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 the forces of 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): exchange rates are determined by the private sectors. No intervention by monetary authorities

dirty (managed) float: occasional monetary intervention designed to smooth out fluctuations to delay a change in the exchange rates. (i.e., the policy makers think they know better.)


  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" of their currency in terms of a base currency, and a "band" of exchange rates, within which the exchange rates are allowed to vary.

International reserve assets



For example, if Bank of England announces that the par value of £ = $2.00 and supports the 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 depleting or accumulating 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 Special Drawing Rights (SDRs) and foreign currencies.


International Reserve Assets of EU = All currencies + gold bullion - own currencies

+ gold

- own currency

While gold can be held by the private sector as well as by 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 at present gold cannot be directly used to settle payments between central banks.

Lower price limit

(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 $3.9 trillion at the end of 2014. 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.

Upper price limit

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

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


  3. 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: used in countries with high inflation rates. 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 high inflation countries, it is better to adopt a crawling peg than to devalue its currency periodically. That is, 1.2% devaluation per month for 10 years is better than a 50% devaluation once a decade.

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; the currency board issues domestic money in exchange for the foreign currency at a fixed exchange rate.

Problem : When USD is strong, any currency tied to USD also becomes strong. Accordingly, Hong Kong had trouble exporting its products when USD was strong.

Currency Boards do not engage in discretionary monetary policy. Many small countries/cities 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.

Chinese government is pushing yuanization since 2013 by establishing bilateral swaps between central banks. Only used in North Korea. Not likely to succeed until all exchange controls are removed.

Reserve currencies in 2016: #1 = USD (41%), #2 = euro (31%), #3 = yuan (11%)



  4. 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)

US Current Account in 2016
(debit transactions) (credit transactions, billions of dollars)
Imports of goods $2210 exports of goods $1460
Imports of services $503 exports of services $752
total $2712 total = $2212
  Thus, Current Account deficit = $501

If a country has a large current account deficit for several years, macroeconomic fundamentals are not at equilibrium levels.

US imports from China in 2017 US exports to China
$506 billion $130 billion
US trade deficit with China: $375 billion  
US gold reserves = 8,000 tons. 1ton = 32000 troy ounces = not enough to cover US-China trade deficit for 1 year. 256 million troy ounces = $307 billion = Market value of gold the US has accumulated.
Total gold ever mined = 180,000 tons

1 ton of gold = $40 million

180,000 tons = about $7 trillion.


To reduce trade deficit, the government (exec branch) can

(i) raise tariffs,

(ii) devalue its currency or

(iii) or the Fed can raise interest.

Currency devaluation is not an option when China pegs the yuan to the USD.

Capital Account

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

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

A 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.

Current Account deficit must be offset by an equal amount of net capital inflow (i.e., private borrowing or official liabilities to foreign central banks).

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 . (PBOC accumulates $ and delays dollar depreciation, buy USD high, and sell USD low)

(ii) counter disorderly conditions in the FE market .

To make money, buy gold low and sell gold high.



  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
(fundamental equilibrium)

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 (determined by the private sector)

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. If BB is large and sustained for several years, some parameters need to be changed, e.g., exchange rates.

Greece minimum wage and sovereign debt


Living in Greece A majority 80 percent of workers in the public sector earn 1000-1500 euros/month and have salaries 40 percent higher than the workers in the private sector, once allowances and bonuses are added. (2011)
Income of the Fed employee: $115,000 vs private sector, $66,000 (74% more) in 2013.
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

ORTB excludes the transactions of monetary authorities

ORTB = 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 actions by US monetary authorities or foreign central banks to delay a change in exchange rates.

measures 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 (of the US and China) 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 billion,
obtaining FE by exporting $10 billion of gold, or
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 an 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