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Balance of Payments

Current account

Trade in goods and services

1.      Visibles - trade balance

2.      Invisible trade

3.      Other invisibles

a.      ipd - investment

b.      transfer payments

Capital account

Buying and selling of assets (stocks, bond, money)


Problem with deficit is that it makes foreign debt grows cumlatively higher.

How to finance deficit:

1.      Overseas borrowing

Foreign organisations (IMF)

Foreign banks

2.      Central banks have reserves

3.      Sale country domestic assets to foreign firms


Sustained deficit is not bad if you are importing productive capacity at the beginning.

Accounting balance of payments

balancing item captures differences.

Market balance of payments.

In equilibrium they are equal.

This describes the market supply and demand before government intervention. This can be imbalanced.

You adjust equilibrium by changing exchange rate or govn intervention.

Different systems:

1.      fixed rates

2.      floating rates

3.      dirty float


From one extreme to other

Bretton wood - all currencies in terms of dollars, that was on gold stadard. USA did not like.


1.         Elasticities approach

- excess demand for foreign currency then devalue your currency

Competitiveness aproach P(foregin currency)xP(foreign goods)/

eP*/P - real exchange rate. Price of foreign currency increases because of devaluation leads to an increase in competitiveness as home goods are cheaper. Domestic inflation decreases competitiveness, foreign inflation increases.

Starting point: deficit in current account - devaluate.

1.      Impact on volumes - competitiveness boosted, import volumes decline.

2.      Impact on values - imports you are buying are more expensive and income earned from exports is less in real terms.

when you want an improvement on current account volume effect must outweigh the value -

Marshall Lernel condition

E(export)+E(import)>1 this must be satisfyed for the trade balance to improve.


1.   More things should be indluded, partial equilibrium on trade balance is not representitave

2.   Income effects are not accounted for in exchange rate (marginal propensity to improt from the extra export income)

3.   Ignores monetary aspects, money supply and demand effects

4.   In order to derive Marshall Lerner you need to assume the initial trade balance of 0

5.   Little empirical evidence, it  is mixed.

2.         Absorption aproach better

National Income identities




Using the current account surplus, rather than simple trade balance (X-M)



Y+R-T is disposable income of domestic residents

R - transfers

X+R-M - Current account surplus(CAS)





NFA - net financial assets - CAS = change in NFA

Foreign trade multiplier




s=1-c   -   marginal propensity to save

Y=1/(s+m) * (c0+I+G+X-m0)

1/(s+m) is the multiplier

Trade Balance (TB) =X-M=X-m0-mY=X-m0-m/(s+m)  *  (c0+I+G+X-m0)


Twin deficit hypotheses - government deficit leads to the current account deficit. Derive the TB equation wrt G and X to see the effects.

Achieving internal and external balance

Internal balance - full employment and stable inflation. One can use fiscal and monetary policy to deal with that. We are assuming a tradeoff between unemployment and inflation.

External balance - Balance on the Balance of Payments.

Tinbergen's Rule - you need as many policy instruments as there are problems needed to be solved at the same time.

Mundell's Principle of Effective Market Classication - instruments should the targeted to the problems they have most effect on. This is a solution to the assignment problem.

Stabilisation policy - targets both external and internal balance.

Instruments - fiscal policy (deficit)and monetary policy (interest)

EB slopes upwards because if there is an increase in the fiscal deficit G-T there will be an increase in the currrent account deficit - the interest must be increased to attract hot money

IB slopes upwards because an increase in interest depresses activity, the fical deficit must increase to boost it.

ISLM BP approach

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