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As a student I am trying to understand the BoP dynamics resulting from a net inflow in the financial account (FA) of a country.

Assuming a country has a Current Account (CA) deficit of -50.

CASE1: if the surplus in the FA is exactly 50, then the financing whole is filled

CASE2: if the surplus in the FA is less than 50, then the financing whole is filled by the central bank selling reserves

my question is

CASE3: if the surplus in the FA is more than 50, say 70, and the central bank does not buy this surplus, where is recorded this amount in the BoP(70-50 = 20)? How can the FA and CA match given there is more inflow of capital than needed to finance the CA ( assuming the Central bank does not intervene in the FX market)?

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  • $\begingroup$ What BoP model are you using? You can always explain these things by shifts in IS-LM or parts of BoP but it seems like your problem assumes some things constant without specifying it. For example, your question could be resolved by changes to exchange rate but do you assume that it is fixed? $\endgroup$ Commented Jan 16 at 15:00
  • $\begingroup$ yes i am assuming FX to be fixed for the sake of simplicity. Would like to get an example of case CASE3 to better understand how the net capital inflows in excess of the CA deficit are recorded and how in this case CA = FA holds. $\endgroup$ Commented Jan 16 at 15:37

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Under fixed exchange rate the balance will be restored by shifts to the IS curve.

BoP equals to current account $T$ which depends on real exchange rate $q$ and output $Y$ and capital and financial account (K) which depends on relative difference in interest rates between foreign (*) and domestic country, and change in net international reserves (IR):

$$BoP = T (q, Y) + K (i - i*) - [\Delta IR] = 0 $$

If you decide to fix $K$ (and implicitly interest rates in both countries) and also forbid central bank intervention then only thing that can change is real output $Y$ because country will be forced to lower their imports (as it will not have means to procure imports) and this will reduce the CA deficit until BoP= T (current account) + K (capital and financial account).

Alternatively if you did not meant to also fix exchange rate abroad, and you only meant to fix $i$ portion of FA, then simply FA will fall as there will be capital outflow when $i^*$ changes.

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  • $\begingroup$ would you be able to show the effect of 'forced to lower their imports' with a numerical example, maybe starting with the assumptions of CASE 3? If there is a surplus in the financial account (net inflow of capital) in excess of the imports of a country why the country is forced to lower imports (they have more money in than what is needed to import) ? $\endgroup$ Commented Jan 17 at 10:51
  • $\begingroup$ @Finance_student I will oversimplify it because to showcase all equations of the model with solution would take too much time but if we simplify, the reason for that is that they simply are not producing sufficient amount of output to get those imports, by definition $Y= C+I+G+CA$, you can solve it for CA as $CA=Y-C-I-G$. Then if $BoP= CA+CFA- \Delta IR$ then $CA= BoP-CFA+ \Delta IR$ if you use your assumption and CFA is magically fixed to lets say 40, no change to IR and BoP must be zero you simply have $CA= 40$ this means that either Y has to so that we get from original $\endgroup$ Commented Jan 17 at 16:56
  • $\begingroup$ CA= -50 = Y-C-I-G to -40 = Y-C-I-G, so either Y increases by 10, or C, I and G (consumer spending investment spending and government spending) decrease by 10. Simply because of your assumption the country was not rich enough to have -50 CA deficit. You could also reverse it and say that country was not exporting enough to get 40 CFA inflows. Both ways of looking at it are equivalent because they are two sides of the same coin. However, since you said you want CFA fixed to 50 then I opted to just look at the CA side which simply plainly states that country does not have sufficient income $\endgroup$ Commented Jan 17 at 17:09
  • $\begingroup$ to have both -50 CA deficit. PS in my first comment (today) I accidentally forgot - sign in front of CA $\endgroup$ Commented Jan 17 at 17:11
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The International Monetary Fund (IMF) publishes a manual for Balance of Payments, which is defined as:

The balance of payments is a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world (IMF Balance of Payments Manual 5th ed. p.6)

Reflecting changes in characterisation and classification of the accounts in question, the macroeconomic accounting identity for international Balance of Payments (BoP), is as follows:

$$ Current \, Account \, (CA) + Capital \, and \, Financial \, Account \, (CFA) = 0 $$

The current account pertains to goods and services, income, and current transfers

and

The capital and financial account pertains to (i) capital transfers and acquisition or disposal of nonproduced, nonfinancial assets and (ii) financial assets and liabilities.

This is a binding mathematical identity precisely because all of the components of the various accounts have been defined as such to make it so. It represents net changes to stocks over a period of time and therefore measures the flows of funds (and real resources) between the domestic and foreign sectors as they carry out monetary transactions.

For instance, in your example, it would not be possible for the current account to be -50 in deficit (CA = -50) while the financial account component (FA) of the CFA was +70 in surplus (FA = +70) unless the capital component (Cap) of the CFA was -20 in deficit (CapA = -20).

$$ -50 + (-20 + 70) = 0 $$

If my country, in aggregate, imports more goods and services, and receives less income over a period of time (eg. a year), than it exports/provides, the result is a current account deficit. This represents a net outflow transfer of my domestic currency in exchange for a net inflow of real resources. The result is that the foreign sector accumulates financial claims against, what will ultimately be reserves at, my country's central bank.

This net accumulation of my domestic currency in the hands of the foreign sector is accounted for as a surplus in the capital and financial account. It exactly matches the overall current account deficit because it has to, by definition. It is Newton's 3rd law for international balance of payments.

This makes more sense if the foreign sector uses these accumulated net claims against my central bank to purchase financial assets denominated in my domestic currency (eg. bonds or equities) as you can then see how the current account deficit money (which ended up in foreign hands) inflows back into my country in exchange for non-money financial assets 'leaving' it.

There could also be foreign currency exchange happening but this wouldn't change the fundamental macro BoP identity detailed above.

I hope this addresses your question in that your case 3 simply isn't possible in accounting terms. Balances must always balance.

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    $\begingroup$ -1 by me, this is clearly completely incorrect. OP in the 3 case does not fix CA so CA can adjust and balance. Your answer just focuses on empty accounting that is economically irrelevant. OPs question is clearly about Mundell-Fleming model and the case 3 is not only possible but also resolvable through IS shift $\endgroup$ Commented Jan 16 at 18:53
  • $\begingroup$ @LorenzoPozzi The assumption is literally that the CA has a -50 deficit. I answered with that in mind and I don't see how my answer is irrelevant or wrong at all? "Empty accounting"? This literally is international accounting. $\endgroup$ Commented Jan 16 at 19:01
  • $\begingroup$ no this is international economics, and -50 deficit is clearly initial state, this is classic textbook MF bop problem that you can see in INT econ, it has nothing to do with accounting $\endgroup$ Commented Jan 16 at 19:03
  • $\begingroup$ I'm sorry but it's a grotesque mis-use of language to state that international Balance of Payments has "nothing to do with accounting". It's also international economics but I chose to answer based on the macro accounting identity - which will hold given his case 3. Feel free to provide your own answer based on potential consequences in economics terms but don't downvote mine just because I didn't frame my answer like you would. $\endgroup$ Commented Jan 16 at 19:09
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    $\begingroup$ @Finance_student If I am an American that buys a product from the UK, my US bank will debit my USD deposit account. The Fed will debit my US bank's USD reserve account and credit the USD reserve account of the BoE. The BoE will credit the GBP reserve account of the UK bank and the UK bank will credit the GBP deposit account of the seller. The net result is USD accumulates in USD reserve accounts held by the BoE (or sometimes by commercial banks). Those USD reserves held by the foreign sector as a result of a Current Account deficit count as a surplus of the Capital and Financial Account $\endgroup$ Commented Jan 17 at 11:32

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