4.5.1 Current Account

• External equilibrium is concerned with the Balance of Payments: An account of the transactions between domestic and foreign economies.
• The current account includes the trade account which records the goods and services imported and exported from the home country.
  • A deficit on the trade account means that imports are larger than exports.
• Those items which lead to Europeans receiving money from abroad are counted as positive items in the balance of payments.
  • A more technical definition: those items which lead to more Euros being purchased are counted as a positive item on the Balance of Payments.
• The current account:
  • Records all international transactions involving goods and services.

The Balance of Trade

• Merchandise account: also called the visible account in Britain, which records all transactions involving goods.
• The Traded Service account which records all transactions involving services.
• The Capital Servicing account:
  • Includes the interest, profits and dividends paid to and by foreigners.
  • For developing countries, this section is usually negative. More is paid out to foreign investors than is received as interest and dividends.
  • For industrialized countries like the US and Japan, this account is typically positive because of the large amount earned on foreign investments.

Invisible Balance

• Consists of the Capital Servicing account plus the Traded Services account.

4.5.2 Capital Account

• The capital account records financial transactions involving short term and long term capital movements into and out of the country.
• When financial capital flows into a country, that country is exporting a security to the foreigner.
  • The security can consist of a money market instrument, a bond, a stock or a joint venture agreement or some kind of contractual arrangement.
  • When those securities are exported, financial capital flows into the domestic economy and counts as a plus in the Balance of payments.

• Capital account: if the Japanese invest in US treasury bills, it is the US that gets the money, and the Japanese that get the TB's.
  • It counts as negative on the Japanese balance of payments (and their GDP).

This is how the balance of payments is always balanced: if there are negatives on the current account, they must be balanced by a plus on the capital account.

• Short term capital is held mainly in money market instruments such as treasury bills or bank accounts (portfolio as opposed to direct investment).
• Long term capital movements:
  • Portfolio: generally involve the purchase of stocks or bonds.
  • Direct: investments in capital in the country or joint venture agreements.

• As an alternative to short term and long term, the Capital account is divided by:
  • Direct investments: which includes direct investment in a branch plant or a subsidiary for a large multinational company or a joint venture agreement
  • Portfolio investments: which includes transactions involving securities such as money market instruments or stocks and bonds.

Official Reserves

• If we include official reserves, the balance of payments is always in balance.
• One of the easiest ways to think about it is to ask who gets the money.
  • Current account: if Japan imports apples from China, the Chinese get the money, the Japanese get the apples. It counts as a minus in the Japanese balance of payments (and for the GDP).
  • If the Chinese buy cars from Japan, the Chinese get the cars and the Japanese get the money: a plus on Japan’s balance of payments.
  • For services: if the Japanese go skiing in Switzerland, the Swiss get the money, and the Japanese get the tourism experience. It enters as a negative on the Japanese balance of payments.

• Factors influencing the balance of payments include:
• Income: as national income rises the demand for imports rise shifting the current account toward a deficit.
  • Changes in relative prices: as domestic prices rise relative to foreign prices, imports appear cheaper and exports more expensive and the current account will move toward a deficit.
  • Changes in relative investment prospects: as return on investment rises, foreign capital will be attracted into the country and the capital account will move toward a surplus.
  • Changes in relative interest rates: as domestic interest rates rise, short term capital is attracted moving the capital account toward a surplus.

• If the foreign exchange rate is rising (domestic currency appreciating), the central bank may intervene by selling more domestic currency.
• If the foreign exchange rate is falling (domestic currency is depreciating), the central bank may intervene by buying domestic currency with the reserve of foreign currency.