Identify and distinguish among, in balance-of-payments accounting, various “bala
ID: 1223429 • Letter: I
Question
Identify and distinguish among, in balance-of-payments accounting, various “balances” that can appear in a country’s balance-of-payments statement. What must conceptually be the numerical relationship between a country’s “balance on current account” (or “current account balance”) and its “capital/financial account balance?” Why? Then, for each of the two statements below, explain why the statement is either TRUE or FALSE.
(a) “A rise in interest rates in a country, such as occurred in the United States in the early 1980s, can lead to an increased deficit in the country’s merchandise trade balance.”
(b) “A decrease in saving by households in a country can lead to a deterioration in that country’s balance on current account (i.e., can make the current account balance less positive or more negative).”
Explanation / Answer
see balance of payments is the sum total of all the financial transactions of a country with rest of the world.
it has two components current account and capital /financial account. the items which come under balance of payent are imports , exports , unilateral transfer, loans , foreign investments like fdi or fii .etc. we can put these items under current account and capital /finacial account.
current account will contain visible and invisible trade like exports , imports of goods and services, income from land or rental income or income from foreign shares .basically all those items which have real impact on output emloyment or income of a country through movement of goods and services will come under current account.
regarding capital/finacial account, it deals with the net change of asset ownership of a nation. if there is deficit i.e country is inceasing its foreign asset ownership as more money is flowing out of the country and vice versa in case of surplus. it will include fdi (foreign direct investment) or investment in bonds and shares, commercial borrowings etc.
current account items have short term impact whereas capital/financial account shows long-term impact.
numerically sum total of current account balances and capital account/financial account balances should be equal to zero. beacause current account surplus means deficit in capital account and vice- versa. so one positive term and one negative term will cancel out be equal to zero only as magnitude of both the accounts are same. these accounts are offsetting in nature.
see here balance of trade means difference in the value of exports and imports of a country. if the value of exports is more than the value of imports the country will experience a surplus in balance of trade and vice versa.
a)interest rate can rise can lead to deficit in balance of trade through exchange rete movement. if us interest rate is higher the what the residents in other ciuntries do they will convert all their investment in their respective countries to us dollar in order to invest in US to earn more interest. as a result of this dollar demand will be high relative to other currency leading to appreciation of value of US dollar . now US dollar will command more units of foreign currency. due to this exports of US will be more expensive as foreigners will have to pay more as their currency is weak due to appreciation of US dollar and at same time imports for US will be cheaper as after appreciation 1 dollar can buy more of foreign goods. so US import rises with respect to exports and due to this balance of trade eperinces deficit.
b) see by natinal income accounting identity ,current account= savings - investments .. so if savings are going down then from the equation current account will be more neagative or less positive.
intitutively
suppose savings are going down and level of investment is same then what happens. people are spending more on consumpton of goods and services and their consumption will also include imports. and to finance the level of investment a country has to borrow more which will be showwn as surplus in capital account. and we know that the surplus in capital account is matched by equal deficitn in current account.