ECN 306 exam 3

Look at each of the cases below from the point of view of the balance of payments for the U.S. Determine the subcategory of the current account or financial account that each transaction would be classified in, and state whether it would enter as a credit or debit. Chapter 9 Trade and Balance of Payments 1. The U.S government sells gold for dollars. 2. A migrant worker in California sends $500 home to his village in Mexico. 3. An american mutual fund manager uses the deposits of his fund investors to buy Brazilian telecommunications stocks. 4. A Japanese firm in Tennessee buys car parts from a subsidiary in Malayaia. 5.

1. The U.S exports official reserve assets; it is a credit in the financial account. 2. A resident of the U.S transfers money to a foreign locale; it is a debit in the current account and goes in the secondary income category. 3. There is an import of foreign assets; it is a debit in the financial account under the category of a net change in U.S private assets abroad. 4. An American based producer imports goods; it is a debit in the current account (imports of goods). 5. There is secondary income from the U.S to abroad foreign country; it is a debit in the current account. 6. America residents purchase a service from a foreign firm; it is a debit in the current account (imports of services). 7. There is a net increase in nonreserve foreign assets held by the U.S government; it is a debit in the financial account.

What is a current account surplus equivalent to foreign investment?

A current account surplus leads to the net accumulation of foreign assets, whether real or financial. In either case, there is the prospect of a future stream of revenue that will be generated from the assets. Another way to look at it is to consider that in order to export to a greater value than imports, a nation must not consume some of its income (production). Instead, the goods and services are sent abroad. The effect is the same as domestic investment: Consumption out of a current periodic production is postponed until a future date, and the excess output is used to increase the capacity of the economy to generate a future stream of income (production).

Use the following information to answer the questions below. Assume that the capital account is equal to 0. Export of goods and services = 500 Primary income recieved = 200 Secondary income recieved = 300 Imports of goods and services = 700 Primary income paid abroad = 300 Secondary income paid = 100 Net acquisition of financial assets = 300 Net incurrence of liabilities = 400 Net change in financial derivatives = 600 Questions 1. What is the trade balance? 2. What is the current account balance? 3. Does the financial account equal the current account plus the capital account balance? 4. What is the statistical discrepancy?

Answers 1. The trade balance is 500-700 = -100. Note that this is really the balance on goods and services, not the merchandise trade balance. 2. The current account is trade balance + net primary income + net secondary income; 500 + 200 + 300 - 300 - 100 = -100. 3. The financial account is net financial assets - liabilities + statistical discrepencies (300 - 400 + 600 = 500). 4. The statistical discrepancy is financial account balance minus (current plus capital account balance) (500-(-100+0))=600 (Note, since there is no given data on capital transfers, capital a/c balance is assumed to zero) here.

Is the government budget deficit of a country linked to it's current account balance? How deficit has disappeared, as happened in the 1990s

The budget deficit and the current account are linked but there are the other variables of domestic private savings and domestic investment that are also joined in the savings investment balance. For this reason, there is no such thing as a one to one correspondence between budget and trade balances. The basic relationship is captured in the equation (4b in the text): Sp? government budget ?/? current account. From this it can be seen that as the government budget went to zero and the current account became more negative, either savings fell, investment rose, or some combination of the two occured.

Compare and contrast portfolio capital flows with direct investment capital flows

These two types of capital flows are similar in that they both provide a nation with the use of foreign savings. That is, they both represent financial flows that are a net increase in the moment of resources available for investment. On the other hand, they are very different in the time dimensions that they represent and in their liquidity. FDI is illiquid and generally represents funds with a longer time horizon than portfolio capital. Portfolio investment can move in or out of a nation extremely quickly and is the main focus of concerns about the destabilizing effects of foreign investment.

Weigh the pros and cons of a large deficit

Trade deficits are generally considered a negative for a country, but the reality is more subtle. On the negative side, large deficits signal that a country is accumulating foreign debt that can be difficult to service if the excess imports are not used to enhance national productivity. Furthermore, trade deficits require capital inflows. If foreign investors lose confidence, it may be difficult to search the necessary foreign reserves. This is partly what happened to Mexico in 1994 and Thailand and Indonesia in 1997. On the positive side, a large trade deficit can also signal that foreigners have confidence in the current set of economic policies and future prospects of the economy. Furthermore, and most importantly, a large trade deficit and the attendant capital inflows allow a higher level of investment than would be possible solely on the basis of domestic savings.