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If the Balance of Payments (BP) is defined as $$BP=\text{Current Account}+\text{Capital Account}$$ where: $$\text{Current Account}=X-M+\text{Net Income Interest}$$ and $$\text{Capital Account}=\text{F}-\Delta \text{R}$$

Assume current account is positive, and $\text{Net Income Interest}=0$ for simplifying. Then there are 2 remaining ways for the balance of payments to be theoretically equal to zero:

1)$\text{F}<0$ and $\Delta R=0$ i.e. by home country acquiring foreign assets, or

2) $\text{F}=0$ and $\Delta R>0$ i.e. by the domestic Central Bank (CB) to increase their foreign exchange rate reserves.

Why would there be a need for official intervention by having the domestic central bank (CB) to increase its foreign reserves, if there was no buying of foreign assets ($\text{F}=0$), of ?

Any help would be appreciated.

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  • $\begingroup$ This question is difficult to understand. Please consider adding more detail and improving the grammar. Also, please give a specific example of central bank intervention in such a situation, and consider defining all terms and abbreviations prior to use for the sake of clarity. $\endgroup$ – Jason Nichols Jun 30 '16 at 0:10
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    $\begingroup$ @JasonNichols What about now? $\endgroup$ – An old man in the sea. Jun 30 '16 at 7:31
  • $\begingroup$ I think you're still missing Net Current Transfers from your Current Account equation, and several bits from your Capital Account Equation. Also, $R$ is not defined in question. It's definitely more clear, but the goal is not just to answer your question but to help others who may be looking for similar information, so more text and clarity generally provides a better chance of people finding the answer they're looking for. $\endgroup$ – Jason Nichols Jun 30 '16 at 13:23
  • $\begingroup$ @JasonNichols my answer is a bit poor. Would you like to give a better one? ;) $\endgroup$ – An old man in the sea. Jun 30 '16 at 15:58
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The Balance of Payments is supposed to be a form of double-entry bookkeeping, in that every transaction has two opposite effects, often in different accounts. Hence the word balance. In fact it might be considered quadruple-entry bookkeeping, as there are another two effects on the foreign side too.

For a country's Current Account to be in surplus there must be some net income, for example from the sales of exported goods and services exceeding the purchase of imported goods and services.

The surplus could be represented by a debt owed by the foreign importer to the domestic exporter. If the exporter uses this to invest in the foreign country then this counts in the Capital Account (or the Financial Account as the IMF calls it) which balances the Current Account. But even if it simply remains as debt or as the exporter's balance in a foreign bank, this still counts as other investment and balances in the same way. If the foreign importer pays in domestic currency then that reduces the outstanding liabilities to foreigners, again with the same net effect on the Financial Account.

If somebody actually turns a debt into money, then it amounts to an investment in the liabilities of the foreign money-issuing authority (typically its Central Bank). Bringing the foreign money home and selling it to somebody else domestically for domestic currency makes no difference to the impact on the Current or Financial Accounts, unless you sell foreign currency to the domestic Central Bank in which case it turns into a change in the Central Bank's Reserves.

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  • $\begingroup$ Thanks for your answer. I think IMF makes a distinction between Capital and Financial Account. For example, in your second paragraph, if the exporter uses that surplus to buy machine, land, etc in the foreign country then it goes into the capital account, otherwise it goes to the financial account. I think you're downplaying a bit the role for official intervention. Could you elaborate a bit more on it? Your answer seems more like you're explaining what is a balance of payments account... $\endgroup$ – An old man in the sea. Jul 19 '16 at 23:42
  • $\begingroup$ The IMF does make a distinction between the Capital and Financial Accounts in its manual. Its Capital Account is small and relatively difficult to interpret: capital transfers such as some overseas aid grants plus acquisition or disposal of nonproduced, nonfinancial assets. Its Financial Account is what economics textbooks mean when they say Capital Account. Investment and Reserves are part of the IMF's Financial Account $\endgroup$ – Henry Jul 19 '16 at 23:59
  • $\begingroup$ Henry's answer is spot on. The question seems to imply that the central bank suddenly sees and imbalance and says, oh may god I've to balance this, and then buys foreign assets. Instead, there's all kinds of international transactions, each of them with a seller and a buyer. If one side reports that it bought more goods than it sold, then it must have sold more assets than it bought. If the private sector bought less goods and assets from foreigners than it sold to foreigners, it must be the case that the public sector must have bought some goods or services from foreigners. $\endgroup$ – Fix.B. Jul 20 '16 at 23:31
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If there's none who will sell foreign assets, or borrow from the domestic country, then it means that foreign country is paying in domestic currency by borrowing from a country other than the domestic. Since, the foreign country is paying in domestic currency, to prevent a change in the exchange rate(in case of a fixed regime), the CB will accumulate the foreign currency.

However, what would be the need in the case of a flexible regime?

In both cases, the CB could finance the government(private) spending, by buying govt(corporate) bonds, issuing more money.

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