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March 24’ 2010 Lisaniz M. Figueroa Oyola
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CHAPTER 4

THE BALANCE OF PAYMENTS AND
INTERNATIONAL ECONOMIC LINKAGES
Shapiro, Alan C. Multinational Financial Management, 6th Edition

CHAPTER 5: Shapiro, Alan C. Multinational Financial Management, 8th Edition, John Wiley & Sons,

The purpose of this chapter is to help students understand the financial and real linkagesbetween the domestic and world economies and how these linkages affect business viability. It identifies the basic forces underlying the flows of goods, services and capital between countries and relates these flows to key political, economic, and cultural factors. These trade and capital flows are summarized in the balance of payments statistics.

Key Points

1. The balance of payments is anaccounting statement that shows the sum of economic transactions of individuals, businesses and government agencies located in one nation with those located in the rest of the world during a specified period. Thus, the U.S. balance of payments for a given year is an accounting of all transactions between Americans and non-Americans during the year.

2. The balance-of-payments statement is based ondouble-entry bookkeeping; every transaction recorded as a credit requires an equal and offsetting debit entry, and vice versa. A debit entry shows a purchase of foreign goods, services, and assets or a decline in liabilities to foreigners. A credit entry shows a sale of domestic goods, services, and assets or an increase in liabilities to foreigners.

3. The balance of payments often is dividedinto several different components. Each shows a particular kind of transaction such as merchandise exports or foreign purchases of U.S. government securities. The most basic distinction among transactions in the balance of payments is between those that represent purchases and sales of goods and services in the current period, called the current account, and those that represent capitaltransactions, called the capital account. Changes in official reserves appear on the official reserves account.

4. Since double-entry bookkeeping ensures that debits equal credits, the sum of all transactions is zero. Absent official reserve transactions, a capital account surplus must just offset the current account deficit, and a capital account deficit must offset a current account surplus.

5. Thetotal size of the current account deficit is a macroeconomic phenomenon; there is a basic accounting identity that a nation's current account deficit reflects excess domestic spending. Equivalently, a current account deficit equals the excess of domestic investment over domestic savings. Taking government explicitly into account yields a new relation: The domestic spending balance equals theprivate savings-investment balance minus the government budget deficit.

6. In order to reduce the current account deficit, domestic savings must rise, private investment must decline, or the government deficit must be reduced. Absent any of these changes, the current account deficit will not diminish, regardless of the trade barriers imposed or the amount of dollar depreciation.

7. The long-termconsequences for a nation that runs a current account deficit depend on how the resulting capital inflow is used. If the capital account surplus finances productive investment, then the nation is better off; the returns from these added investments will service the foreign debts and leave something extra. Conversely, a capital account surplus that finances consumption will increase the nation'swell-being today at the expense of its future well-being.

SUGGESTED ANSWERS TO CHAPTER 4 QUESTIONS

1. In a freely floating exchange rate system, if the current account is running a deficit, what are the consequences for the nation's balance on capital account and its overall balance of payments?

Answer. In a freely floating exchange rate system, the nation's balance of payments must...