Balance of payment : Book Keeping

The balance of payment is essentially an application of double entry book

keeping, since it records both transactions and the money flow associated with

those transactions.

Balance of payment

Definition: balance of payment is a systematic record of all transactions between the residents of the country and the rest of the world during a given period.

Current Account: Transfer of real income.

Capital Account: Transfer of funds without effecting a shift in real income.

CURRENT ACCOUNTExport and import of services, income on investments and unilateral

payments (gifts, remittances for family maintenance etc.)

a) Current Account Receipts: Export of goods Invisibles: Services, unilateral transfers, investment income Non-Monetary movement of gold.

b) Current Account Payments: Import of goods Invisibles: Services, unilateral transfers, investment income Non-Monetary movement of gold.

Current account surplus = X-M (Export-Import)

CAPITAL ACCOUNT

a) Capital Account Receipts: Long term inflow of funds Short term inflow of funds

b) Capital Account Payments : Long term outflow of funds Short term outflow of funds

Balance of Trade

Favorable balance of trade(surplus)= export > import

Unfavorable balance of trade (deficit) = import > export

The basic balance Defined as the sum of the current account balance and the net balance

account on long term capital, which were then seen as the most stable elements in the balance of payments.

This is one of the indicators of the economy’s position of the country.

OFFICIAL SETTLEMENT CONCEPT

The official settlement concept is to settle the balance of payment.

1) If the net transfer is negative, i.e. there is an outflow, then the balance of payment is deficit then the monetary authorities may finance a deficit by depleting their reserves of foreign currencies, by borrowing from the IMF, or by borrowing from monetary authorities.

The External Wealth Account

The external wealth accounts of a country shows the stocks of these assets and liabilities, recorded usually in the end of the calendar year.

Assets: BOP reflect changes in the foreign assets held by the country (claims on foreigners)

Liabilities: BOP reflect changes in domestic assets held by foreign investors (i.e. liabilities to foreigners)

Stock Theory of the Capital Account

This theory is based on how rational individuals would distribute their wealth between different assets in order to maximize their utility.

Asset holders are depended on1) Expected return to an asset2) Uncertainty of the actual return

Expected Return of an asset depends on,1) Interest Rate2) Expected profit

RATE OF INTEREST AND INVESTMENT DEMAND

INVESTMENT DEMAND CURVE• I curve is MEC• I1,i2,i3 = rate of

interest• So, when i1 is rate of

interest, Ia is Investment

• When it falls to i3, investment increases to Ic.

INVESTMENT

I

MEC

& R

ATE O

F IN

TEREST

Ia Ib Ic

i1

i2

i3

o

RATE OF INTEREST AND INVESTMENT DEMAND

• Investment demand curve shifts when the marginal efficiency of capital or profit expectations differ.

SHIFTS IN INVESTMENT DEMAND CURVE

INVESTMENT

RA

TE OF IN

TEREST &

M

EC

O I’’ I I’

I’’

II’

r

Optimum Portfolio Stock ModelsSuppose, two interest bearing assets are available for investors, each with

same expected yield a1=a2=a but with different yield variances.Assumptions: a1 is less risky than a2 and the correlation between the yields

offered by the two assets is p. Let the proportion of wealth of investor holds in a1 is¶ and his total wealth is 1.Since, the two assets have the same expected yield, the investor will enjoy that

expected yield no matter what the value of ¶

Assumption : p is negatively correlated then the gain from diversifying the portfolio is greater. In this case he would hold the combination of assets rather than money, which has zero yield.

Assumption: p is positive then the gain in risk reduction from diversification is reduced. The investor will choose to put all his wealth in the low risk asset, if the correlation between the two yields of the two assets is greater than 4times.

IS-LM CURVE

INCOME/GDP

INTEREST RATE

•LM- IS THE LIQUIDITY PREFERENCE CURVE

includes-transaction money, precautionary and speculative money

the independent variable is income and the dependent variable is the interest rate

•IS curve-Investment supply curve

Depends on, independent variable is the interest rate and the dependent variable is the level of income

Mundell-Fleming Model (ISLM-BP Model) The Balance of Payments

• Policy Analysis with Partial Capital Mobility• Currency Crises• International Capital Flows &

Indebtedness

Policy Analysis with the BP Curve

The intersection of the IS-LM curves• establishes internal equilibrium.• The BP curve establishes external

equilibrium.If joint internal and external equilibrium doesnot exist, then either:• The currency must appreciate or

depreciate, or• The central bank must intervene to

stabilize the

The slope of the BP line indicates the

Degree of capital mobility in a country• Horizontal: perfect capital mobility Domestic Rate of Interest = World R• Vertical: complete capital immobility Domestic R completely independent of

world R• Upward sloping: partial capital mobilityDomestic R differs from the world R

Policy Analysis withPerfect Capital Mobility

• Expansionary fiscal policy, fixed exchange rates• IS curve shifts right, Y and R increase.• Higher R increases foreign capital inflow.• Creates BP surplus and upward pressure on currency.• Central bank intervenes in the foreign exchange market.• Buys excess foreign currency.• Increases foreign exchange reserves.• Sells domestic currency.• Increases the domestic money supply.• That is, non-sterilized intervention.• LM curve shifts right, Y increases, R decreases to its original level.• Result is much higher Y and constant R.

Mundell-Fleming Model (ISLM-BP Model)Perfect capital mobility

National Income

RateOfINTEREST

An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal

Mundell-Fleming Model (ISLM-BP Model)complete capital immobility

RATE OF IN

TEREST & MEC

OY’’ Y’

BP’’BP’

LM’’

IS’’

IS’

LM’

National Income

In case of monetary expansion, LM’’ SHIFT TO LM’ then new equilibrium will form at intersection of LM’ and IS’’.Then BOP deficit, hence IS’’ shifts to IS’With floating exchange rate, both IS and BP will shift to the right.Hence new equilibrium at E2 and rate ofInterest also falls.The level of output increases to Y’E2

E1

Policy Analysis withPartial Capital Mobility

• Expansionary fiscal policy, fixed exchange rates• IS curve shifts right, Y and R increase.• Higher R increases foreign capital inflow.• Creates BP surplus and upward pressure on currency.• Central bank intervenes in the foreign exchange market.• Buys excess foreign currency.• Increases foreign exchange reserves.• Sells domestic currency.• Increases the domestic money supply.• That is, non-sterilized intervention.• LM curve shifts right, Y increases, R decreases to its original level.• Result is higher Y and R.

Mundell-Fleming Model (ISLM-BP Model)Partial capital mobility

RATE OF IN

TEREST & MEC

OY

BP

IS LM

National Income

E

Determination of Exchange Rate

PPP- Purchasing Power Parity.ER = Er x Pd/Pf,

Where, ER= equilibrium exchange rate Er= exchange rate in the reference period.Pd= domestic price indexPf= foreign country’s price index.

Determination of exchange rateInternational Fisher effect (IFE) The country with higher nominal interest rate should

have higher inflation and hence that country’s currency will weaken in future.

Nominal interest rate= real interest rate + inflation

Dornbusch Sticky Price

• Dornbusch model is a an hybrid: short-run features as the Mundell-Fleming model and long-run features as in the Monetary Model.

• Sticky price model: prices are fixed in the short run and they adjust slowly towards the long run equilibrium