The Balance of Payment

The Internationalization of Indian

Economy (Rupees Billion)
The Internationalization of Indian
Economy (US $ million)
Open-Economy Macroeconomics:
Basic Concepts
Open and Closed Economies
A closed economy is one that does not interact with other
economies in the world.
 There are no exports, no imports, and no capital flows.
An open economy is one that interacts freely with other
economies around the world.
Open-Economy Macroeconomics:
Basic Concepts
An Open Economy
An open economy interacts with other
countries in two ways.
It buys and sells goods and services in world
product markets.
It buys and sells capital assets in world
financial markets.
THE INTERNATIONAL FLOW OF
GOODS AND CAPITAL
An Open Economy
The United States and India are very large
and open economy—it imports and
exports huge quantities of goods and
services.
Over the past four decades, international
trade and finance have become
increasingly important.
The Flow of Goods: Exports, Imports, Net
Exports
Exports are goods and services
that are produced domestically and
sold abroad.
Imports are goods and services
that are produced abroad and sold
domestically.
The Flow of Goods: Exports, Imports, Net
Exports
Net exports (NX) are the
value of a nation’s exports
minus the value of its
imports.
Net exports are also called
the trade balance.
 The Flow of Goods: Exports, Imports, Net
A trade deficit is a situation in which net
Exports
exports (NX) are negative.
Imports > Exports
A trade surplus is a situation in which net
exports (NX) are positive.
Exports > Imports
Balanced trade refers to when net exports are
zero—exports and imports are exactly equal.
The Flow of Goods: Exports, Imports, Net
Exports
Factors That Affect Net Exports
The tastes of consumers for domestic
and foreign goods.
The prices of goods at home and
abroad.
The exchange rates at which people
can use domestic currency to buy
foreign currencies.
The Flow of Goods: Exports, Imports, Net
Exports
Factors That Affect Net Exports
The incomes of consumers at
home and abroad.
The costs of transporting goods
from country to country.
The policies of the government
toward international trade.
 The Balance of Payments
Balance of Payments (BOP): The balance of
payments is an accounting listing (tabulation)
of the values of economic (trade and financial)
transactions between the residents of a (home)
country and residents of other countries.
The balance of payments is the record of a
country’s transactions in goods, services, and
assets with the rest of the world; also the
record of a country’s sources (supply) and uses
(demand) of foreign exchange.
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For example…
BOP transactions (US side)

TATA -India purchases manufacturer in Chicago.

Toyota-India pays dividends to parent in Japan.

An American tourist purchases a necklace in India.

A Indian CitizenUS bond via investment broker in

Cleveland.

Rule of thumb: “follow the cash flow”

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BOP data may be important
Indicates pressure on exchange
rate
May signal imposition/ removal
of controls over payments,
dividends, interest.
Helps forecast country’s market
potential
B of P
A. Current Account
A. Net exports/imports goods&services (Balance of Trade)
B. Net Income (investment income from direct portfolio investment plus employee
compensation
C. Net transfers (sums sent home by migrant abroad)

B. Capital Account
Capital transfers related to purchase and sale of fixed assets such as real estate

C. Financial Account
A. Net foreign direct investment Basic Balance = A+B+C
B. Net portfolio investment
C. Other financial items

D. Net Errors and Omissions

Missing data such as illegal transfers

E. Reserves and Related Items

Changes in official monetary reserves including gold and foreign exchange reserves
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Σ (A:E) = Overall Balance
 The Current Account
 Goods Trade or Balance of Trade (BOT) – export/import
of goods.
 Services Trade – export/import of services (financial,
construction, and tourism).
 Income – predominately current income associated with
investments made in previous periods, + wages & salaries
paid to non-resident workers.
 Current Transfers – financial settlements due to change in
ownership of real resources or financial items. Any
transfer b/n countries which is one-way, a gift or a grant.
 CA typically dominated by export/import of goods, for this
reason Balance of Trade (BOT) is widely quoted.

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For example…
•Trade balance
•Debit: IIT KGP buys LCDs from Hong Kong.
•Credit: Singapore Airlines buys TATA buses.
•Trade in services
•Debit: Indian rents an apartment in Singapore.
•Credit: Malaysia- tourism places an ad in the DD1.
•Income payments
•Debit: Honda India pays dividend to Honda Japan.
•Credit: Bank America pays salary to Indian in New Delhi office.
•Unilateral Current Transactions
•Debit: India pays rehabilitation relief to Cogno.
•Credit: USA humanitarian grant to India for foold in
Uttrakhand.

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National Income Account and BOP
Y = C + I + G + CA
Y = GDP
C = consumption
G = government spending
CA = current account balance

This is called National Income Identity

Current Account
CA = X – M = net export of goods and
services
X = export; M = import
 Strictly speaking CA = X – M +UT but, for a while,
we ignore UT = unilateral transfer
In a closed economy, we do not have CA. (because X
= M = 0)
National Income Account
Consumption
= spending by households, including consumer
spending on durable goods
Investment
= Business sector’s adding to the physical stock of
capital, including inventories. (individual
household’s purchases of stocks, bonds or real
estates are not included)
Government purchases
= spending by federal, state, or local governments
Current account balance
(Domestic spending on goods and services produced
domestically)
=C+I+G–M
(Foreign spending on goods and services produced
domestically)
=X
Current account balance (cont’d)
CA = X – M
When X > M or CA > 0, we say current account
surplus.
When X < M or CA < 0, we say current account
deficit.
CA = Y – (C + I + G) = Y – A
where A = domestic absorption
Current account balance (cont’d)
 A country with current account deficit is buying
more from foreigners than it sells to them

It has to increase net foreign debts.

CA = net foreign wealth
Saving and Investment
Let S = national saving = Y – C – G.
Then
S = I + CA
(In a closed economy S = I)
where
I = domestic investment = capital stock accumulation
CA = foreign wealth acquisition = net foreign
investment
An open economy can increase investment by
borrowing abroad.
Saving
S = SP + SG
where SP = Yd – C = Y – T – C
SG = T – G
SP = private saving; SG = government saving;
Yd = disposable income; T = net tax.
Then SP = (C + I + G + CA) – T – C
= I + CA + (G - T)
where G – T = government budget deficit.
So CA = SP – I – (G – T)
A large gov’t budget deficit leads to a large current
account deficit.
Balance of Payment Accounts
Double-entry bookkeeping
each entry is recorded twice.
A debit entry  a payment to foreigners
A credit entry  a receipt from foreigners
Current Account (CA)
the record of commodity and services transaction
A. Exports (credit)
B. Imports (debit)
1. Merchandise: commodity transaction
2. Services: travel, tourism, royalties, transportation
costs, insurance premiums.
3. Income
 Income receipts on Indian assets abroad (credit)
 Income payments on foreign assets in India S (debit)
 Direct investment receipts and payments
 Interest, dividends.
Current Account (cont’d)
C. Unilateral Transfers (debit)
US foreign aid, gifts, retirement pensions, interest
payments to foreigners on their US gov’t debt, workers’
remittances.
CA > 0: current account surplus
 the country is a net lender to the rest of world
CA < 0: current account deficit
 the country is a net borrower from the rest of
world
Capital Account (KA)
the record of financial assets transaction
A. Indian assets abroad
1. Indian official reserve assets (Gold, SDR, reserve in
IMF, foreign currencies)
2. India gov’t assets
3.Indian private assets (direct investment, foreign
securities)
B. Foreign assets in India
1. Foreign official assets in India (Indian gov’t securities,
…)
2. Other foreign assets in India (direct investment, US
treasury securities)
Statistical Discrepancy
Theoretically, current account and capital account
should add up to zero. But in reality, there is a
discrepancy due to errors, time lags, and so on.
Official Reserve Assets
Official reserve assets:
purchase or sale of foreign assets held by the central
bank
Official international reserves: gold, SDR, foreign
currencies, etc.
(current account) + (non-reserve capital account) +
(statistical discrepancy)
= Balance of Payment (official settlement)
Balance of Payment
Balance of Payment (official settlement)
= current account deficit needed to be covered by the
central bank’s official reserve transactions.
BOP deficit  the country is running down its official
reserves.
Outline
Defining Exchange Rate
Measuring Exchange Rate Movements
Appreciation/Depreciation of a currency
Exchange Rate Equilibrium
Factors that influence Exchange Rate Movements
Meaning of Exchange Rate and
Measuring Changes in Exchange Rates
Value of one currency in units of another currency
A decline in a currency’s value is referred to as
depreciation and an increase in currency’s value is
called appreciation.
If currency A can buy you more units of foreign
currency, currency A has appreciated and foreign
currency depreciated
If currency A can buy you less units of foreign
currency, currency A has depreciated and foreign
currency appreciated
Appreciation/Depreciation
Percentage change in value US $
New Value of Foreign Currency
per unit of $ - Old value of foreign currency per $

-------------------------------------------------- X 100
Old value of Foreign Currency per $

Percentage change in value of Foreign

Currency
New Value of $ per units of
Foreign Currency - Old value of $ per unit of foreign currency

-------------------------------------------------- X 100
Old value of $ per unit of Foreign Currency
Exchange Rate Equilibrium
Forces of Demand and Supply
Demand for foreign currency negatively related to the
price of foreign currency
Supply of foreign currency positively related to the
price of foreign currency
Forces of demand and supply together determine the
exchange rate
Demand for Foreign Currency
Price for Foreign Currency

D
$2.00

$1.50
D
50m 75 m Units of Foreign Currency (£)
Supply of Foreign Currency
Supply for Foreign Currency

S
$2.00

$1.50
S

50 m 75 m Units of Foreign Currency (£)

Equilibrium Exchange Rate

D
S

Exchange rate in
Rupees

S D
Units of Foreign
Currency($)
Factors that influence the Exchange
Rate
Expectations of the Market
Political Events
Relative Inflation Rates
Relative Interest Rates
Relative Income Levels
Exchange rate is the results of an interaction of these
factors
Market Expectations
Expectations about future exchange rate changes
on the basis of current and future political and
economic conditions
Political Events
Relative Inflation
High inflation relative to a foreign country, decline in
value of currency—Why?
Low inflation relative to a foreign country, increase in
value of currency—Why?
Relative Interest Rates
High interest rates in home country relative to a
foreign country may cause domestic currency to
appreciate—Why?
Relative Income Levels
Increase in domestic income relative to foreign income
may lead to a decline in the value of domestic
currency– Why?
Exchange Rate Determination
An interaction of factors
Is it possible for a country with high real returns to
have a low currency value?
Is it possible for a country with low real returns to
have a high currency value?