A purchase of dollars and the consequent open market sale of foreign assets decreases the
monetary base and the money supply. The resulting fall in the money supply leads to a rise
in domestic interest rates that raises the relative expected return on dollar assets. The
Chapter 16 The International Financial System
379
Balance of Payments
Because international financial transactions such as foreign exchange interven-
tions have considerable effects on monetary policy, it is worth knowing how these
transactions are measured. The balance of payments is a bookkeeping system
for recording all receipts and payments that have a direct bearing on the move-
ment of funds between a nation (private sector and government) and foreign coun-
tries. Here we examine the key items in the balance of payments that you often hear
about in the media.
The current account shows international transactions that involve currently
produced goods and services. The difference between merchandise exports and
imports, the net receipts from trade, is called the trade balance. When merchan-
dise imports are greater than exports (by $378 billion in 2009), we have a trade
deficit; if exports are greater than imports, we have a trade surplus.
Additional items included in the current account are the net receipts (cash flows
received from abroad minus cash flows sent abroad) from three categories: invest-
ment income, service transactions, and unilateral transfers (gifts, pensions, and for-
eign aid). In 2009, for example, net investment income was $121 billion for the United
States because Americans received more investment income from abroad than they
paid out. Americans bought less in services from foreigners than foreigners bought
from Americans, so net services generated $132 billion in receipts. Because
Americans made more unilateral transfers to foreign countries (especially foreign
aid) than foreigners made to the United States, net unilateral transfers were nega-
tive $125 billion. The sum of the previous three items plus the trade balance is the
current account balance, which in 2009 showed a deficit of –$250 billion (–$378 +
$121 + $132 – $125 = –$250 billion).
Another important item in the balance of payments is the capital account, the
net receipts from capital transactions (e.g., purchases of stocks and bonds, bank loans).
In 2009 the capital account was $140 million, indicating that $140 million more capi-
tal flowed into the United States than went out. Another way of saying this is that the
United States had a net capital inflow of $140 million.
3
The sum of the current account
and the capital account equals the
official reserve transactions balance
(net change in government international reserves), which was negative $250 billion
in 2009 (–$250 + $0.140 = –$249.86 billion). When economists refer to a surplus or
deficit in the balance of payments, they actually mean a surplus or deficit in the offi-
cial reserve transactions balance.
Because the balance of payments must balance, the official reserve transac-
tions balance, which equals the current account plus the capital account, tells us
the net amount of international reserves that must move between governments (as
represented by their central banks) to finance international transactions:
Current account + capital account = net change in government international reserves
This equation shows us why the current account receives so much attention from
economists and the media. The current account balance tells us whether the United
States (private sector and government combined) is increasing or decreasing its
Access
http://research
.stlouisfed.org/fred2
. This
Web site contains
exchange rates, balance of
payments, and trade data.
G O O N L I N E
3
The capital account balance number reported here includes a statistical discrepancy item that rep-
resents errors due to unrecorded transactions involving smuggling and other capital flows (–$18 billion
in 2009). Many experts believe that the statistical discrepancy item, which keeps the balance of pay-
ments in balance, is primarily the result of large hidden capital flows, and this is why it is included in
the capital account balance.
380
Part 5 Financial Markets
claims on foreign wealth. A surplus indicates that America is increasing its claims
on foreign wealth and thus is increasing its holdings of foreign assets (both good
things for Americans); a deficit (as in 2009) indicates that the United States is reduc-
ing its holdings of foreign assets and foreign countries are increasing their claims
on the United States.
4
The large U.S. current account deficit in recent years, which
is now near $250 billion, has raised serious concerns that these large deficits may
have negative consequences for the U.S. economy (see the Global box, “Why the
Large U.S. Current Account Deficit Worries Economists”).
Exchange Rate Regimes in the International
Financial System
Exchange rate regimes in the international financial system are classified into two
basic types: fixed and floating. In a fixed exchange rate regime, the value of
a currency is pegged relative to the value of one other currency (called the
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