International Trade and Finance

International Economics The effects upon economic activity of international differences in productive resources and consumer preferences and the institutions that affect them. Explains the patterns and consequences of transactions and interactions between the inhabitants of different countries, including trade, investment and migration, economies of scale, etc. Science of cross-border relationships between countries
Mercantilism 16th-17th Century When is a country right? When it owns a lot of gold (Bullionism) How does a country get rich? Promote exports, discourage imports (conquest or mercantilist policy; mercantilism on trade)
Classic Theory of Trade Adam Smith, The Wealth of Nations (1776) -> explains international trade by referring to absolute advantages (in cost) David Ricardo, On the Principles of Political Economy and Taxation (1817)-> explains international trade by referring to comparative advantages (relative cost) Models based on differences in technology between countries Tech differences -> labor productivity differences (labor is the only production factor for both Ricardo and Smith)
How are costs defined in the classical framework? Opportunity costs
Absolute Advantages In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources.
Comparative Advantages Comparative advantage is when a country produces a good or service for a lower opportunity cost than other countriesExists if a country faces lower opportunity cost while producing product X than another country
Difference between absolute and comparative advantage Comparative advantage refers to the ability of a party to produce a particular good or service at a lower opportunity cost than another. Even if one country has an absolute advantage in producing all goods, different countries could still have different comparative advantages.
Opportunity Cost The opportunity cost of a decision is the value of the next best alternative foregone as a result of the decision. For example, consider an individual who can buy either a book or a DVD with his money. The opportunity cost of buying the book would be the DVD, since he has to forego the DVD in order to buy the book.
Trade (Comparative Advantage) If we allow trade: ->Specialization will automatically occur ->Total production will increase->Every country benefits from trade -> Simplifying assumption: world economy must be able to produce at least the same bundle with trade as it was enjoying without trade
Heckscher-Ohlin Countries have different factors of production needed to produce goods: 1) Labor 2) CapitalExample with Silk and microchips: USA has 10 labor and 30 capital China has 30 labor and 10 capital Silk needs 5 labor and 1 capital microchips needs 3 labor and 5 capital So, China is perfect for silk because it can provide more labor and US is perfect for microchips because it can provide more capital Countries that have relatively more labor will have a comparative advantage in products that require a lot of labor Countries that have relatively more capital will have a comparative advantage in products that require a lot of capitalA country will export the good that makes the most intensive use of the production factor that is available most abundantly Tells us what happens to trade patterns if factor endowments change Tells us what the impact of trade on domestic incomes of the production factors Tells about conflicting interests between production factors This theory explains the trade between OECD and developing countries well but does not explain trade among OECD countries.
Iso-Utility Curve
MRS Marginal Rate of Substitution
Production Possibility Curve A production possibilities curve (PPC, also called a production possibilities frontier or PPF) illustrates the fundamental economic concepts of scarcity, choice, and opportunity cost. It is a simplified model which shows that a society must make choices about how to allocate its scarce resources.In the PPC model, the economy is simplified based on four assumptions:1. The society only produces two types of output: capital goods and consumer goods2. All of the society’s resources are being fully employed3. Thesocietyhasafixednumberofresources4. The society has a fixed level of technology
Constant Opportunity Cost PPC is a straight line
Marginal Rate of Transformation The marginal rate of transformation tells you how many more units of X you could produce if you produce one less unit of Y, i.e. the opportunity cost of producing one in terms of the other. If making one less Ferrari frees up enough resources to make five Toyota Prius, the rate of transformation is five to one at the margin. The rate of transformation may change as the number of units of X relative to Y changes, and the line plotting these values is called the transformation curve.SUPPLY
Marginal Rate of Substitution The marginal rate of substitution tells you how many units of X which a given consumer, or group of consumers, would consider to be compensation for one less unit of Y. For instance, a consumer who prefers Coca Cola may be equally happy if offered two cans of Pepsi instead. A line joining all points on a chart showing those quantities of X and Y considered by the consumer to provide equivalent utility is called an indifference curve.DEMAND
International Exchange Ratio The PPC indicated what a country can produce What a country will produce depends on the (relative) prices at the international market Relative prices: -> Expressed in goods (money is means of exchange) -> Relative price of clothing: amount of clothing which can be exchanged for 1 unit of food International exchange ratio must lie between the opportunity costs of both countries otherwise trade wouldn’t be beneficial ->Depends on preferences ->Where indifference curve touches the international exchange ratio curve at maximum utility ->Marginal rate of substitution (slope of the indifference curves) = slope of international exchange ratio
Lowest Opportunity Cost Country with the lowest opportunity cost will export
Isoquant Presents the various combination of factor inputs for a constant amount of output
Vector Ratio of factor input leading to highest iso-quant curve
Rybczynski Theorem If product prices and production technology are constant, then the output quantity of the product that uses the growing factor intensively will increase, while the output quantity of the other product must contract. The reason is that expanding production of the intensive good also requires some of the other factor.
Stolper-Samuelson Increase in welfare due to specialization Abundant factor used intensively in export sector will gain (labor) Scarce factor used intensively in the import-competing industry loses (land) Cheese and Wheat example
Economies of scale Economies of scale is the cost advantage that arises with increased output of a product. Economies of scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs are spread out over a larger number of goods. Economies of scale may also reduce variable costs per unit because of operational efficiencies and synergies. Economies of scale can be classified into two main types: Internal – arising from within the company; and External – arising from extraneous factors such as industry size.
External returns to scale External economies of scale: -> Specialized inputs (machinery) -> Common pool of skilled labor -> Spillover of knowledge -> Trade with decreasing opp. costs
Internal returns to scale Internal economies of scale: ->Factors explaining trade: -product ‘lifecycle’ (Vernon product cycle) -preference similarity hypothesis (product diversification)
Product Cycle of Vernon Productivity increases in the course of time Advantage in know how -> product cycle of Vernon (1966) › I Product development and sales in the home market › II Growth in exports as foreign demand is cultivated› III Decline in exports as production abroad begins to serve foreign markets› IV Home country becomes a net importer as foreign prices fallDescriptive theory: difficult to apply in a systematic way Short-run theory Competitive cost positions in Long Run determined by factor endowments (a quality or ability possessed – in other words a factor of production)
Preference Similarity Hypothesis › Staffan Burenstam Lindner (1961)› Most promising export markets found in countries whose income levels and tastes are comparable to those of the exporting country› Product differentiation: Polo, Yaris, 207 › Does not explain why products originate incountries or why firms entered the market› Markets must be large enough, however, to support the products
Microeconomic primer Marginal Product of Labour (MPL) › Marginal Product of Capital (MPK)› If I hire an additional worker, how much will he add to my production? => this is as much as I can pay him in wageMPL = ΔL /ΔY(output) MPK = ΔK /ΔY(output)› If wages / return on investment are higher abroad – factors of production will flow out of the economy› If wages / return on investment are higher domestically- factors of production will flow into the economy› If MPKDometic = MPKForeign -> no movement › If MPLDomestic = MPLForeign -> no movement
Capital mobility – basic model › Shows how factor mobility increases efficiency and total output› Shows who wins, who looses from factor movements› DOES NOT SHOW HOW TRADE IS AFFECTED› Suggests that investment flows are always going in the same direction => in reality this is not the case (explanation: diversification of portfolio risks)› Figure 8.1 discussed above suggests that migration causes the wage to fall in the country that initially has the higher wage and to rise in the country that initially has lower wages.› If migration reduces wages domestically => voters are not happy => restrict migration› More labour will lead to an increase in total domestic output in OECD countries but may reduce per GDP per capita (if the contribution of a migrant to GDP is less than the current average)› So empirically (and in reality) things are more complex of course
Income Elasticity of Demand § Defined as: Percentage change in demanded volume in response to percentage change in income› Increase in demand / increase in income› Needed in order to differentiate goods bydependency:§ Inferior good: negative income elasticity; increase inincome leads to a fall in demand§ Necessity good: income elasticity is between 0 and 1; increase in income leads to a rise in demand§ Luxury good: elasticity of demand is larger than 1; increase in income leads to a rise in demand› Economic growth can trigger changes in demand patterns for import and export (elasticities)› This can change the value of a country’s exports in terms of its imports (terms of trade)1. High income elasticity of demand:In this case increase in income is accompanied by relatively larger increase in quantity demanded.-> Income elasticity of demand > 1E.g.: 20% increase in quantity demanded due to 10% increase in income.2. Unitary income elasticity of demand:In this case increase in income is accompanied by same proportionate increase in quantity demanded. -> Income elasticity of demand = 1E.g.: 10% increase in quantity demanded due to 10% increase in income.3. Low income elasticity of demand:In this case proportionate increase in income is accompanied by less than increase in quantity demanded. -> Income elasticity of demand Income elasticity of demand = 0E.g.: No change in quantity demanded even with a 10% increase in income.5. Negative income elasticity of demand:In this case increase in income is accompanied by decrease in quantity demanded. -> Income elasticity of demand < 0E.g.: 5% decrease in quantity demanded due to 10% increase in income.
Terms of Trade › TOT = Price Exports / Price Imports› Describes what quantity of imports can be purchased through the sale of a fixed quantity of exports.› Graphic representation: flatter slope of the ‘barter line’› High income elasticity: more money => weimport more fancy stuff› How do we pay? => more exports› Large supply of export goods => fall in market price of exports (unit price of exports falls and terms of trade deteriorates)
Divide in Developing Countries › Divide:§ Countries that import manufactured goods and focus (still) on primary goods for export (‘least developed countries’)§ Countries that have focused on labour intensive manufactured goods (4 Asian Tigers and the NIC’s)NIC – newly industrialized countries
Prebisch-Singer Hypothesis Argues that the price of primary commodities declines relative to the price of manufactured goods over the long term, which causes the terms of trade of primary-product-based economies to deteriorate
Developing Countries Issues With Trade › Revenues from export (P×Q) of primary goods are strongly volatile (liable to change)› Standard of living cannot be stabilised:§ Prices are determined on very competitive auctionmarkets§ Price volatility results from:- Supply is inelastic / demand is inelastic§ Supplied volume is also volatile due to weather conditions, crop diseases, etc.Solutions: 1. › The ‘cynical’ reaction:§ Some poor countries withdrew themselves from world trade → autarky (economic independency) § They started producing goods they previouslyimported, with the goal of:- Becoming less reliant on volatile export revenues – Protecting infant industry (South Korea / Taiwan)§ Technique: trade barriers → import / export tariff- This policy can be useful, though only temporary, as countries should exploit their comparative advantages timely- Trade barriers might lead to unintended results → protection inefficiency: production of textile machines had a negative impact on textile trade in India- Solution: (local) free-trade zone2. › Developing countries that focused on the production of labour intensive manufactured goods (H-O!)› Four Tigers and the Newly Industrialized Countries› Governments support by supply of infrastructure and tax instruments› New problems: Import tariffs from rich countries for products from low wage countries?
Reasons to Implement Trade Barriers ›Protectionism to create employment (‘Beggar thy neighbour’)›Adverse effects on income distribution›Protection against low wage countries ›Lobbying in favour of government intervention by certain business sectors (quota for agriculture)›Large countries might gain a benefit from levying taxes (‘optimum tariff’, terms-of-trade gain)›Preventing dumping›’Infant industry’Temporary protection of production sectors that might exploit a comparative advantage in the future › Strategic considerations › Defence: protection of national security › Cultural or social motives › Fighting trade balance deficits
Trade Barriers 1. Tariffs: § Import tariff: compulsory tax at the border without something done in return-> Specific tariff (10 Euro per unit) -> Ad valorem (% on value)§ Export tariff: tax on exports2. Non-tariff trade barriers: § Quota: restriction on the product volume allowed to be imported during a period of time§ Export subsidy: government contribution to export§ Other: sanitary norms, customs regulations, etc.
Two Types of Economic/Welfare Analyses ›Partial equilibrium (PE): Single market›General equilibrium (GE): All markets ›Partial equilibrium is based on the ceterisparibus assumption (other things being equal) ›General equilibrium is often simplified to two markets›Partial equilibrium: Welfare gain/loss on one market›General equilibrium: Welfare gain/loss in entire economy›General equilibrium is generally preferred for the analysis of policy implications, but is often (too) difficult to apply›Frequently only a qualitative estimation of GEPartial EQ effects is presented
Imposing a Tariff
Preferential Trade Agreements (PTAs) Preferential treatment of bilateral trade between any two parties to the agreement relative to their trade with the rest of the world
Advantages of PTAs Economic: ->Neutralising beggar-thy-neighbour trade policies->Gaining credibility->Benefiting from lower average costs-> Improving access to investments and foreign technologyPolitical: -> Regional political integration: economic integration as a stepping-stone towards political integration? -> A lack of progress at the multilateral level? -> Others: to increase influence in international negotiations, counteracting the growth of other regional arrangements, and foreign policy considerations
Types of PTAs o Free Trade Areas o Customs Union o Common Market o Economic and Monetary Union (most extensive form of economic integration) • As you move down the list, the economic integration becomes more and more extensive
Free Trade Areas (FTAs) • Eliminate duties and other restrictive regulations of commerce with respect to trade in products originating in such territories. Example: NAFTA (Canada, US, Mexico) • No common outside tariff (when US, Mexico or Canada trade with certain countries, outside their agreement, they determine their own tariffs, there is no common external tariff – if countries are applying different tariffs, the state that is applying the lowest tariff is likely to be the entry point; so for example, Toyota would access the US market which has the lowest tariff and in that way it can reach Mexico and Canada) • Risk: imports flow through the country with the lowest tariff • Solution: certificate of origin
Customs Union • An FTA with common external commercial policy (abolish the internal tariff, and create a common external policy – they agree on one set of tariff) • Example: SACU (Southern African Customs Union: Botswana, Lesotho, Namibia, South Africa, and Swaziland)
Common Market • A Customs Union with freedom of movement for goods, services, and production factors (labor/capital) • Example: the EU
Economic and Monetary Union • The most far-reaching state of economic integration: • One market, one currency, one economic/fiscal and monetary policy, and one central bank • Member countries maintain sovereignty • Final outcome: political unionExample: none
Are PTAs welfare-enhancing? o Jacob Viner (1953) introduced the concepts of trade creation and trade diversion to evaluate the welfare effects of PTAs/ o Trade creation: elimination of restrictive regulations of commerce could lead to more trade between member countries o Trade diversion: discriminatory tariff cutting could also divert trade from (more efficient) non-member countries to (less efficient) member countries
From GATT 1947 to GATT 1994 The genesis of the GATT o 1944 (Bretton Woods): WB and IMF -> IMF: overseeing the global monitoring system – exchange years; WB: rebuilding Europe o 1946-1948 (London, New York, Geneva and Havana): the Havana Charter for an International Trade Organization o WB, IMF, and ITO: promote international economic cooperation in the post-war period o 6 Dec 1950: the ITO Charter fails in the US congress The GATT in the GATT era (1947-1994) • The GATT was negotiated in 1947 as a trade agreement to relax government-mandated trade restrictions • 1 Jan 1948: the GATT entered into force provisionally and independent of the ITO • Over the years, the GATT developed, through a learning by doing approach, institutional infrastructure • During the GATT era, the GATT served both as an agreement and as an institution The GATT rounds of trade liberalization • The GATT’s approach to trade liberalization: limiting states’ option to protecting domestic producers to tariffs only • How? -> By reducing tariff volatility (through tariff binding) and -> By reducing the general level of tariffs altogether (through successive multilateral negotiations) During the GATT years: there were eight rounds of negotiation – from Geneva (1947) to Uruguay (1986-1994)The Uruguay Round: most extensive and complex, led to the establishment of the WTO
WTO -> The WTO entered into force on 1 January 1995-> The GATT became a trade agreement under the institutional umbrella of the WTO – as originally envisaged-> “The WTO takes over the GATT institution and provides the necessary institutional coverage for the GATT agreement” (Mavroidis 2007: 26).The WTO Agreement-> Multilateral Trade Agreements (annexes 1-3): binding on all CONTRACTING PARTIES-> Plurilateral Trade Agreements (annex 4) binding on members that have accepted them-> The Doha round (since 2001): the first negotiation round since the WTO
Basic Principle of WTO Law Art. I GATT: Most Favored Nation treatment-> Any advantage, favor, privilege or immunity accorded to products of one country should be granted immediately and unconditionally to like products of Contracting Parties.-> Principle of non-discrimination: prohibits a country from discriminating between countries.Art. II GATT : Tariffs-> Tariffs are, by and large, the only permissible forms of protection -> To bind tariffs (laid down in Schedules of Concessions and annexed to GATT)-> To reduce tariffs (through successive negotiation rounds)Art. III GATT: National Treatment-> Principle of non-discrimination: prohibits a country from discriminating against other countries.-> Differences with MFN Treatment? MFN ensures equality of treatment for products at import/export; NT ensures equality of treatment on the (domestic) market place between like imported and domestic productsArt. XI GATT : Elimination of Quantitative Restrictions-> Quotas, import or export licenses, etc.-> Applies between contracting partiesArt. XX GATT: General exceptions-> An otherwise GATT inconsistent measure may be taken for achieving certain legitimate objectives.Art. XXIV GATT: Regional integration exceptions-> Allow formation of FTAs and CUs upon the fulfillment of certain conditions Generalized system of preferences/ Enabling clause-> Decision of CONTRACTING PARTIES (1979)-> Reduced tariffs for developing/least developed countriesDispute Settlement-> Bilateral consultation-> Dispute Settlement Body: Discharged by the General Council; Establishes panels, adopts panels and Appellate Body (AB) reports, and supervises implementation-> Panels: Assess facts/applicability + conformity with covered agreements.-> The Appellate Body: Reviews decisions of panel on issues of law-> Dispute Settlement Body: Positive consensus: no member present formally objects to the proposed decision (during the GATT era); Negative consensus: a decision is adopted unless otherwise decided by consensus-> Panel/AB recommendations: binding? Panel/AB recommendations, once adopted by the DSB, should be unconditionally accepted by the parties to the dispute.-> Enforcement?
History of Money -> Rich Romans: exchanged goods against gold –> Poor Romans: exchanged goods against salt-> 1609 Amsterdam (private) exchange bank: accepted gold/silver as colateral for credit-> Since 1648 the ‘Gulden’ was the sole legal tender->Gold standard: ca. 40% of the value of the coin was contained in gold• 1694 The Bank of England:- Issued bank notes that were `redeemable in Gold or Silvercoins’ → 1816: Dutch bank followed suit• Later:- People stopped to exchange their bills forgold/silver. So more money could be issued => now we have ‘fiat money’ (legal tender decreed by law, without an intrinsic value – fundamental value)
Measures of Money • 363 C -> Currency• 1148 M1 -> Sum of currency, demand deposits, traveler’s checks, and other checkable deposits• 3630 M2 -> Sum of M1 and overnight repurchase agreements, Eurodollars (6 months time deposits outside the US), money market deposit accounts, money market mutual fund shares, and savings and small time deposits• 4357 M3 -> Sum of M2 and large time deposits and term repurchase agreements• 5426 L -> Sum of M3 and savings bonds, short-term Treasury securities, and other liquid assets
Money Multiplier The money multiplier is defined as the reciprocal of the reserve ratio (1/RR) So if you invest the 10,000 euros into the bank and they save 1,000 euros then to find the money multiplier you would fill in the formula 1/RR which would be 1/0.1 = 10. Here the money multiplier would equal to 10.
Bank run When consumers all cash out their deposits at the same time
Ensure Stability with Money Multiplier The CB/ECB (central and European central bank) can restrict the amount of money that is being created by commercial banks by influencing the reserve ratio
Money Creation by the Government/European Central Bank • The ‘running of the printing press’ is done via non-cash deposits• Lending money from the CB (not allowed under EMU)• ECB buying government bonds (Jean- Claude Trichet bought Greek bonds …)• Mario Draghi gives money to Greek banks that do NOT have access to financial markets• These Greek banks give money to Greece that does not have access to financial markets
Players in monetary transactions • Central Bank (ECB in the Eurozone): determines monetary policy, offers credit to commercial banks• Commercial banks: lend money from the CBs, execute monetary transactions and services• Consumers: all clients of the bank
International Transactions • International transactions go via commercial banks• Commercial banks hold assets at foreign banks (or at their subsidiaries) in the form of:- foreign currency- foreign obligations→ Payment is then executedExample: • Dutch contractor sells a windmill to a city in the US for 10 million USD• The mayor pays the sum to a bank in N.Y. Since the Dutch contractor prefers Euros to Dollars, the money is being exchanged
Foreign Currency Demand Shift inDemand curve: -> Δ in income -> Δ in consumer tastes -> Δ in price of substitutes Supply curve: -> Δ in income -> Δ consumer tastes -> Δ in price of substitutes
Exchange rate Price of a foreign currency expressed in the domestic currencyDirect quotation: foreign currency for 1 Euro Indirect quotation: euros per unit of foreign currency Stable/predictable exchange rates are good for business + transactions
Exchange rate regimes • Fixed exchange rates- Currencies that entered the EMU – Currency pegs (Argentina) (A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency’s value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold)- Revaluation / Devaluation (Under a fixed exchange rate system, devaluation and revaluation are official changes in the value of a country’s currency relative to other currencies)• Flexible (or floating) exchange rates – Following demand and supply- Appreciation / Depreciation (Under a floating exchange rate system, market forces generate changes in the value of the currency, known as currency depreciation or appreciation)-Euro,Dollar,Yen-In this system, the country’s exchange rate is entirely determined by market forces, specifically the interaction of supply and demand on FOREX markets. The government does not intervene to affect the value of its currency.• Managed floating exchange rates- Appreciation / Depreciation within a bandwidth around a target rate (parity)- If the parity is altered we talk of revaluation and devaluation- In this system, the government sets a range of values (in terms of another currency) within which it will keep its currency’s exchange rate. For example, it might decide to keep its currency worth between $1.20 and $1.80. To keep the exchange rate within this range, it may have to occasionally intervene on FOREX markets
Balance of Payments and Exchange Rates • BoP -> The balance of payments is the sum total of all international economic activity flowing into and out of a country in a given time period, usually one year• Trade balance deficits are financed via opposite bookings on the financial account• => Changes in the trade balance impact demand and supply of foreign currency
Central Bank Assets • Under fixed exchange rate regimes CB’s interventions become predictable• If CB’s reserves are depleated => exchange rate will adjust according to market forces…• CB has substantial assets- Bank notes, deposits at banks etc.• CB can intervene quickly on the money market • CB also can use its official reserves• Problem: if CB intervenesto stabilize the exchange rate, domestic money supply can be affected => CB can take measures to keep money supply constant (sterilization)
Liability In financial accounting, a liability is defined as the future sacrifices of economic benefits that the entity is obliged to make to other entities as a result of past transactions or other past events,[1] the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future
Trade Balance in small open economy and fixed exchange rates • Nationalsaving(SN)-Investment(I)=TB• Exports(X)-Imports(M)=TB
Small open economy and fixed exchange rates Expansionary fiscal policy: Asgovt.spendsmore(G↑),government savings go down ((T-G) ↓) => national savings ↓=> (SN-I) ↓ => Trade deficit (more imports) and SN-I shifts to the rightIncome rises => more people want to buy => increase in money demand => increase in interest rate => Investment ↓ (Crowding out) => Y contracts! SN-I shifts to the left but less Expansionary monetary policy: Expansionarymonetarypolicy=>lowerstheinterest rate => Investment ↑ => (SN-I)↓ shifts to the rightDevaluation=>imprortsaremoreexpensive (M ↓), export are getting cheaper (X ↑) => X- M shifts rightExternal shock: World recession => Exports fall (X↓)=> trade balance deficit = X-M line shifts left (X’-M)=> trade deficit leads to depreciation since no one needs our money to buy our goods => depreciation makes our goods cheaper, imports more expensive => eventually foreigners will want to buy our goods again => X-M shifts back to normal (X”-M”)Expansionary monetary policy: As govt. spends more (G ↑), government savings go down ((T-G) ↓) => national savings ↓=> (SN-I) ↓ => Trade deficit (more imports) and SN-I shifts to the right… trade deficit leads to depreciation since no one needs our money to buy our goods => depreciation makes our goods cheaper, imports more expensive => eventually foreigners will want to buy our goods again => X-M shifts right (X’-M’)Expansionary monetary policy: Expansionary monetary policy => lowers the interest rate => Investment ↑ => (SN-I)↓ => SN-I shifts to the right (SN-I’)… trade deficit leads to depreciation since no one needs our money to buy our goods => depreciation makes our goods cheaper, imports more expensive => eventually foreigners will want to buy our goods again => X-M shifts right (X’-M’)
Balance of Payments › BoP: a set of accounts that summarizes the transactions between residents of aneconomy with the rest of the world for a given period of time (a year)› Any transaction resulting in:§ a payment to foreigners is entered as a debit and is given a negative (-) sign. (Eg. Imports)§ a receipt from foreigners is entered as a credit and takes a positive (+) sign. (Eg. Exports) Composed of: ->Current Account->Capital Account ->Financial Account ->Statistical Discrepancy
Current Account 1. Goods Balance (GB)-> refers to trade in goods that cross a border (equivalent to net flow of goods)• Net export (more money flows in than out): surplus• Net import (more money flows out than in): deficit2. Services Balance (SB):-> conceptually analogous to export and import of goods.-> services (financial/legal) that are tradable across countries3. Net Income Receipts-> Sum of a country’s income receipts (profits, dividends, interest) from assets it owns abroad AND income payments on foreign-owned assets in the country.-> Inflow (+) (money flows in); Outflow (-) (money flows out) 4. Unilateral current transfers-> One-sided transactions.-> Private (e.g. wages by migrant workers) and public transfers (e.g. government aid).-> Inflow (+) (money flows in); Outflow (-) (money flows out)
Financial Account 1. Foreign Direct Investments-> long-term financial investments abroad characterized bylarge ownership stakes (often over 10 per cent)-> Home invests abroad (-) (money flows out) -> Abroad invests in Home (+) (money flows in)2. Portfolio Investments-> Investment in (more) liquid assets: stocks, bonds-> Residents invest abroad (-) (money flows out)-> Foreigners invest in home (+) (money flows in)3. Official Reserve Transactions-> Tracks the international (currency) dealings of a country’s Central Bank-> CB’s assets: domestic currency, foreign currency holdings, deposits abroad, gold-> Home CB invests abroad (-) (money flows out)-> Foreign CBs invest in Home (+) (money flows in)
Capital Account › records capital transfers and the buying and selling of non-produced and non-financial assets› negligiblein size› E.g. transfer of ownership in natural resources, intellectual property rights, franchises and leases› Imports (-) (money flows out)› Export (+) (money flows in)
Satisfactory Discrepancy › In theory, CA+KA+FA=0;› Inpractice,no!› Small differences, mistakes and errors (smuggling, drugs trade,underreporting abroad (tax fraud) etc.)› SD =- (CA+KA+FA)› Can a country have adeficit/surplus in its balance of payments?
Advantages of BoP › A BoP tells:§ if a country is net importer/exporter of goods, services and investment§ how imports are financed§ where residents are investing§ the international competitiveness of a country› International investment position (IIP) of a country: a measure of what (foreignassets) a country owns in relation to what it owes (to non-residents) => net foreign wealth› The current account balance shows the size and directionof international borrowing:§ The financial accountrepresents (moreor less)themirror imageofthe current account.§ Acountry running current account deficit should offset the deficit byborrowing a sum equivalent to the deficit (Net Imports ↑ / Net foreign assets ↓)§ Similarly, a country with acurrent account surplus can lend to those countries with deficit (Net imports ↓ / Net foreignassets ↑)› Changes in the BoP components trigger changes in exchange rates› Transactions in the BoPcan indicate changes in the supply/demand forforeign currency=>exchangerate› Example: atrade balance deficit may lower the price of the country’s currency
Balance Deficit › Deficit: is it a problem?§ It can indicate that the domestic economy isgrowing stronger than other countries§ It can also indicate that residents consume lots of foreign products§ The mirror image must be a strong financial account of comparable magnitude§ It comes at a cost: interest and dividend payments, decreasing of official reserves› Deficit: solution?§ Make it less attractivefor citizens to consume foreign goods§ Devalue currency to stimulate exports • Increase money supply• Lower interest rates§ Increase competitiveness ofthe economy • Lower(real)wages

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