Balance of Payments
The account statement which summarizes the transactions of a country’s citizens with foreigners is commonly called the balance of payments.
Balance of Payments Accounting Identity
Current Account Balance + Financial Account Balance + Reserve Balance = 0
Current Account Balance
Composed of a country’s net exports for goods and services (is negative when exports > imports), net income from investments, and net current transfers (primarily foreign aid, foreign military support, and charity).
Financial or (Capital) Account Balance
Composed of direct investments, financial asset investments, bank assets liabilities, and a statistical discrepancy.
The statistical discrepancy is typically small in amount and serves as a plug value to tie the identity to 0 (zero).
Reserve Account Balance
Consists mostly of a government’s foreign currency holdings, but could also include inter-governmental exchange of gold.
If the value on the reserve account balance is positive, then a government has sold official reserve assets to buy back domestic currency.
Using Monetary Policy
A country’s central bank may ease monetary policy by increasing the money supply, with the objective of stimulating the economy. The theoretical sequence of events is:
- Monetary stimulus (increasing the supply of money) causes real interest rates to drop;
- Foreign demand for domestic financial assets decreases because returns are now lower;
- The financial account balance declines because the inflow of foreign investment has dropped;
- The domestic currency then depreciates;
- The currency depreciation reduces imports (which have become more expensive) and increases exports (which are now cheaper to the rest of the world);
- The increase in exports reverses the deficit trend in the current account balance, as the growth in exports stimulates the country’s economy.
Using Fiscal Policy
A government may also use fiscal policy (taxing and spending) to stimulate the economy and this also has implications for interest rates, the balance of payments and the domestic currency valuation.
- Fiscal stimulus causes interest rates to rise, as lower tax revenues or higher government spending has increased the demand for borrowing by the government;
- Rising real interest rates attracts foreign capital, which increases the financial account balance;
- The inflow of foreign capital increases the value of the domestic currency;
- The decrease in the current account balance is matched by an increase in the financial account balance, as foreign investors have increased their holdings of the domestic currency.
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