Balance of Payments

1. Flexible Exchange Rates


When the exchange rates are not stabilized by government authorities, the FE market closely resembles the theoretical model of perfect competition. There is a large number of buyers and sellers who act as price takers.

Accordingly, the exchange rates are determined by demand and supply in the foreign exchange (FE) market.


the demand for foreign exchange originates in the debit items in the BP.

The amounts of FE demanded is inversely related to its price.

Debit transactions involve payments by domestic residents to foreign residents.

Imports of merchandise
foreign transportation services
purchases of American residents traveling abroad
foreign investment by home residents.


the supply of FE derives from the credit items in the BP.

Credit transactions involve receipts by domestic residents from foreign residents

exports of merchandise
purchases of foreign travelers in the US
investment in the US by foreign residents

There is a direct relationship with price.

  pure float (clean float): No intervention by monetary authorities

dirty (managed) float: occasional monetary intervention designed to smooth out fluctuations


2. Fixed Exchange Rates

par value Government officials strive to keep the exchange rates stable even if the rates they choose deviate from the current equilibrium rates. They announce the "par value" and a "band" of exchange rates. The exchange rates are allowed to vary within the band.

For example, if Bank of England announces that the par value of £ = $2.00 and supports British pound at 2% below the par or supports $ at 2% above the par, they have to get rid of the excess supply or demand at these prices using their international reserve assets.

During the Bretton Woods era, a country's international reserve assets included gold and other foreign currencies. (See for instance, Japan's international reserves (copy)). Since 1973, they included SDRs and foreign currencies.


While gold can be held by the private sector as well as public institutions, gold is no longer used as a means to settle international payments. In countries where gold is held as a reserve asset, its market value is listed, but gold cannot be directly used to settle payments between central banks.


(i) US buys £, this ⇒ increases £ reserve in US

(For example, because of its low dollar peg of RMB, China is buying dollars, about $200 billion a year. China accumulated over $3 trillion at the end of 2011. China is considering selling dollars ⇒ As $ ↓, the value of China's reserve asset declines. )

(ii) UK buys £ (sell $), this ⇒ decreases $ reserve in UK.

Russian ruble was fixed way above the equilibrium level, but it was not convertible into gold.


(i) US sells £ (£ reserve falls in the US)

(ii) UK sells ($ reserve increases in UK). China sells RMB and $ reserve increase in China.


2. Systems of Exchange

  Monetary authorities differ greatly in their approach to maintaining the value of their currency in the FE market. Some central banks intervene on a daily basis. With most banks, intervention is intermittent. Others make no attempt to influence the price of their currencies.
Fixed Rates the government announces an exchange rate, called the parity rate and defends it.

Hard peg: Permanently fixed rate (the government has no plan to change it): Currency Boards, Dollarization

Adjustable peg: Rates are periodically adjusted (Bretton woods)

Soft peg

High frequency pegging: day-to-day dollar pegging or week-to-week pegging

Low frequency pegging: month-to-month pegging or quarter-to-quarter pegging

Exchange control: rates may be maintained through rationing of foreign exchange

wide band: rates are fixed, but a considerable amount of fluctuation is allowed around the parity rate.

crawling peg: at any point in time, a country is committed to maintain its pegged exchange rate within a margin of X percent. The level is equal to its moving average of the exchange rates over a preceding period of Y weeks.

where ZY = mean of Z over Y weeks.


Mexico's arrangement during the early 1990s provides a good example of a crawling peg. Mexico pegged the peso to the US dollar. However, the inflation rates of the two countries diverged considerably, which necessitated a gradual depreciation of the peso. In this case, it is better to adopt a crawling peg than to devalue the peso drastically once in a while.

Similarly, Nicaragua pegged the value of its currency to the US dollar. US inflation rate averaged about 2 to 3 %, but inflation in Nicaragua remained between 10 to 20% a year. Because of this large difference in inflation rates, there would be a tendency for the córdoba to depreciate against the US dollar. Thus, Nicaragua adopted a crawling peg. (Daniels and van Hoose, 2002)

Currency Baskets

While it is efficient to peg one's currency to a stable currency, relying on a single currency might be risky. For this reason, a nation might peg its currency to a basket of foreign currencies. A basket of currencies is likely to be less variable than a single currency.

If all other currencies were included in the basket, the resulting peg would be most stable. However, managing such a peg can be quite cumbersome. Moreover, not all currencies are equally important, and weights should be assigned to each currency in accordance with the economic power of the nations included in the basket. For this reason, the currency baskets often include a small number of major currencies. For instance, the Czech Republic pegged its currency koruna to a basket of currencies including 0.0125 USD and 0.0329 DM, equivalent to 1 koruna (Kc 1).

Currency Boards Some countries do not have a central bank that conduct monetary policies. Instead they have a currency board, an independent monetary agency, that links the growth of its money supply to the foreign exchange holdings; it issues domestic money in exchange for foreign currency at a fixed exchange rate.

Currency Boards do not engage in discretionary monetary policy. Many small countries have currency boards: Estonia, Hong Kong, Lithuania, and Argentina.

Recently, Lithuania abadoned its currency board because in 1997 a rise in the value of USD resulted in an appreciation of lit against the currencies of its major trading partners and a huge trade deficit.


Some countries use the currencies of another nation as their legal tender. Other nations may also abandon their domestic currencies. This practice is called dollarization, i.e., the use of any other currency (dollar or not) as the legal tender.

Euroization Some European countries now consider euroization, namely to use euro as a legal tender in their countries unilaterally without consulting European Union. The new member states are expected to use euro as legal tender sooner or later. There is as yet no movement to use euro as legal tender in other European countries.

3. Balance of Payments

Organizing BP accounts The majority of countries publish payments accounts. The items can be grouped into three categories.
Current Account

Merchandise Balance = merchandise exports - merchandise imports

Services = transportation, insurance, travel, investment services (interest income, dividends, profits), royalties and other services

Unilateral transfers = gifts to foreigners
private transfers = expenditures for missionary, charitable and educational organizations + personal remittances (of immigrants to their families and relatives)

government transfers = tax receipts from nonresidents, nonmilitary grants, but the largest is government aid toward developing countries (net military transactions)

Capital Account

records the net changes in the country's international financial assets and liabilities

Capital inflow occurs when residents' financial liabilities increase, e.g. selling bonds to foreigners

Capital outflow occurs when residents' financial claims on foreigners increase (or liabilities decrease)

Direct Investment = long term capital outflow. This includes only foreign branches + subsidiaries effectively controlled. (US residents control 50% or more of the voting stock)

Portfolio Investment = long term capital outflow that do not give effective control over investments. covers all international financial transactions with maturity exceeding one year.

Short term capital flows = transactions of international assets with maturity of one year or less. short term borrowing from foreign banks/short term deposits in foreign banks. Most volatile component/ errors & Omissions

Official Reserve Account

records the transactions of the central bank (Federal Reserve system, Treasury, exchange stabilization agency) when it buys/sells foreign currencies.

The central bank has only two purposes for these transactions:

(i) delay a change in the exchange rate.

(ii) counter disorderly conditions in the FE market.




4. Concepts of BP surplus/deficit


Surplus and deficit are economic concepts that are used to measure disequilibrium in the balance of payments.

Autonomous activities by the private sector generally cause a gap in the balance of payments. Accommodating activities are by the monetary authorities intended to fill the gap.

Merchandise Balance

This balance measures only exports and imports of merchandise by putting them above the line, i.e., treating them as autonomous decisions. Available monthly, and hence popular.

Xg - Mg

US Balance of Merchandise Trade

Goods & Service Balance

X - M.

It is more difficult to keep track of service transactions.

Current Account Balance

This measure covers all transactions that are current,

X - M - T

If surplus, it represents the amount of international lending and corresponds to net foreign investment.
Large current account deficits do not necessarily imply there is a problem in the economy.

Basic Balance

The basic balance is the sum of the current account balance and the net movement of long term capital (direct and portfolio investments).

X - M - T - LTC

LTC = long term capital outflow

Basic Balance is intended to measure structural changes in a country's balance of payments

insensitive to short run changes in economic variables such as interest rates, exchange rates, expectations.

responsive only to long term changes in productivity, international competitiveness. This concept is close to the theoretical concept of fundamental equilibrium.

Liquidity Balance

This balance measures the liquidity position of the US,

X - M - T - LTC - STCUS.

STCUS = short term US capital outflow

In case of trouble, STCUS cannot be mobilized, but STCforeign can be quickly retrieved from the US. Appropriate measure in a crisis, but not in a steady state.

Official Reserve Transactions Balance

This balance puts the transactions of monetary authorities below the line, and all others above the line. X - M - T - LTC - STCprivate. If the monetary authorities engage in no transactions to manipulate exchange rates, the official reserve transactions are zero by definition. This balance measures the extent of actions by monetary authorities to delay a change in exchange rates.

intended to measure the exchange market pressure on the country's currency

useful when the monetary authorities are in charge of maintaining a stable exchange rate

If ORTB (was a deficit) = -$10B, then the monetary authorities were compelled to intervene in the FE market for the same amount to prevent a depreciation of the country's currency by

(i) depleting FE reserve by $10 B, (ii) obtaining FE by exporting $10 B of gold, or (iii) borrowing FE from foreign central banks.


5. BP Accounting under Flexible Exchange Rate

US BP accounts

Since 1978 the US decided not to intervene in the FE market, except in emergency. However, several countries have intervened in the FE markets occasionally, when a currency appreciated or depreciated too much relative to other currencies (e.g., Plaza accord in 1985). Accordingly, BP accounts are prepared in a different way. In a country with a clean float, no reserve transactions occur, so the official reserve transactions account is zero by definition.

If there are no reserve movements, then the current account and capital account must total zero.

If there is a shock in the payments system, the adjustment is made through exchange rates, i.e., a change in the foreign price of a domestic currency. If clean floats were in operation, then payments accounts would include only current and capital accounts.

For instance, the downgrading of Greek sovereign debt to junk bond status in 2010 precipitated a crisis, which spread to other countries (Italy, Spain, Portgal, etc.) Consequently, euro was weakened for a while.

However, the US and many industrial countries maintain dirty or managed floats.

Since 1977 in the US, BP accounts have been published in a different format which reflects the nonintervention policy of the Federal Reserve Bank. (No reserve transactions)

Current Account

Exports of goods, services, and income

Merchandise export

service export

income receipts on US assets abroad

Imports of goods, services, and income

merchandise import

service import

income payments on foreign assets in US

Unilateral transfers

Capital Account
US Assets Abroad
    US official reserve asset (gold, SDR, reserve position
    in the IMF)
    US government assets
    US private assets

Foreign Assets in the US
    Foreign official assets in the US
    other foreign assets
Statistical discrepancy
  No reserve account transactions