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Components and the Balance of Payment

Components and the Balance of Payment (Con't). Capital Account (KA) is the part of the BOP that records capital flows, which consist of purchases and sales of foreign assets by domestic citizens, and purchases and sales of domestic assets by foreign citizens.Official Reserve Account (R) measures th

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Components and the Balance of Payment

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    2. Components and the Balance of Payment Balance of Payment (BOP) is an account showing the receipts from, and payments to, foreign countries. Current Account (CA) is the part of the BOP that includes exports, imports, investment income and unilateral transfer payments to and from foreigners.

    3. Components and the Balance of Payment (Con’t) Capital Account (KA) is the part of the BOP that records capital flows, which consist of purchases and sales of foreign assets by domestic citizens, and purchases and sales of domestic assets by foreign citizens. Official Reserve Account (R) measures the change in a country’s official reverse assets and the change in foreign official assets in that country.

    4. Credit Items VS Debt Items in BOP Credit item is any item that gives to a sale of foreign currency and a purchase of domestic currency to settle for the payment. Debit item is any item that gives to a sale of domestic currency and a purchase of foreign currency to settle for the payment.

    5. Double-Entry Bookkeeping It refers to the practice of recording an offsetting debit or credit in the BOP for every credit or debit transaction entered. Through this technique, the BOP must always in balance. Once we talk about a BOP surplus or deficit, we are referring to the Current plus Capital Accounts only.

    12. Net International Investment Position It is the difference between all foreign assets owned by domestic citizens and domestic assets owned by foreign citizens It depends on the Current Account balance position. If CA is in deficit, it must be financed by Capital Account surplus which implies that the net international investment position is negative, vice versa.

    13. How to Draw BOP Curve? The BP curve shows the combinations of r and Y that will yield equilibrium in the BOP. If Y increases, imports increases which worsens the Current Account. To make BOP to attain new equilibrium, r need to increase to induce capital inflow and reduce capital outflow so as to offset the worsening of the Current Account.Therefore, BP curve slope upward.

    14. How to Draw BOP Curve? (Con’t) However, if tiny adjustment in r can offset the worsening Current Account caused by changing Y (i.e. perfect capital mobility), BP curve tends to be horizontal. Or, if infinitive adjustment in r cannot offset the worsening Current Account caused by changing Y (i.e. perfect capital immobility), BP curve tends to be vertical.

    16. Exchange Rates The foreign exchange rate (e) is the amount of domestic currency for purchasing one unit of foreign currency.

    21. Exchange Rate and BOP The demand for and the supply of foreign currency will determine the exchange rate. The demand for and the supply of foreign currency arises primarily from international BOP. The demand for (supply of ) foreign currency arises due to import (export) of goods and services, and make (receive) foreign investments.

    22. Exchange Rate Determination: Floating Exchange Rate System

    24. Floating Exchange Rate System: Appreciation

    26. Factors Affecting the Exchange Rate

    27. Purchasing-Power-Parity Theory (PPPT) The PPPT holds that the exchange rate between any two national currencies adjusts to reflect differences in the prices levels (or inflation rate) in the two countries. For example, if country A has a faster rate of inflation than country B, then country A’s exchange rate must be depreciating.

    28. Reasons for the failure of PPPT Absence of free trade Presence of non-tradable product Presence of different price indices (i.e. different basket of goods for price indices) Presence of transaction costs Other factors: government tax or subsidies, different profit margin set by firms, etc.

    29. Floating Exchange Rate and BOP

    32. Exchange Rate Determination: Fixed Exchange Rate System The fixed exchange rate system is the system that the exchange rate is set by a government or by the agreement among countries. Revaluation means that the value of a currency relative to one or more other currencies is raised by the monetary authorities. Devaluation means that the value of a currency relative to one or more other currencies is lowered by the monetary authorities.

    34. Fixed Exchange Rate and BOP The BOP surplus of a country is the amount by which the quantity supplied of foreign currency exceeds its quantity demanded at the fixed rate. The BOP deficit of a country is the amount by which the quantity demanded of foreign currency exceeds its quantity supplied at the fixed rate.

    37. Measures to Maintain Fixed Exchange Rate?

    39. IS-LM-BP Model The IS curve shows the combinations of r and Y which are points of equilibrium for the goods market. The LM curve shows the combinations of r and Y which are points of equilibrium for the money market. The BP curve shows the combinations of r and Y that will yield equilibrium in the BOP.

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