International Finance

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Econ 371: Answer Key for Problem Set 1
(Chapter 12-13)
Instructor: Kanda Naknoi
September 14, 2005
1. (2 points) Is it possible for a country to have a current account deficit at the same time and has a surplus in its balance of payments? Explain your answer using hypothetical figures. ANSWER: (1 point) Yes. The balance of payments (BoP) is the sum of current account (CA), capital account (KA) and financial account (FA). Theoretically, because of the double-entry bookkeeping practice, the sum is supposed to be zero. BoP = CA + KA + FA = 0

(1 point) Given a current account deficit, the theory predicts that the sum of the capital account and the financial account must be surplus. However, in practice, the balance of payments may deviate from zero because of statistical discrepancy, particularly in recording financial transactions in the financial account. Suppose the current account deficit is 100 billion dollars, a combined surplus of the capital account and the financial account must be greater than 100 billion dollars to produce a surplus in the balance of payments.

(Optional note) Sometimes the term ”balance of payments” is used to describe the official settlements balance with the opposite sign. This balance indicates the payments gap covered by the official reserve transactions. For example, the U.S. official settlements balance in 2003 is 250 billion dollars. In this case, some newspapers may say that ”the U.S. balance of payments in 2003 is -250 billion dollars.” When it is a large negative number, it is often a subject of concern because it indicates an excessive role of the central bank in financing the current account deficit. 2. (2 points) Suppose that the U.S. net foreign debt is 25 percent of U.S. GDP and that foreign assets and liabilities alike pay an interest rate of 5 percent per year. What would be the drain on U.S. GDP (as a percentage) from paying interest on the net foreign debt? What if the net foreign debt were 100 percent of GDP? At what point do you think a country’s government should become worried about the 1

size of its foreign debt?
(1 point) 25 percent debt-to-GDP ratio and 5 percent interest rate implies that the interest payment as the ratio to GDP is 0.25x0.05 = 0.0125 = 1.25 percent of GDP. If the debt-to-GDP ratio is 100 percent, then the interst payment willl become 1x0.05 = 0.05 = 5 percent of GDP.

(1 point) Intuitively, the government should be concerned about the net foreign debt when paying back the debt becomes difficult. We can use the balance of payments accounting to find out how much output needed to pay back the debt. CA = savings - investment

When a country run a current account surplus, their residents have more savings than the domestic investment and so they also invest overseas. That is how a country with a current account surplus can accumulate net foreign assets. In contrast, a country that runs a current account deficit does not have enough savings for its domestic investment, so it must borrow from abroad and accumulate net foreign debts. In other words, the stock of net foreign debts are a result of past capital inflows triggered by current account deficits. The only way to reduce the foreign debt is to reverse the direction of capital flows. So, we must run a current account surplus from now, and use the surplus to pay back the debt.

The size of foreign debt comes to play a role because the larger it is, the larger the interest payment and the larger future current account surpluses need to be. This can also be explained using another current account accounting. (See Table 12-2 for an example.)

CA = export - import + net income transfer from abroad
In this case, the net income transfer is the ”negative” value of the interest payment we calculated above. In order to run a current account surplus in the future, the U.S. will have to run a trade balance surplus which is greater than the amount of the interest payment. When the debt-to-GDP ratio is 25 percent, to reduce...
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