Macroeconomic

Theory and Policy

Biswa Swarup Misra

Session-11

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Balance of Payments

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The Balance of Payments: Linking the Domestic Economy
to the International Economy

Open economy An economy that has interactions in trade

or finance with other countries.

Closed economy An economy that has no interactions in

trade or finance with other countries.

Balance of payments The record of a country’s trade with

other countries in goods, services, and assets.

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LEARNING OBJECTIVES

▪ Measuring Macroeconomic Activity: Overview

▪ Identify the relationship between the national income
and product accounts, and the balance of payments
account using the circular flow.
▪ Define the key components of the national income and
product accounts, and the balance of payments account.
▪ Understand how each component of the balance of
payments accounts affects the flow of income and
spending in the circular flow.

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Flow of Payments in a Closed Economy
▪ Gross national expenditure (GNE): total national spending on
final goods and services.
▪ It can be divided into three components.
▪ Personal consumption expenditures C (“Consumption”).
▪ Total household spending on final goods and services.
▪ Gross private domestic investment I (“Investment”)
▪ Total spending by firms and households on final goods and services that add
to the nation’s capital stock.

▪ Government consumption expenditures and gross investment G

▪ Government spending on final goods and services, including additions to the
capital stock.

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Flow of Payments in a Closed Economy

▪ Where does expenditure go?

▪ Total spending (GNE) is total payments for final goods
and services in the market.
▪ In a closed economy, this must equal total sales by firms
of goods excluding sales to other firms.
▪ This measure is known as value added.
▪ Firms sell intermediate goods and services to other
firms. These are excluded to avoid double counting.

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Flow of Payments in a Closed Economy

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Flow of Payments in a Closed Economy

▪ Where does value added go?

▪ Firms use revenues in two ways:
▪ Payments for intermediate goods and services.
▪ Income payments to factors of production, such as wages and salaries to
labor, dividends and interest to capital, and rent to landowners.

▪ The latter is just value added since it is what is leftover once

intermediate purchases are deducted from total sales.
▪ Value added avoids double-counting and is considered the “true” measure
of production in the economy, and is also called gross domestic product
(GDP).

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Flow of Payments in a Closed Economy

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Flow of Payments in a Closed Economy

▪ Where do factor payments go?

▪ Gross national income (GNI) or GNP is the sum of factor income
payments received by national entities.
▪ As with other flows, we neglect taxes and transfers, so these entities can be
thought of as the aggregate of households, firms, and government.
▪ These income resources are the only resources available from
which the closed economy can finance expenditure.
▪ The income flow GNI is spent as the expenditure flow GNE.

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Flow of Payments in a Closed Economy

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The Circular Flow in a Closed Economy
GNE = GDP = GNI

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Flow of Payments in an Open Economy

▪ The balance of payments account records international

transactions in the open economy.
▪ In the flow of payments for an open economy, the
transactions in the balance of payments affects the flow
of spending, income, and production.
▪ GNE, GDP, and GNI need not be equal.
▪ The macroeconomic plumbing is more complicated.
▪ Modifications are need at five points.

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Flow of Payments in an Open Economy
▪ Point 1:
▪ Some home spending is on foreign goods; and some
foreign spending is on home goods.
▪ International payments result.
▪ We must deduct imports (IM) and adds exports (EX) to
GNE to calculate the total payments received by home
firms.
▪ Total spending on final goods and services is the sum of
GNE and the trade balance (TB).
GNE + TB = GDP
TB = EX – IM
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Flow of Payments in an Open Economy

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Flow of Payments in an Open Economy
▪ Point 2:
▪ Some home GDP might be produced using “imported” foreign
factors and some foreign GDP might be produced using
“exported” home factors.
▪ International payments result (e.g., wages, rents).
▪ We must subtract factor service imports (IMFS) and add
factor service exports (EXFS) to GDP to calculate the income
received by the home nation.
▪ The difference between factor service exports and imports is
net factor income from abroad (NFIA).
GDP + NFIA = GNI
NFIA = EXFS – IMFS

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Flow of Payments in an Open Economy

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Flow of Payments in an Open Economy
▪ Point 3:
▪ Country’s disposable income may differ from income
earned due to unilateral transfers paid to (UTOUT) and
received from abroad (UTIN), e.g. aid.
▪ Net unilateral transfers (NUT) is the net amount the
country receives from the rest of the world.
▪ Gross national disposable income (GNDI) is income
available including transfers.
GNI + NUT = GNDI
NUT = UTIN – UTOUT

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Flow of Payments in an Open Economy

GNDI = GNI + net unilateral transfers

GNI=GDP+NFIA
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Flow of Payments in an Open Economy
▪ Point 4:
▪ Income is not the only resource by which an open
economy can finance expenditure.
▪ The economy can increase/decrease its spending power
by exporting/importing assets internationally.
▪ These transactions are recorded on the financial
account (FA).
▪ The financial account is equal to asset exports (EXA)
less asset imports (IMA).
FA = EXA – IMA

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Flow of Payments in an Open Economy
▪ Point 5:
▪ A country may transfer/receive assets as gifts.
▪ Like income transfers, these must be recorded properly.
▪ Asset imports which are gifts (KAIN) do not reduce
resources, so we must add those.
▪ Asset exports which are gifts (KAOUT) do not increase
resources, so we must subtract those.
▪ These transfers of assets are recorded in the capital
account (KA).
KA = KAIN – KAOUT

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Flow of Payments in an Open Economy

GNDI = GNI + net unilateral transfers

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The Big Picture

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GNI, GNDI and NUT for India

2021-22

Figures are in Rs. Crores

GNDI 2,36,06,704

GNI 2,30,01,260

NUT 6,05,444

Re-Dollar Exchange Rate 74.5

NUT in Dollars in Millions 81267.651

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 Flow of Payments: Quick Summary
Key Issue Number 1
▪ International transactions appear in two places
▪ In the National Income & Product Accounts
▪ Because they account for the differences between measures of
expenditure, product, and income.
▪ In the Balance of Payments Accounts
▪ Where they are broken down by concept and presented in much more
detail.
– Transactions in goods & services TB, factor services NFIA, and income
transfers NUT go in the current account CA.
– Transactions in assets are recorded elsewhere. The financial account FA
records all asset movements. The capital account KA records transfers of
assets.

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Flow of Payments: Quick Summary

Key Issue Number 2

▪ International transactions complete the circular flow and
add up to zero
▪ As we saw the transactions from the balance of payments are
added to GNE at each step.
▪ But the end result is still GNE.
▪ So the balance of payments adds up to zero.
▪ A positive entry in the balance of payments must be offset by a
negative entry elsewhere in the account.

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Three Approaches to
Measuring Economic Activity
▪ Expenditure approach: GNE = C + I + G
▪ Demand for goods and services
▪ GNE = total expenditure on all final goods and services.
▪ Product approach: GDP = GNE + TB
▪ Supply of goods and services
▪ GDP = value of all goods and services produced by firms, less intermediate
goods purchased.
▪ Income approach: GNI = GDP + NFIA
▪ Payments to factors of production
▪ GNI = value of all payments earned by factor residents in the economy
GNDI=GNI + Net Unilateral Transfer
=Total resources available for spending

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 Balance of Payments Accounts

▪ A country’s balance of payments accounts accounts for

its payments to and its receipts from foreigners.
▪ An international transaction involves two parties, and
each transaction enters the accounts twice: once as a
credit (+) and once as a debit (-).

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Balance of Payments Accounts (cont.)

▪ The balance of payments accounts are separated into

3 broad accounts:
▪ current account: accounts for flows of goods and services
(imports and exports).
▪ financial account: accounts for flows of financial assets
(financial capital).
▪ capital account: flows of special categories of assets
(capital): typically non-market, non-produced, or intangible
assets like debt forgiveness, copyrights and trademarks.

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Broad Components of different Accounts

▪ Current Account = Balance on Trade(exports of goods-

import of Goods) + Balance on services(export of
services-import of services)+ Investment Income and
dividends + net transfers
▪ Financial Account = net direct investment + net
portfolio flows+ other investment + change in reserve
assets

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The BOP records two types of transactions:
1. Transactions that involve exports or imports of goods and
services or transfers are registered in the current account
▪ When a Jordanian resident buys a US made product
this is recorded as a debit in the BOP of Jordan and as a
credit in the US BOP.
2. Transactions that involve the purchase or sale of assets are
registered in the Financial account
▪ When a company from Jordan buys a US company
(building, bond, ..), the transaction is recorded in the
Jordanian BOP as a debit in the financial account and
is recorded in the US as a credit in the Financial
account
▪ Why debit, because Jordan is "importing" the Asset

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 Guidelines for Classification of Credit and Debit
Items in Financial Account

▪ 1. Purchase of assets - Debit and sale of assets – Credit

▪ 2. Purchase of asset is just like importing the asset
(Krugman)
▪ 3.Every increase in liability or decrease in asset is a credit
and every decrease in liability or increase in asset is a
debit.(Moss)

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The Balance of Payment
▪ Double-entry book keeping, every transaction enters into the BOP
twice, once as a credit and once as a debit
▪ Example: A US company buys Jordanian phosphates for
USD20,000 and pays with a cheque
▪ Debit in US current account (import) credit in the Jordanian
Current account (export)
▪ Credit in US financial account (The dollars are liabilities of US
Fed. An increase in liability is a credit entry) and debit in the
Jordanian Financial account as there is an increase in
assets(Increase in Asset is a debit entry)
▪ Financial Account + Current Account + Capital Account=0
▪ So, what does a Balance of Payment deficit mean?

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The Balance of Payment
▪ The BOP keeps track of a country's payments to foreigners
and receipts from foreigners

▪ Transactions resulting into a payment to foreigners are

entered in the BOP as a debit and is given (-).

▪ Transactions resulting into a payment from foreigners are

entered in the BOP as a credit and is given (+).

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 Balance of Payments Accounting

▪ In practice, measurement problems, recorded as a

statistical discrepancy, prevent CA + KFA = 0 from holding
exactly.

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Nearly all economies of the world are:
a. Open economies.
b. Closed economies.
c. Closed economies about to become open in
today’s global economy.
d. Open to trade but closed to investment and
finance interactions with other economies.

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Nearly all economies of the world are:
a. Open economies.
b. Closed economies.
c. Closed economies about to become open in
today’s global economy.
d. Open to trade but closed to investment and
finance interactions with other economies.

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The Balance of Payments: Linking the Domestic
Economy to the International Economy

The Current Account

Current account The part of the

balance of payments that records a
country’s net exports, net investment
income, and net transfers.

The Balance of Trade

Balance of trade The difference

between the value of the goods a
country exports and the value of the
goods a country imports.

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A country has a trade surplus when:
a. exports are greater than imports.
b. imports are greater than exports.
c. government revenues are greater than government
expenditures.
d. the balance on the current account must be positive.

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A country has a trade surplus when:
a. exports are greater than imports.
b. imports are greater than exports.
c. government revenues are greater than government
expenditures.
d. the balance on the current account must be positive.

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The Balance of Payments: Linking the Domestic Economy
to the International Economy
The Current Account
Net Exports Equals the Sum of the Balance of Trade
and the Balance of Services
CURRENT ACCOUNT
Illustrative Exports of goods $52,308
Example: Imports of goods −62,326
The Balance of Balance of trade −10,017
Payments of Exports of services 46,807
India, April-
Imports of services −26,304
June 2020
Balance of services 20,503
(Millions of
dollars) Income received on investments 5,070
Income payments on investments −12,768
Net income on investments -7,698
Net transfers 17,010
Balance on current account 19,798

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In the Illustrative Example, the trade position of
India was:
a. A trade surplus of $10.48 billion.
b. A trade surplus of $10.01 billion.
c. A trade deficit of $10.48 billion.
d. A trade deficit of $10.01 billion.

Trade considers tangible goods and not intangible

services

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In the Illustrative Example, the trade position of
India was:

a.A trade surplus of $10.48 billion.

b.A trade surplus of $10.01 billion.
c.A trade deficit of $10.48 billion.
d.A trade deficit of $10.01 billion.

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ARE TRADE DEFICITS NECESSARILY BAD?

▪ There is a myth that deficits are bad and surpluses are

good, but this is not always true
▪ A poor country usually has abundant labor and scarce
capital
▪ Raising the GDP per capita requires increasing capital
per worker and this is difficult to do as capital is scarce
and rising populations make increasing capital per
worker even more difficult
▪ The solution is to import foreign capital

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The Balance of Payments: Linking the Domestic Economy to
the International Economy
The Current Account
Net Exports Equals the Sum of the Balance of Trade
and the Balance of Services
Illustrative Example:
The Balance of
Payments of India
during Apr-June
2020,(Millions of
dollars) (continued)
FINANCIAL ACCOUNT

Increase in foreign holdings of assets in India 1,26,703

Increase in Indian holdings of assets in foreign
countries −1.45241
Balance on Financial Account -18,538
BALANCE ON CAPITAL ACCOUNT -780
Statistical discrepancy -480
Balance of payments 0
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The Balance of Payments: Linking the Domestic Economy to
the International Economy
The Financial Account
Financial account The part of the balance of
payments that records purchases of assets a
country has made abroad and foreign
purchases of assets in the country.

Net foreign investment The difference

between capital outflows from a country and
capital inflows, also equal to net foreign direct
investment plus net foreign portfolio
investment.

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Purchases of assets a country has made abroad and
foreign purchases of assets in the country are
recorded in:
a. The current account.
b. The financial account.
c. The capital account.
d. All of the above.

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Purchases of assets a country has made abroad and
foreign purchases of assets in the country are
recorded in:
a. The current account.
b. The financial account.
c. The capital account.
d. All of the above.

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The Balance of Payments: Linking the Domestic Economy to
the International Economy

The Capital Account

Capital account The part of the balance of payments

that records relatively minor transactions, such as
migrants’ transfers, and debt forgiveness
Migrant’s transfer means the assets that migrants take
with them when they move into or out of a country

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 Current versus Capital Transfers
Current Transfers Capital Transfers
▪ Current transfers consist of all transfers ▪ A capital transfer should result in a
that are not transfers of capital. change in the stocks of assets.
▪ Current transfers directly affect the level ▪ Capital transfer can be in cash or in
of disposable income and should kind
influence the consumption of goods or
services. ▪ First, a transfer in kind is a capital
transfer when it consists of
▪ Current transfers reduce the income and
consumption possibilities of the donor and ▪ (i) the transfer of ownership of a fixed
increase the income and consumption asset. Investment grants in kind consist
possibilities of the recipient. of transfers of transport equipment,
▪ Current transfers are classified, according machinery, other equipment, and the
to the sector of the compiling economy, direct provision of buildings or other
into two main categories: general structures by governments to
government and other sectors. nonresident units.

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 Current versus Capital Transfers
Current Transfers Capital Transfers
▪ General government transfers comprise current ▪ Second, a transfer of cash is a capital transfer
international cooperation, which covers current when it is linked to, or conditional on the
transfers-in cash or in kind-between acquisition of a fixed asset (for example, an
governments and international organizations. investment grant). Investment grants in cash are
for purposes of gross fixed capital formation,
▪ Included are cash transfers effected between and the grants are often tied to specific
governments for the purpose of financing
investment projects, such as large construction
current expenditures by the recipient
projects.
government. Takes the form of gifts of food,
clothing, other consumer goods, medical ▪ Capital transfers also include migrants’
supplies, etc. associated with relief efforts in the transfers and debt forgiveness.
wake of famine, earthquakes, other natural ▪ In the strictest sense, migrant transfers are not
disasters, war, or other actions. transactions between two parties but contra-
▪ Payments by governments or international entries to flows of goods and changes in
organizations to governments for salaries of financial items that arise from the migration
technical assistance staff and for related costs (change of residence for at least a year) of
and expenses. individuals from one economy to another. The
transfers to be recorded are thus equal to the
net worth of the migrants.

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 Current versus Capital Transfers
Current Transfers Capital Transfers
▪ Other current transfers, in cash or in kind, ▪ All the household and personal effects of
between resident and nonresident entities migrants, together with any movable capital
include those (such as food, clothing, other goods actually transferred from the old to the
consumer goods, medical supplies, etc.) for new economy, are included under goods-
distribution to relieve hardships caused by general merchandise.
famine, other natural disasters, war, etc. and
regular contributions (including membership ▪ Enterprises (including those that utilize land,
dues) to charitable, religious, scientific, and structures, and movable capital goods not
cultural organizations. actually transferred) in which migrants retain
ownership after departure become foreign
▪ Workers’ remittances covers current claims of the migrants and, consequently, of
transfers by migrants who are employed in the economies to which they have migrated.
new economies and considered residents
there.
▪ A migrant is a person who comes to an
economy and stays, or is expected to stay, for
a year or more.

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 Recording of transfers
▪ Although no good, service, or asset is received in return from the
counterpart, the recording of a transfer nevertheless must give rise
to two entries for each party to the transaction.
▪ For a transfer in cash, the donor records a decrease in currency or
deposits and a transfer payable; the recipient records an increase
in currency or deposits and a transfer receivable.
▪ For a provision of goods or services in kind without a charge, the
donor records an export of goods or services and a transfer
payable; the recipient records an import of goods or services and a
transfer receivable.
▪ When a liability is forgiven, the creditor and debtor extinguish the
financial asset and liability, respectively, with the corresponding
entries recorded as transfers.
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Which of the following is a less important
component of the balance of payments?
a. The current account.
b. The financial account.
c. The capital-account.
d. None of the above. All three components are
equally important.

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Which of the following is a less important
component of the balance of payments?
a. The current account.
b. The financial account.
c. The capital-account.
d. None of the above. All three components are
equally important.

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The Balance of Payments: Linking the Domestic Economy to
the International Economy
Why Is the Balance of Payments Always Zero?
The sum of the current account balance, the financial
account balance, and the capital account balance
equals the balance of payments.

To make the balance on the current account equal the

balance on the financial account, the balance of
payments includes an entry called the statistical
discrepancy.

Don’t Confuse the Balance of Trade, the Current Account Balance, and the
Balance of Payments

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Which of the following statements about the
balance of payment is correct?
a. Foreign investment in the United States
shows up as positive entry in the U.S.
financial account.
b. Additions to foreign holdings of dollars show
up as positive entries in the U.S. financial
account.
c. A current account deficit must be exactly
offset by a capital and financial account
surplus, leaving the balance of payments
equal to zero.
d. All of the above statements are correct.

slide 56
Which of the following statements about the
balance of payment is correct?
a. Foreign investment in the United States
shows up as positive entry in the U.S.
financial account.
b. Additions to foreign holdings of dollars show
up as positive entries in the U.S. financial
account.
c. A current account deficit must be exactly
offset by a capital and financial account
surplus, leaving the balance of payments
equal to zero.
d. All of the above statements are correct.

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 Statistical Discrepancy
▪ While conceptually and arithmetically the net difference between
current and capital accounts must compensate the movement in
reserves, in practice this is not often so because of errors and
omissions in the reported data.

▪ For instance, information on payments for imports not passing

through the banking channels is obtained from other sources,
primarily government records. The timing of recording for each leg
of the transaction may also vary.

▪ The balance of payments statistics of a country will therefore

generally include a compensating term ‘statistical discrepancy’ or
‘errors and omissions’.

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 How Do the Balance of Payments Accounts
Balance?
▪ Due to the double entry of each transaction, the balance
of payments accounts will balance by the following
equation:
current account +
financial account +
capital account = 0

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What Next?
1. Equivalences of a Current Account Surplus
2. Official reserve Account
3. Accretion and Depletion of Forex reserves
4. National income identity in an Open economy
5. Link between trade and capital flows
6. Saving, Investment, and their Relationship to the International Flows

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