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Unformatted text preview: ProfM.’s Simple Rules for
Balancing the Balancing of Payments. 1. Some so-called “experts” will tell you the Balance of Payments has to balance because it
involves double entry book-keeping. Fortunately for you, this is baloney. You don’t have
to know any accounting or double entry book-keeping to work out how the B of P balances.
The fact that the B ofP has to balance is due to an economic constraint not due to the
mysteries of accounting. The simple fact is, if you, I, or the government want to buy
somethingfrom a foreigner, we need foreign currency. Conversely if foreigners want to
buy from you, I or the government they need dollars. And you.' I, and the government face
a simple budget constraint. We cannot buy foreign goods, give. or lend to foreigners,
unless we earn foreign currency, borrow it, or have it given to us. And we can’t spend more
than our earnings. borrowings and gifts. Putting that in a simple identity [more identig'j:
£(Our export earnings +foreigners gifts to us+our borrowings from foreigners)EZ(Our
spending on imports+our gifts to foreigners + our lendings to foreigners).
That is the balance of payments in a nutshell, and why the balance has to balance.
Basically to do foreign trade, we need foreign currency. And that constrains our total
spending for goods, services produced by foreigners.
2. People very early on looking at the B ofP came to see that it makes sense to divide it
into two. All transactions involving lending or borrowing, let’s put in a Capital Account.
All others, let‘s put in a Current Account. It is easy to distinguish between the two
Accounts. Any transaction involving the movement of an I.O.U. , as Paul Samuelson
simpliﬁed for us, we put in the Capital Account. All others go in the Current Account.
iAn I.O.U. is a certiﬁcate of indebtedness. You and I borrow from a Japanese bank, then
we export an 1.0.1}. to Japan]
3. When people set up the two] accounts, another fundamental but subsidiary identity
became obvious: the Current Account Balanceztthe Capital Account Balance 5 0. Lets do
this in gold as that how it happened early on in world trade. Suppose Americans sells
things worth $100 abroad. They get $100 in gold. Suppose they import $50. They, in other
words, use up $50 in gold. That must mean on net that America has imported $50 in
gold. So the export surplus of $50 on Current Account exactly equals the $50 on gold
inﬂow. $50-$50=0. The Current Account Balance: the Capital Account Balance 5 0.
Lets do this in the modern world. Suppose foreigners have only earned $50 in American
currency. But they want $100 to buy imports. Where did the other $50 come from?
Americans simply lent the dollars to foreigners. And imported an 1.0.U. See, you can’t buy
American goods unless, ultimately, you pay in dollars. Do not proceed any further until
you see the logic of the two identities: the fundamental budget constraint and the
subsidiary, internal balance, constraint.
4. Let’s spell it out a bit more formally now. A Balance of Payments consists ofthree
vertical columns [for convenience lets name them A, B, C from left to right]. EA entries -
EB entries 5 0. Hence EC entries 5 0. The rows of the B of? are divided into two parts.
The top rows are the Current Account. The bottom rows are the Capital Account.
The Current Account Balance : The Capital Account Balance E 0. [IMPORTANT
OBSERVATION: THE FACT THAT THE BALANCE OF PAYMENTS SUMS TO
ZERO, HAS NO, REPEAT, NO ECONOMIC SIGNIFICANCE WHATSOEVER!!!
WHAT IS IMPORTANT IS THE CURRENT ACCOUNT BALANCE OR THE CAPITAL
ACCOUNT BALANCE WHICH IS JUST THE SAME AMOUNT AS THE CURRENT ACCOUNT BALANCE BUT OF OPPOSITE SIGN}. 5. Now your-job on the homework and on the midterm wiii be to take a list of items ant;-
assemble them in a balance. Follow these rules.
5a. lfa transaction involves the import or export of an iOU. it goes in the capital balance.
Export ofIOUs [our borrowings] go in column A. Import of IOUs [our lendingsgo in
513. All other transactions go in the Current Account.
5c. The moment you have the Current Account balance, you know the Capital Account
balance. It will be of identical value but of opposite sign.
5. Some items in the Current Account, after you know the rules above, may still seem
mysterious. GIFTS. How about gifts of individuals or of governments? Well these don’t
involve flows of IOUs so they must go in the Current Account. But do they go in Column A
or Column 3?. To sort out puzzles always look at the ﬂow of the commodity or service.
ifa commodity or service leaves America, it is an export. But if you give $100 to a friend iln
Costa Rica that is money leaving the US, not a commodity or service. So it can’t be an export. It is an import then. Think of yourself as importing some gratitude or friendship
for the 5100. If the US government sends dollars abroad that is like an import too. Think
of the US government as importing “inﬂuence” or “permission” [like the right to ﬂy over
Turkey]. TOURISM. What happens if someone from Upper Volta goes to Disneyland?
That is an export, isn’t it. We get Upper Voltese currency. Disney has exported the services
of Disneyland. If you go to London to see the Marble Arch, you are importing a view of the
Marble Arch. INVESTMENT INCOME. Lucky you have stock in Lloyds of London and
just got a fat dividend check. That’s a current payment as no IOU ﬂow is involved. What
is it? Export or import? You’ve got pounds. 50 it isjust like an export. You certainly will
have exported your thanks to Lloyds if you want to think of it that way.
7’. One puzzle in the statistics we get on foreign trade is that some ﬁgures are “net” and
some are “gross.” Grossﬁgures we appropriately enter in Column A or Column B
depending on their sign and we net them out in Column C. Here is an example from 1990: l m Merchandise 498,337gross 389,307-498,337:
-109,030net Nezﬁgures are also entered in Column A if plus and Column B if minus. And they
reappear in Column C with the same sign. You don’t, obviously, have to net out. But with
net ﬁgures you are not getting the full information. Here is an example: Column A Column B Column C
L’S Net Military Services, millions , ne — , net The real situation could be somethin like:
I 5,000gross 12,599gross -7,599net I Note. All Column C entries are net entries. With some Column C nets we can get back to
gross entries. With some we cannot. In other words, sometimes the B ofP does not give us
enOugh information to ﬁnd the gross data. . [Advanced question: Does the Balance of
Payments give a correct representation of total ﬂows? Obviously not. So why do statistical; agencies sometimes use Net ﬁgures in columns A and B?] ‘ twp51\econ I 07\demystifyingBOP.wpd ...
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