Any transaction resulting in a payment to other countries is entered in the Balance of Payments account as a debit.
Any transaction resulting in a receipt from other countries is entered as a credit.
Balance of Payments Approach – The BOP approach to forecasting exchange rates looks at current account balances, portfolio investment, foreign direct investment, exchange rate regimes, and official monetary reserves to determine the direction of the exchange rate.
Current Account Balance + Capital Account Balance + Financial Account Balance + Reserve Balance = BOP (X – M) + (CI – CO) + (FI – FO) + FXB = Balance of Payments
X = exports of goods and services
M = imports of goods and services
CI = capital inflows
CO = capital outflows
FI = financial inflows
FO = financial outflows
FXB = official monetary reserves
Note: Whether or not the country has a fixed exchange rate is an important determinate when forecasting exchange rate movements using the balance of payments approach.
Q: Suppose a country has a fixed exchange rate. What are the potential effects on a country’s foreign exchange reserves of a balance of payments deficit?
A deficit in either the basic balance or the official settlements balance will cause an initial decrease in the country’s foreign exchange reserves caused by increased flight from the local currency to stronger foreign currencies… if this continues the country will have to devalue its currency.
Remember: Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. To ensure a fixed exchange rate, the government must intervene in the foreign exchange market and buy or sell domestic currencies to bring the BOP back to near zero. Thus, it is very important for a government to maintain significant foreign exchange reserve balances to allow it to intervene in the foreign exchange market effectively.
Q: Suppose a country has a floating exchange rate. What are the potential effects on a country’s foreign exchange reserves of a balance of payments deficit?
An account deficit will cause private parties to judge the economy as being weak, and the currency will probably drop in value in the free exchange markets. This drop might be self-correcting because a cheaper local currency will encourage more exports and make imports more expensive. No specific reason exists to expect foreign exchange reserves to change.
The Balance of Payments accounts are divided into two main sections:
1. The current account – records transactions that pertain to four categories a. Goods Trade (Merchandise) – the export or import of physical goods (autos, computers, chemicals) b. Services Trade – intangible products such as banking service, insurance services, and travel services. c. (Investment) Income – income from foreign investments and payments made to foreign investors. d. Current Transfers – financial settlements associated with the change in ownership of real resources and financial items such as one-way gifts or grants.
Example: U.S. citizen owns a share of a Finnish company and receives a dividend of $5, the payment shows up on the U.S. balance of payments as a credit on the current account (investment income).
2. The capital/financial account – records transactions that involve the purchase and sale of assets. There are two main categories. a. Capital Account
b. Financial Account
i. Direct Investment – 10% or more of the voting shares. ii. Portfolio Investment – investment of less than 10%. iii. Other Asset Investment – financial institutions, currency deposits and bank deposits, and other accounts receivable and payable related to cross-border trade.
Example: A firm in Peru purchases stock (less than 10%) in a U.S. company, the transaction enters the U.S. balance of payments as a...