 1GNI = GDP + NFI2.
19. By subtracting a country’s total expenditures on consumption, investment, and
government pur- chases from its gross national income, we are left with net exports plus
net factor income from abroad, which is equal to the current account (CA) of the balance
of payments.
20. If a country has a current account surplus, it must have national income that exceeds
national expenditures. If a country has a current account deficit, the country’s
expenditures exceed its income.
21. The owners of a country’s factors of production receive its national income plus transfer
payments from the government and interest on government debt, but they must pay taxes
to the government. After-tax disposable income must be either spent on consumption or
saved in some form of asset.
22. Net private saving, which is private saving in excess of expenditures on investment
goods, plus national government saving, which is taxes minus total gov- ernment
spending or the surplus on the government budget, equals the current account of the
balance of payments.
23. Because national savings and national investment decisions affect a country’s current
account, inter- est rates and other rates of return around the world influence, and in turn
are influenced by, the current account.
24. Feldstein and Horioka demonstrated that there is a very strong cross-sectional correlation
between the national savings rate and the national investment rate of countries. They
argued that this is evidence of strong international capital market imperfec- tions, but
there is a large debate regarding this interpretation.