Tue Bnnrucr

or PnymENTs AccouNrs
arts I throughIII of his book concentrated the behvior "real" varion of ablesin the international economy-on the quantitiesof goods procluced, consunted, traded. and Prices *'erecrucial secLrring in equilibriurn, onlv but (theterms trde)or of factors production. astherelative prices goods of of of The focusnow turnsto the "monetary"sideof international econourics.l This requires an examination the behavior nronetary of magnitudes-the quantityof rnoney of irself andvarious prices that arc measured curreno'Lrnits. in Thcse include overirll pricelevels, wagerates, and the foreignexchange rate,rvhichis the priceat whrch curencies exchaneefolone auother Thesubject internationrl of monetilry economics grou'nrlpicllyin interest has and inrportance over the last 30 vears. \,luch hls happened over this periodin the s'orld econony.In 1973 the major industrialized countriesmoved fronr a slstemunderrvhichexchange rateswerefixed b,vgovernments-r system that had held ss'av sinceVorld War II-to rr ne*,, unfamiliarsvsren in rvhich exchange rates determined them:rrketplirce. noir'hve30 vears experic.nce are in \Ve u'ith o[ fron rvhichto clrrvlessons. this svstem lvleanrvhile, goodsmirrkets both nd financial markets lrirvebeconre highlv integrated, iorcingevenpreviously insularAmerican mlcror'cononrists to recognizethe irnportance the foreign of sector: price' oil hr,cinduced econochangt-s miststo buildbackinto theirviervof the racroeconr)mv of the realfectors sonre hat hd l.ecnleft behind; cleveloping countrics hirvebeconre integrrrted the inro globll econonrl'; European h:rve undcrtkcn countries rllonetrv intcgretion lith eachother;and l;rrge new macrocconomic unl[ec('de]rtcd Poii.. .listrrrl.ncls. tradeimbalances, currency lnd in crises sornc countlirshrrve rcsted limits of the the nlodern financirlsvstenr. the smetime,thinkingon thc subjecr been At has stiniulirted nerv developments the macrocconontic b1, in tht'orv of ckrsed [ntellectual econonries: revolutions thrt in ferv short ]r'ilrs sJw nronct:rrisnr (if adopted a standard s description long-run of equilibriurn not of short-run rel"ratronrle-xpectations" it1'), adopted standrrd as rnethodologv, "relbusiness antl cvclc"theor:rdopted a represent:rtion s of supplv shocks.

l-fhefiekl is alsoknownas the "macroeconomicsopeneconomies." term "intcrnrtionl of The fi nrnce" s rppl i cablrs r v el iparti c ul :rrl r,ro nteri alc ov ered P rtsV nc lV L i e , the in

?31

282

PAYMENTSACCoUNTS BALANcEoF l5 Cxnerrn THE

l5.l

BnroowruorrHAccours

that reeightor ten factors,or variables, This half of the book rvill introduce includethe ceivedlittlc or no attentionin the first half of the book. The variables (emphasizing cyclicalcomponents of the rate, output and employment exchange pricelevel,the the rate,stocksof moneyand reserves, aggregate the each), interest goods, flows of portfoliocapital,and exinternational relativepriceof non-traded rvorkscan be quitedifholv the macroeconomic system pectations. Understanding will Thesevariables simultaneously. all ficult if one tries to consider ten variables in one at a time, so that eachcan be assimilated-understood terms be introduced Thus,rve the rvith the other variables-before next is introduced. of its interaction as rvhatlve haveusedat eachstage lve moveon to the next stage neednot discard rvhatcamebeforeto be the right and the next variable.Rather,rve can consider the rve is u'henthe variablein question held constant; s'ill then examine ansrver is to t'hen the variable allou'ed change. in change the results corresponding of rve hou'ever, briefly explainthe sequence the different Beforeproceeding, rate,and rvill shol how it helps thc Chapter16 will introduce exchange variables. rate balance trade.The effectof the exchange on the trade of a determine country's ' in environment' which price first in the most controlled will be examined balance Then Chapter17 are and all other variables held constant. levels,incomelevels, in in Unlikechanges output considered rvill allorvfor cyclicalfluctrations income. rvill represent changes relatiueto potentialoutput, previousl theseflucnrations are capacity. The,v rvith unemplo.vment labor and unutilized of associated changes and that arerigid, or at least"stickl"-that resist of the consequence rvages prices This represents sharpdepara the movingto equilibrate labor and goodsmarkets. u'ereassumed be flexible to rurefrom the firsr half of the book, in s4richall prices enoughthat tlrey acljmtedro ensurethat stpply ahvaysequaleddemend.Ssse of capacit are familof and suchrs the existence unemployrnent excess the results, nluch will be nerv rnd textbooks.Horvver, iar from standardmacroecononrics the are I-or u'henprices not freeto adjust, differentin the openeconomy. e-xample, equilibrium. rate be exchangc cansometirnes usedto restore rate l8 supply andtheintcrest rvillmake In thelastpan of Chapter themonev balance, At theirappearance. this pointrvct'ill -.,-..-"s horr iilt vrial.les-trade and rate, lelel of income,monel' suppl-r', interestrate-all interrehte. exchange concerns eftects the a the Here,and throughout last half of the bo-ok, key question ln and of monetar.v fiscalpolicv on the openeionom.u. Chapter19 nvo more fscthe tors are added.The first half of the chapterintroduces stock of internationrl hilf of thechapter (e.g., gold)that is held by the centralbank.The second reserves befor exarnines, the first tinte, the overirllprice level.Chapter20 distinguishes tween tracledand non-tradedgoods,providing a partictrlarll'useful model for that LDCsandothercountrics aresmallin world trade. floiv of capital,the mostporverthe The coreof PartV concerns international I Te ful nervfactorin the modcrnworld macroeconomy'. simplifv:Parts throughIII generally it'ith the trde balance llorv o goods, on concentrated the intcrnarional allos'ing ilorv tti money, the to constrained zero;Prrt lV introduces international flow of port' the payments balances; Part V introduces international and nonzero

suchasstocksand bonds.Because asset a claim to future an folio capital-assets is consumption' international trade in assets what allorvscountries spendmore is to thantheyearnin some periods, then makeup for it by spending than they earn less in other periods. Finall Pan VI examines determination exchanee the of raresin international asset markets, whereexpectations ariseas a key variale. also ve rvill seerhat tlvo particularaspects rhe srrucrure the worrd economy of of as it evolved over the 1970s,-1980s, and 1990s-rhe grear easeof international capitalmovements and the systemof market-determined exchangerates-have completely altered horvpolicychanges orher macroeconomic and disturbances operate. Theseaspects the moderneconomyhaveimportant implicationsfor the of resolution iremationalpaymentsimbalances of and other policy problemsthat the world faces. Before beginexploring operationof the international rve the macroeconomy, lr is necessary go rhroughthe mechanics balance-of-paymenrs ro of accounring rhe in present chapter. This tool would be necessary evenif the subject were as tediousas matters accounting of sometimes appear. Balance-of-payments accounts, howeve haveattained nervfascinarion recentyears.Somemeasures the balance a in of of payments closely are watched the pressand policymakers. by considerable insight into presentinternationalpavmentsimbalances can be gainedsimplyfrom the accounting identities, evenbeforethe discussion rurs ro the tnoreinteresting questions economic of causality. accounting An identity is rn eq.ation that must hold precisel,v, a marterof definition or arithmetic,as opas posed behavioral to equations, rvhichrepresent theories econornic of behaviorthat arenot e.\pected hold precisely. to

15. I

BRelxoowr. oFTHE AccouNrs

A nation'sbalance-of-payrnents accountsis the statistical recorclof all economic transactions takingplacebenveen residents the restof the world. Theseare its and mostconvenientlv brokenup into threeaccounrs, shorvnin Table 1.5.1. as Firs, lhe currentitccol.ttt (CAi is the recordof tradein goodsand services othe curand rent transactions, opposed rrade in assels, as to rvhich are obligationsregarding the future.Tradein assets appearsin the capital accounrs, the asseris traded If amongprivatecitizens the countries, of then it appears the priuate capitalacon countlKAl.lf the buyeror seller rheasset a cenrral of is bank-that is, the monetary authorityof eitherthe domestic foreigngovernment-then the transactro or appears the officialreserue on transaciozs account(ORT). Breakdown ofthe Current Account Eachof these rhreeaccounrs in turn dividedinro subaccounrs. is wirhin the current accounr first subaccount merchandise rhe is trade,consisting exports and of importsof goods, rvhichincludes movable all goodseithersold, bought, or orherwisetransferred between domestic and foreignowners.

284

CHprn 15 " THEBALANCE PvNEr'irsAccourrs or

l5.l ' BnaroowN orluAccour.rrs 285

T a b le l5. l Schematic Representationof the Balanceof Payments Accounts Subaccounts and

AccouNr (CA) CURRENT l vlerc handi s e Services o T rns por t . r i o n Touism . Business and professional services . . Inv es t rent i n c o m e Unilateraltransfers Government grants . Privateremittances PRrv,lr C,rrrrr Accornr (KA) Direct investment (securities bankingflorvs) Portfolio investments and . Long-t er m . Shot-term. Orrrcrai- Rsrvc TBANlAcinoNlORT) in assets Changes foreigncentralbanks'holding of dornestic ln Changes the domesticcentralbnkt holding of foreignassets ' G old llrlF c rc d r t s r n . l\ D R > . . Foreignexchange reserves
Each balancet the right is the sun of the prer ious balancend rhe dditional items lisredbetore the doned line

Blances Cumulative

....Nle r chandi sebal ance

bodiedin that factory.It is importantto distinguish these yearlypayments the for seruices capital,rvhichappearin the currentaccount, of from the original investmentitself, which appears the capitalaccounr. in Unilateral transfers a fourth subaccount. are This subaccount consists govof ernmentgrants(foreignaid) and privatereminances (fronl emigrantr.vorkers to their families, from pensions reriredpeople to living abroad, etc.). Transfers appear in the current account ratherthan in the capitalaccount because do not create they anv obligation repayment fhe future,asa loan docs. for in Breakdown of the Capital Account Vithin the capitalaccounr,2 key distincrion benveen the is direcrinvestment and portfoliocrpital. Portfolio invesrmenf fun crn be divicled in inro long-rernr anrl short-term. 1 . Foreign directinuestment occurs whenthe residents onecountryircquire of control over a business enterprise another in country. The acquisition may involvebuving enough stockin an eristingenterprise become controlling (defined ro a shareholder for this purpose 10 percent as qurlght* or ownership), ,4'n&".tg the enterpise tuilding a newiactoryor enterprise (including, well, the purchase from scrach as of real estate). Vhen an investor buysonly a smallfractionof the shaes a foreign of compan)', horvever, is an example long-term it of portfolioirvestnlent. ) Long-termportfolio inuestntent involves international in transactions financialasrvith an originalterm to maturitygreater sets than one year.Suchinvestnentcon(stocks, sists purchases securities of of alsocalled shares equities, bonds) or rnd and long-term bank loans.Oftenthe distincrion betr,veen Iong-term ndshort-rcrnr capital florvs arbitrar.', whenan investor is as governrnenr buvsa 10-.vear bondrntending resell in a shorttime,or huysa bondrht has.lrea,lybeenheldfor to it 9l/2years is aboutto mature. and 3. Short-tenn cLtpitl rvith originalrennsto marurityof lessthrn flotusinvolveasses one)'ear. Eramples treasurv xre bills,commcrcial prrper, certificates deposit ancl of lshort-tenl clainrs thegovernmerrt, on corporsrions. lanks, .rnd respectivcly). Also included short-term as capitalflorvs any intcmational are shiftsin the ox'nershrp of liquid funds,suchas an inrerest-earning deposit, even checkor cashrvhich or doesnol pav interest. example, For Britishpoundnotes, deposits a Birish in or just bank,areassets givinga climon futureBritish goocls sen'ices, ls surcly and as British treasury bills.The distinction benveen short-term ancllong tcrnris still reported Japen,Gerrnanl', sonleothercounrries, not in thc U.S.acin and br:t counts, mainlvbecause is difiiculrto disentangle tu'o typesof porrfolioinit the vestment the data. in
!'i:.'

.......

. Balance goodsand serylces of Ba lance ofgoods,servi ces, and income

brrlance . . . . Currentaccount

...Ba slcbal ance of . . Oveallbalance payments

(alsoknou,nrn u'ithinthe curreut is The seconcl subaccount ilccoLlnt scrvices referto merrvhich the UnitcdKingdomas "invisibles," opposed "visrbles," as to international are chandise). Sonle the irnportant of service transactions asfollorvs: l. Trrrnsportltion scrvices inclLrde freightnd insurence for chelgcs heintcrnrtionl movnlcnt goorlsand alsothe expenditures rntcrnational of trar,el t()Lrrists of on
nd nthe. nrcqenoPrq r_" -"b'_"'

2. Touristservices includeall expenditures a countr,v's bv citizens foreigncor-rntnes in (on food, lodging,local transportation, erc.). 3, Bu sin essa nd pr of es s ional ic es m ak c upadjv e s e c l a s s o f i n t e r n at r orn lr c s er v i : ns coltsttlr: tions.]nternational tadein theservices cngineering firrns, mirnagcment of of ing firms,computer programmers so forth is a rapidlygrowing component and the w'hen trade.Royalties and license fees paid for the useof l work or inr,ention, copyright or patent is held by a residentcitizen of rnother countrv, are also countedas pa,yments a se rvrce, for payInrerest A third subaccount rvithin the currentaccountis inyestment incomc. for pavments the ments or dividendsappear here because thev are considercd ofcapital that is "working" abroad. The profitsearned a factorvorvned services by for of by a foreignresident, example, payments the services the clpitll emfor are

=
-,:it:i

:'r=:

2"Cpital account" r,ill generallv be used to efir to the privare crpitrl accoLlnr, clistinctfrorrr .rs thc trnsctions oi central bauks. (lt does include. horvevcr.nv infcrniltionrl tansactjonsundertak en bv gov er nm en ra g e n c i e s t h e r rh a n rh e c e n l rl b a n k -f o r e ra mp l e , c re c l i t st o U . S . rrme d o foces stationedaboad.)

s-ii,:: i=:::r; ai:: F

256

RALANcE oFPvrnrsAccouNts CHprn . THE 15

15.2. HovlxovlouLTmscrroxsAn REconoeo Zg7

in reconsists centralbank transactions international of Finall the ORT account gold, foreign exchangereserves, credits issuedby the International serveassets: DrarvingRights(SDRs).3 Centralbankshold MonetaryFund (IivfF),and Special to thesereserveassets back up the liabilities they issue (domesticcurrency and much as commercial bankshold that add up to the monetarybase), other assets accountdeposits and that they issue(checking reserves back up the liabilities to that otherassets add up to the total moneysupply).

Credits and Debits on the Capital Account

ARE 15.2 How lnovrouALTRANsAcnoNsRrcoRoro

is The key rule for recordingtransactions as follows: Slhateverentersthe countr),, leaves country, the suchas an as suchas an import, is recorded a debir;rvhatever trade as that export,is recorded a credit.The examples first cometo mind concern (goods). import of an autontobile as An appears a debit in the in merchandise something entering country;the export of jet is the merchandise account because the is the Of appears a creditbecause as something leaving country. course, engines account; and the earns crediton lrs merchandise a countrythat exports automobile receives debit. a the countrythat irnportsthe jet engines for Thereare many other examples exportsand importsof variousservices, as and for each of the other subaccounts rvell. Vhen an Americanimporter r.vitha Greek shippingcompanl',or Americantourists transportation arranges as is cossthe Atlanricon a foreignairline,rhe import of the service recorded a \lhen foreignfirmshire American service account. debitin heU.S.transportation the or cometo the UnitedStates, export ships carrygoods, whenforeigntourists to in of tourists Europe is as of the sevice recorded a credit.The spending Anierican ofJcpanese on account, the spending and ir r..*d.d rt, d.bit, again the service producer as touristsin the United States a credit.Vhen an Americantelevision cartoon,a the contracrs to Koreans rvork of filling in framesin an animated out to \lhen a foreignstudent comes againappears. import of the UnitedStates service an Americanuniversityto stud.vor a foreign medical patient comes to rn for it export. hospital surgerv, appears a U.S.sen,ice as Anierican underunilaterl is are The convention that gifts and other transfers recorded Eventhougha transferfrom anothercountrydoesnot createanl' oblitransfers. that as gationfor futuremonetaryrepayment, doesa loan,a devicefor remembering as it appears a creditmight be to think of thetransfer the exportof a politicalor as payments fromJapan andother received large the moralIOU.In 1991, UnitedStates on These credits not appear did Operation Desert Stormin Kurvait. allies finance to bur accountbecause they were not literally exportsof nlilitarv services the services remittances an importantsourceol are instead transfers. as Ernigrants' appeared the and aroundthe Nfediterranean; creditsfor Mexico,the Philippines, countries countrles, debitsare incurredin the UnitedStates, northernEuropean corresponding that rvorkers. Gulf states hostthe immisran and Persian

oTheacquisition a foreignasset of countsas a debit on the capitalaccount,because the asset, at leasrrhe claim to the asser, enteringthe homecountry.As a deor is vice for remembering that an investment abroad counrsas a debit, think of ir as (The equivalent the "import" of an asset. term-"capital outflow',-rnay be less helpfulhere,in rhat it may not soundlike an imporr, eventhoLrgh is one.)Vhen it GeneralElectricbuilds a factory in Europe, an ourflorv of direct investrlent,a debit,equalto the valueof rhe equitythat GE acquires the factor is recorded in in the U.S.balance payments. this sense purchase machinetools bolted In of rhe of down to a factoryfloo in Scotland similar ro rhe purchase Scotrish is of machine tools importedinto the United States, in the forme casethe debir appears but on the capitll rccounrand in the larter caseit appears the merchandise on trade account. American An purchase ofthe bonds ofa Canadian provincial governnlent is recoded a porrfoliocapitaloutflorv,a debit on the longterm portfolio capital as account.The Americanacquisitionof a short-rermassetin anther count;y.,vhether is a treasur,v corporareIOU, cerrificate deposit,check,or curit bill, of rency-counts as a debit on rhe short-termportfolio capital account.This point shouldbeemphasized ir because rv,illbe inrportanrfor understanding lccour"rrthe ing to follorv.Remember rhat the reasonrhis acquisition counrsas a debit is that an American has increased individualholdingsof a foreignasser, evenif rhe asset is onl-v foreigncurrenc!'. Eversince1982,the U.S.capitalaccounrhas shorvnmany more creditsrhrn debits.Foreigncitizenshave beenacquiring assets everv sort in the Unired of States: cnrrenc,r', rreasury bills, bank loirns,.bonds, stocks,and direct investnent. The rEnn "cre# maffilikc a goodthrngffirrecaiving cornrr{rone sense is true:lt crn vierved a vote of confidence this be as rvhenforeisners decideto invest the UniredSrrtes. in The dorvrside. course, rh; U.Slcirizcns of is rvill haveto service debt (i.e., the pay interesr, eventually and repry rhe principal) in the future;or, in the cases sales stocksrnd of of inrvarddirectinvestnrent, clii,idendsnd profitsrr,illhaveto be reparriated abroadin rhefLrture. If American citizens rcsell a ioreignresiclent bond originall,v to a issued a bv foleign corporation, an1'other foreignasset or they acquired the pirst,that roo in countsas a credit.There is no economicdifference betrveen increrrse your an in obligations a fbreigner a decrease a foreigner's to or in obligations you. Both are to described a decease the net foreigninvestment as in posrtionof the UnitedStates, r,vhich simply is onemoreway of saying"capitalinflorv"or "credrton rhecrpitrl account."Siurilarly, an Americanbuys back a U.S.Treasury fronl a foreign if bill resident who acquired in thepast,ircounrsasa debirin the U.S.capitalaccount it in the samervayas rvhenrhe asser Americirnpurchases the from the foreignrcsidentis onethat u,as issued sonre originally by foreign go\rernment institution.a or
lAs matter fct, increases U.S.-held in of ssets issued broad decreasesioreiqn-held and in assets in the UnitedStates reported are separately the detailed in balance of-prynrents pub,rccuLrnt, lished quarter rheDepartment commerce. every bv of Economic discussionsthe brrlance par,of of nentsr:sually' focus onlyon thenct capital florvs, horvever

sSpecial gold," arean asset created the IlrlF' b,v Dra*'ingRights, sonetimes described "paper as pound, in the andeuro. is of Theirvalue defined ternls four curencies: dollar, r'en,

288

Cspren . TEBrrucorPvlrrsAccouxrs 15

| 5.1 " Douer-ErR'r BooxrprNc

289

The final place where ceditsand debitscan appearis the Official Reserve or Transactions account.Vhen the domestic centralbank buys foreigncurrency rvhena privateinvestor makes the gold, its purchase courts a debit,just asit does as purchase, here it appears the ORT accountratherthan the privatecapital but on can As for that account. a dei,ice remembering it countsasa debit,the purchase be by bank.In this sense thoughtof asan import of gold or foreigncurrency thecentral that in in it is like the import of gold jewelryor shares a foreigngold mine,except and in the gold the in tradeaccount the jewelrycase debit appears the merchandise the mine casein the capitalaccount. Only rvhenthe centralbank makes purchase on doesit appear the ORT account. currencyis Another examplearisesif the country in questionis one rvhose (as asset are the dollar and several other usedby other centralbanks as a reserve currencits Vhen a foreign central bank buyssomeof the donlestic currencresr). purchase accounts, as countsas a creditin the domestic balance-of-payrrents iust it doeswhen a privateforeignerbuyssome. DouaLe-El.rRY BooKKEEPTNG qconomrc tra$Note a critical point: As a matter of accolntiqg,everyqornplete is t*ice, onas a debit and onceas a credit.The reason that in actronis recordFd for transaction thereis something leavingthe countrvin erchange everr corrrplete somerhingenteringthe country. If there were not, then one party or the other is to for One case rvhere this is easy see rvouldbe givingup something nothing.6 for to in barter.if, for crample,Arsentinr exportsrvheat Russia exchange tractors, then both the credit for the rvheatexport and the debitfor the tractorsimport ;rpSimilarlv, Russie if accepted claimto the pear on the merchandise tradeaccount. for the bahncc-ofsonreArgentine farmlandin pavment the tractors, Argentine rvoLrki payments statistics shorva debit to the tradeaccountand a corresponclilg directinvestment. creditunderforeien Paying for lmports throughthe are Usully,horvevettrallsactions paid for in an inlneclirtesense Argcntinapa,vs the tractors rvritinga checkon a bnk' for by bankingsystem.:
5Only contertible foreign currencies are held as foreign erchange reserves. Centrl banks do nor hold Tajikistani rubles as resen'es,becausenerther the governmenr r)or privirre hnks u'ill frcelv convert them irto gold, dollars, or other internatjonl reserveassets. 6The unique case rvhere one prrt,v does in fact give up sornething for nothing ls the unrlterll trnsier. When the United Statesdonates grain to an Africrn country, for errnrple, r debit is ssigned to the trde account of the African countrt' (or to its capitrl account if the donrion consists of monev) becausesomething is entering the countr,y.A credit is assigncdto the United Sttes b e ca rse me th i n gi s leaving the countr ;' .As r vasalr eadvnor ed,th e uni l ter l r r r r s fr r s ec ounri s so wherc accountants.bv convention, also assigna correspondingcredit to the recipientcountry rnd .r d e b i t ro th e d o n o r e^un r u. 7ln a type of intcrnxtional transaction calle,Jcountertrde, the exporter of goods to a counly promises ro import a corrcsponding value of goods from that country. Horvever, rost counrer-

15.3

The credit that corresponds the debit on the trade accountappearson rhe to short-term capitalaccount. Recallthat any time a foreignresident acquires asan set or a claim on the domestic counrry evenif it is a bank depositrather than a more tangible investment, countsas a crediton the domestic it capitalaccounr. It is quitelikely that the Russian rracformanufacturer quicklycashin its check, will rvhichis a claimon an Argentine bank,to buy something moredirectlyusefulro it (perhaps than Argentine pesos that Argentine wheat),but this would count as an entirelyseparate transaction and would appearin the accounts a new creditas debit pair. Other than payingfor transactions cashor check,the only other common by method is trade credit: The tractor manufadurerextendsto the Argentineimporterthe ceditneeded buy rhetactors(i.e.,the importerdoesnot haveto pay to utii a l;rr date)or elsea bank extends creditto rhe importer. this cserhe the In credititem againappears the short-term in capitalaccounr: foreignresidcnt A has acquired short-term a claim against Argentine an resident. this sense In payingfor an import on short,term credit looksjust like payingcash;both appearas cedits in the same line of the balance oavments. of Payln g for Asset Purchases As a finl setof examples, consider how the purchase an asser paid for. If a of is company buysan officebuildingin Los Angeles and paysby chcck,the Japanese U.S.balance payments of registers creditunderdirectinvestment foreigncoma (l panvhasincreased holdings U.S.realestate) a debitundebankingflows its of and (an American companvhasincreased holdings short-tcrm its of clairns foreignon ers-it has the Japanese check).If an American firm buys a Canadianbond and pavsby check, U.S.balance payments the of sho.rvs debirto porrfoliocapital(rhe a firnr has increased holdingsof foreignsecurities) a credit under banking its and florvs(a foreign finn hasincreased holdings shot-term its of claimson Americans). If n Americanbuysa 90-da,v Certificare Depositin the UnitedKingdom and of pavsbl check. both the credirand the debirappear underbankingflorvs{rrvo short-term assets havcbeenexchanged). somecases is difiicukro srv rvhich In ir sideof the transaction payingfor the other.Thereis nothingrvrongrvith this; is both parties haveto getsomething of it. out It rlay be clearernorv rvhy it makesaccoullting sense enter a paynrent to abroadasa creditto the capitalaccount the same ar time that a debitis entered fo (e.g., thetradeaccount thecase an import the otheihalfof the transaction on in of of merchlndise). Takethe caseof an American companypayingfor an import in (either clollars cashor a checkon its bank accounr). the foreign If company werero hold on to the dollars rather than cashingthem in, in exchange for its olvn

rradetransactions paid for throughthe banking are.still svstem. Relatively linle of it is outright barterfor goods, rhisis arvkrvard. (Dalial\4anin,"Tyingin lnrenational as Trade: Evidence on Countertrade," \Xlorld The Econom1., 13,no.3,Scpt. 1990,145-467.J

290

or Blrucr PvmrxrsAccoulrs CHprer . THe 15

15.4. TH B A LA N C E S 291

currency-that is, if there rvereno secondtransactionundoing the capital flowdecision this uould haveto meanthat the foreigncompanyhad madea deliberate credit;it of its to increase holdings dollars.This shouldcount as a capital-account just in foreign investment U.S. assets, as if the foreign companyhad inconsritutes Again,normallythe foreigncompany of its creased holdings U.S.stocksor bonds. more useful,but doing so to would be expected cashin the dollarsfor something sellsthe dollarsto transaction. the foreigncompany If would count as a separate transaction of consists a debit to the U.S.short-term the centralbank,the second of (a its has capitalaccount foreignprivatecompany norv reduced holdings short(theFederal has Reserve e-xported anl term U.S.assets) a creditto the ORT account someforeigncurrencyreserves). What if the lmporter Pays in ForcignCurrency? in The so It hasbeen assumed far that the U.S.importercan makepayment dollars. fist if Assume that the U.S.imhorvever, it paysin foreigncurrency. storyis similar, just for suchpurposes. Initially the porterhason hand a stockof foreigncurrency credit: A U.S. capital-account current accountdebit is paid for by a short-term a its rvhichrepresents capitalincompanyhasreduced holdingsof foreignassets, (Recall that rvhenthe U.S.companydeflorv iust as ii it had sold off a securitl'. it its creases creditpositionvis-)-visforeigncompanies, is as if foreigncompanies if Horvever, the imthei credit positionvis-i-visU.S.companies.) had increased balances the bv porterobtained foreigncurrency drawingdol'n somerranstctions it subsequently ivill probably\vant to rekept on hand for the purpose, that'rvere exch."g. rytk.r. somein theforeign its curency by bu,ving plenish stockof foreign it currency beginu'ith, thenagain to not does havea stockof fbreign If the importer EitherwaJ', irnponer the marketto obtainsome. exchange hasto go into the foreign in trirsaction rvhich it is obforeigncurrenil',and therewill be a second needs bank,thesecond from its central the currency If theimporterobtains foreign tained. and capiral account a creditto the of consists a debitto the short-term transaction exactly in the first exanple. as ORT accounq to allorvsits stockof foreigncurrency reOn the other hand,if the rnporter (or main lower at the end of the periodthan it was at the beginning goesinto debt its to then it must have decided deliberately decrease (net) in foreigncurrency), The net creditthen remains the capitalaccount-as on holdingsof foreignassets. than increase their claimson domestic companies-rather companies when foreign to beingtransferred the ORT account.

cen is zt flows, or total creditsminus total debits.Within any given line of the balanceo[ payments, therewill be many creditsand debitsthat canceleachother out. For example, short-term banking flows are rypicallyvery high in grossterms,as banks buy and sell short-term positions in foreign currency and send checksback and foth for collection.But the net flow is much smaller. The country then addstogetherthe net flows, or subtotals,fom different lines in the accounts detemine to variousbalances, If suchas the trade balance. credits outrveighdebits,then the balancein questionis positive.A positive balancers commonlyreferredto as "favorable." If debits ourweighcredits,the balanceis negative, "unfavorable.' or pull of rhe semantics. Noe the gravitational The export side owns all the positivervords-and has done so ever sincethe eighteenth-centuly mercantilists madea nationalvirtue of sellingabroadmore than one bought in order to "store up treasure."Although economists from Adam Smith on have proclaimedthat economic welfareultimatelydepends the goods availablefor the nation'suse on this linand not on the moneyeanedfrom exporting,they haveneverconquered guisticremnantofmercantilism. \hen the term "un{avorable"is usedin re{erence to a negative trade balance, remember that it may be perfectlyappropriatefor a develcountryto run a tradedeficit,depending the circumstanccs. example, on For oping countries sometimesrun large trade deficits. This practice can be perfectly appropriate they are grorvingrapidly and need,for example, import if to capitalgoodsin orde to investin plant and equipment. Suchcountriesare necessarily borrorving from abroadto financetheir current-account deficits.If they are spending the funds well, they will in the future have the level of capital stock, paleuly cxport ca@ort earningswith which ro repay rhardebr. The Adding-Up e onstraint Because everydebit has an offsettingcredit somewhere, + KA + ORT = 0. CA (Threebarsare usedin the equalirysignto indicatethat this is an accounting idenrt r. r t i r t . )B e c u . ct i . a li l l ys;.i l o , th e th r r e - r cco r nu m i s n o t a ve r vi n te r e sti nre r tr r tic! Trvo interesting statistics (1) the current-account are balance and (2) the sum of the currentand capitalaccounts, rvhich is what is generally meant by the overall (BP): BP = CA + KA. Thesestatistics balanceof payments revealwhether the countryis spending beyondits means,and whethertheeis a net supplyof, or demand for, its currncy. countrythat is runninga current-account A deficit-for exthe anrple, UnitedStates since1982-is borrowing from abroadto do so, running position.Ever since1.91.7,the had beenacdorvnits net foreignasset United States yearsthe enormousdcficits cumulating claimson the restof the world, but in a fer.v rvipedout that accumulated investment position.The official statistrcs of the 1980s shou"+hat countrypassed the from net creditstatus net debtorstatusin 1988. to

;:. :

15.4 TnEBnlaNces
from the internadonal andcredits arising the Everyyear, countryaddsup the debits the in that transactions havetakenplace.For mostpurposes economics, onll'con-

292

Accourrs CuprnI 5 . TueBrce Pwrrs or

15.4. TueBrNces 293 to Theyaresubject largeshon-term fluctuations Service. and somerimes haveto be revised a later date,due in part to lags beforeimports arrive in at substantially port to be counted. This meansthat the merchandisfltrade balancefor irni, one month is not a verygoodindicatorof futuretrends. Thereis no reason, conceptually, focuson exportsand impons of merchanto Thus, a bettermeasure diservhileignoringservices. than the merchandise trade The is on Department balance thebalance goodsand seruices. Commerce began to report service exportsand importson a monthly basisin 1994,in recognition of importance. their grorving The balance goodsand services a point of juncturebetween interis the on and national-incorie accounts. Gross domestic national payments statistics product, chiefmeasure a nation's the of economic output in one yexr,consists of produced homefor consumption, investment, government goods and services t measurc these flols of goods,horvuse,and export.The nationalaccountants ever, not as they are produced but as thev are purchased.Some purchases (rvhether households, firms,governments, foreignresidents) or consist iniof by abroad. Therefore, are ports-goodsthat areproduced afterall purchases dded mustthen subtract out importsin orderto arive:rt rhe deup, the statisticians prorlr:ctron Tlreimport totll is otenshownas a subof siredmeasure domestic traction from exports.Thus, GD P=C +1 +G+( X- i I) 'fhe term in parentheses the balance goodsand services. the ntirnlIn is of "net exports goods "l0 of income accounts is called it and services. and other rnplaceto drarvthc line is to incltde intercst pavnlents Another ntl l'estment income.This total is referredto as the balnce oi goods,seruices, ittconte,tt of balance, nreasure the balace ptrvthc of Next, comes current-account tlie We irlconle. have in and nents th1t addstransfers rvith goods,sert'ices, investntent the it is explained the currentirccount inrportrntbecause represents net that alreadv (u,hether privrrte bv citizens the hrtnlecountrvor bv of acquisirion foreignrrssets of (also \\'as of the central bank).Alsodiscussed thc overilllblance pa,vments clledthe rvhichaddsm the currentrccount privatecapitalall balance), officialsenlements of it the and accounttransactions is importrnt becrtuse represents net acquisition that theline reserve bank.Some economists haveirrgued foreign assets thecenrral bl along thesetrvo, that "exports" of clairnsto factories, shouldbe dral'n benveen
l',The rrndproducr U.S.tradebalance numbers tilfic from "nct exports"in c ntionl income rv of i of tec l ccoutsn r nrnl hc r nti nor hni c ;rl rs , s uc h s thc trei rtmc nr gol d. rl Thedi sti ncti on (2) sc (l bl ofgoods ands en,i c es ; the[' l .urc on goo,1s , rv i c es , e anrong ) rl re nc e bei bal s s to 11) nd i ncome; (3thec urrent c ount ancie nrughl v i nri l ar thetl i s ti nc ti on l r' een and ac production; grossnaproducr, shich includcs onlv inconre from domestic grossdomestit {2) and (l) roralnprofitsironr brorcl (net frctor inconte); s'hichalsoincludes tional product, o beg;rtl tlnph.rgovcrnnrertt from trsles.Thc LJ.S. r'hich lsoincludes inconle tionalincome, l si ze PoverGN Pi n 199 . GD

for surplus-Japan, example-is A country that is running a current-accounr ponet asset accumulating claimson foreigners and buildingup a positive foreign of are sition.sIf the foreignassets acquiredby the privateresidents the domestic surplusand deficit offsetsthe current-account country, then the capital-account KA of is the overallbalance payments zero.In this case, = -CA, so ORT = 0. surplusand its On the other hand, if a country is runninga cuent-account privateresidents not acquiringforeignassets, then it mustbe the centralbank Ne In that is acquiringforeign assets: this case,KA = 0, so ORT = -CA. Sucha not just on its currentaccount, alsoon its overall but country is runninga surplus, (Notethat it is the rregcalledthe official settlements balance. BP. BP is sometimes ORT = -BP.) The overallbalatiueof the sum of the itemson the ORT account: (or anceof payments the net supply of foreigncurrency the net demandfor dois hasnladell its nrestic currenc), which is the sarnething), after the privatesector nuntber, If current-accoullt capital-account and transactions. it is a positive desired which meansdrat the centralbank is addingto its foreigne.vthe ORT is negative, (or in that privateagents the changereserves is supplyingthe domesticcurrency numforeignexchange market rvant,rvhich is the samething).If BP is a negative foreignexrvhich meansthat the centralbank is selling ber,then ORT is positive, d+aage reserdar is brying tfrrdonresticcnrrency tharprivate agemsin the Rlrket rvlnt to sell.. Where to Draw the Line? higherin runningfrom itersreported Thereusecl be a presurnption causrrlity to of logl,.lvcr. Trade,for example, shorvnin Table l5.l to itemsreported the accounts for icllly camefirst. Suppose line is dra*'n underthe entries tradein goodsand a by by Then, if the balnce in deficit,it could be financed transfers, boris services. "trove line'are considered the rowing (KA), or by reserve (ORT).All itenrs loss or the tobe autontnnous-the1'cruse itenisbelorvthe line,rvhicharefinancing lcThere rvas mucl-rdebateas to where to drrv the line. OblittLs cornntod:rting. ivith KA nd ORT:rs rccomtrodting, rrt BP, uith or pl,rces the CA balance, are line.rs plilccs dr,tu'the to I Iorvelcr, iirere r)ther rr aloncrrs cc<.rmrnodating. ORT in columnin Tble 15.1.e shorvn the right-hLrnd nrore received numbers havetraditionally Nlonthly r-nech,rndise balance tracle lr',rilThey become of of attentionthan any other measure the balance pa,vments. [teof coniponents the U.S.balance payrnents of nlorequicklythln financial rble Department the Custonls by causethey are ieported directly to the Commerce
$Thismay be rheapproprilteplcc ro introduce distincrion the benveen -.tolsan,l/iolls. Flors ol Fr.unl.lcs anrl havca "pcr unit of finle" dimension, l'hile srocks irbsolutc rlinlcnsionlc:s. are held stocksrc the levelof reserves beid by a centralb:rnkrrndthe levelof assets try prrvrteinExamples flo*'sare the blance of or capital. 1,estors, whethermone bonds,equities, phvsical A incorne, spending, saving. florv is the rltc t,f ch.tttge and oi pivmcnts,the currentrtccount, of rt,rck. o "i\{easuringEqLrilibrium the Balance Priments,".lorrrn,tl in of "CharlesP. Kindleberger, 7 PoliticalEcononn', t-,6 ll9 69]l: 873-89l.

294

CHpren, . TUEBur.corPryeNrsAccoururs 15

15.5. Snrrslcr ERnons rNrsepyNeNrsAccouNrs zgs by Americans import more goods and services to causedthe current-accounr deticits,rvhichthen had to be financedby borro,,vingfrom abrqrd.The rmportant point is that no clearpresumption existsas to rhe directionof causaliry. In realiry,the various acc.ounts generallydeterminedsimultaneously. are For this reason, distinction the benveen autonomous and accommodaring transactions is no longerobserved. In fact, eventhe figuresfor the overall barance payments no longerexof are plicitly reportedfor the united srares, can be seen as }om rhe actual balanceof paymenrs statisrics reproduced Table 1j.2. The ner capital-accounr in balance has beencomputed. Noticerhat in 1983 it turned sharplyfrm deficit inro surplus,as foreigners beganro acquire u.S. assers record amounrs.we rust add tlie capiin tal-account numberto the balance current account(a largecleficitsince19C3, on to find the overallbalance payments. first, the privatecapitl inflorv was sufof At ficientto finance u.S.currenr-account the deficit.In t9g6-200, horvever, prithe vatecapitalinflorv usuallyfell far short of the current-accounr cleficit,an foreign centralbanksmadeup rhe difference, evidenced Table 1i.2 urider ,,forei[n as in officialassets." The unired stares ran a deficir,not just on ifs current account,b-ut alsoon its overallbalance payments. of Nlakingthese calculations be instructiveeventhough rve haveabanclonecl can the presumption that the U.S.balance-of-pal'menrs deficit ivas necessarih' c,tusittg cenrral banks buv up unrvrnted ro dollars, ratherthcn rheorherrvrl. ,rrond.

wirh other forms of foreign direct investment and sales longterm assets, of should counr aboverhe line-as do exportsof goods.Thus, the basicbalance addsthese long-term capitalinflowsto the current account. The accounting shoivs that thisbalancemust be financed, accommodated, o eitherby shorttermprivatecapitalflows or by official reserve transactions. The basic balanceis no longer reporredfor the UnitedStates. Indeed, cannotevenbecomputed it because sradsrics the collected no longer distinguishbenveen long-termand short-termporrfolio invesrmenr. balThe anceis still reported Japanand someothercountries. for Are There Really Accommodating Transactions! originall rhe reasonfor drarvingthe line-rvhether at the merchandise trade balance; goodsand se^,ices; goods,se^'ices, and income; currentaccount;basic balance; overallbalance payments-wasso that transactions or of belorvthe line could be thoughtof asfinancingor accommodating (being caused rransacions by) abovethe line.This reasoning now somervhar of dare. is our A lnore modern view of causalityin the balance-of-payments accounts has evo.lvcd of the rrrnrirrirr lo ilorringexchange ort rates thepart of mosrmajor on industrialized countriesin 1973.t1 The definitionof (pure)floatingis ORT = 0: The centralbank doesnot buy or sellforeignexchange, thereareno officialreso servetransactions record.obviousl in this case is not an interestinq to Bp statistic, as ir is norv ahvays equalto zero. Currcntly, nlosr cenrral banks at tinles do participatein foreign exchange nrarketsto try ro inluencethe exchange rare. This is ntanaged floating, rarher than pure floating.rr Yer thereis no clearsense rvhichcenralbank sales in or purchases international of reserves nectssarily accommodate are f'r.e., czrsety) pri'are tradcand capiralflol's, rarhethn the other*,ay around. For e_rample, in the late 1960s,undefixed exchange rates,it madesomesense say that to largeu.s. balance-of-payments deficits caused fo.eigncentralbanksro buv up unrvntccl dollars. rhecase rhedeficirs in of run b1'rheunitedstates some rein centycrs,horvever, n,srsconcct to say that rhe voluntarv it clecision bl.foreigncentrll bankers buy dollarsallot,ed,or even"caused,"'the deficirs. to u.s. This point is evenmore applicable rvhenassets sold to foreignprivare are residents rather rhan to foreign central banks.A surplusin the privatetapital accourltis rvhat allorvs,or evencauses, country to run a deficit on the current a account, as much so as fhe deficit in the current accountgiving rise to the surrlns thecapitalaccouut. in The mostprominent example the large is currentaccount deficirhat the united States bcganto nrn afrer 1982.To sa,v thar rhe decisionbv privare foreigners incrcase ro their holdinesof u.s. assers hs caused u.s. currenr-account the deficits as correct saying is as that the cecision
rrRohert stern,"The Presentation he u.s. Ilalance parments: Sr.nrposium,,, of in of A Fssays Intcrntional lilrcc, I2i. lrinceronIIniversitv.,\ugust 1971. rrln the Iate1990s, Unitecl the States Mexicowererwo countries tloared and that with verylittle ln t c r v e n t i o n .

pAyMENTs 15.5 Srnsrrcal Ennons THE tN AccouNTs

When governnlent statisticiuls assernble the record of r nrion's internationrrl transactions, do nor obseive thev diiectly thervides of everyrransacion. Erorl creepin for trvo reasolis: Sometransactions are valued incorrectly.so that the quantity recorded onesideof rhc rranst.ti,,lt to eqLr,rl or its corrren_for [:rils th:rt sating transaction, onesideof a transaction ontitted or is entirelv. While the statisticin measures clrss transrction rccur.rr(l\' possible, ech of rs ,rr [rec,ruse these of 1nd other errorsthe sunsoi credit and delrit iterrs ilo nut a,r,naout eoual. Therefbre, statistician the sirnpl,v includes irem called"stristical an cliscrepancy," or "errosand omissions," equalto this difference. Thesenleasure,llant .rro.r r.. no small proLrlem. errors the u.S. sratisrics The in began run rvrldin the 19g0s, ro indicating unmeasured inflorv of monel',as can be seenin Table 15.2. This an ner inf]oiv *'as due in pa.r-c llnrestin someforeign countriesthat impelledfnds to to seek safe a hrvenin theunitedstates. The:rcquisition ofsuchclaimi by forergners, called "capitalflight,"ofrenis clandesrine goesunrecorded. the 1990sthis and In netflo*' re'ersed, suggesring this flight capitalrvasrerurning tht honre.The absolute magnitude the discrepirncy still large. of is Anothernrajordiscrepancy appears when the ner current-account posrtions of all countries addedtogether. are Because every export is some cou.t.y's import, thcreaccouiirs rvouldsun tr. zeroif all countries thcir n,.,.,r,,ranl.,lr, goi ,ight. The discrepancy as largeas $100 billion in the 1990s.It irppearsas thoi.rghthe ran world r.vere runninga deficitrvith orherplaners.

CHAPTER PROBLEMS

Table15.2 U.S.Balance Payments of Statistics Summary in Form

15. Suu'raRv
The study of internationalmonetary economicsbegins with rhe balance-ofpayments accounts. currentaccount The addsup all credits from and debitsarising lnd from transfers, private capital accountcovers trade in goods and services the the purchase saleof assets, the official reserve and and accountconsists transactions in reserve holdings thecentralbank. of changes international by 'We norv turn from rules of accountingto models of economicbehavior. Throughoutmostof the book, the subaccounts usuallybe ignoredand the forvill cus rvill be on the CAIKAIORTlevelof aggregation. example, discussion For the rvill often abstractfrom transfers speakinterchangeably the trade balance to of (CA). (TB)andcurrent account CHapren Pnogll.ls you must play balance-of-payments 1. In this question accountant. The Rules r On the currentaccount, exportsarecredits; importsare debits. . On the capitalaccount, (exports stocks, capit,rlurflswre credrls of bonds, (imports stocks, etc.); are capital outflorvs debits of bonds, etc.). r On the officialreserve transctions account, reserve losses credits(exports are etc.);reserve gainsare debits(importsof gold,forof gold,foreigncurrencies, eigncurrencies, etc.). . Everyautonomous debit(e.g., merchandise a import) musthavean accommoclating credit(e.g., inflorvof short-tem an capitalto pay for the import), and vlceversa. indicte (a) on rvhichaccountthe delitocFor eachof the folloivingtranslctions curs,and (b) on rvhichaccourtt credit occurs.Your choices merchandise, rhe are directinvestment, capital, services, inconre, trlnsfers, long-term capital,short-terrn Also, in eachcaseindicate(c) the effecton the and official reser\e rransirctions. (*,0, or -), and (d) the effect the over1ll currenr-:rccount balence of balance on plvnrents (-F,0, or -). Ansn'er onlv for the transrrction specified; not assnme clo that the recipients pavments fronr abroadnecessarily of exchange foreigncurrency rvith the centralbank as r,r'ould the caseif capital flows were assunled be be to zero.(TheUnitedSttesis the domestic countr.v.) 1. 2. 3. 4. 5. U.S.importsBivlWsfrom German paysby checkin euros. grainto Jrpan,is paidbv check dollers. U.S.exporrs in fronl Brrtzil, irgrees piry in dollarsthreenronthslater. U.S.importscoffee to Srviss francs Genevir. in spend U.S.tourists fronr U.S.firm, rvhichtg,rees let the i\{e.xicans \lerico bui'slocomotives to lter. pav in dollarsl8 months because are accumulatin! 6. French firnlsand banks, thev more dolhrs than thev rvant or thrn U.S. b;lnksrvill :rcccpt,turn them in to the Federal Reserve, *'hich lgreesto givethemeuros. a 7, A U.S.investor bLr,vs2-yearCanadian treasurv note,paysby check.

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8. U.S.firm buildsa factoryin Mexico, paysfor land, local labor,and so on, in pesos. , sends foreignaid to Pakistan, rvhichPakistanis hold in the 9. U.S.go!'emment form of dollars. from the U.S.government, paysin gold. (No 10. Chinabu'snucleareactors centralbankis involved.) immigrantsends moneybackto familyin Lisbonin the form of lL Portuguese a 10-year U.S.savings bond. profits in the form of pesos from the factoryit previously 12, U.S.fim receives built in Mexico. 13. Dutch holdingcompanybuys a controllinginterestin an Aniericanfirnr, paysin dollars. to for 14. U.S.ship is leased carry beeffrom Australiato Britain. Payment freight is charges in dollars. Reserve gold to supportthe valueof the dollar. sells 15. Federal

Tur FonncNExcHnNGE MARKET

AND Tnnor EnsrcrlEs

FFh. foreignexchange marketis wheredomestic money(for example,dollars) I is tradedior foreignmoney(for example,poundssterling).The exchange defined the priceof the foreigncurrency termsof the doas in -E- mte is usually mestic currency', thoughit couid as easilyhave beenthe reverse,l and this convention will be follorvedhere.Note that a deprecintion,a decrease the value of the in domestic currency, an increase the exchange is in rate, because is an increase it in the price of foreigncurrenc)'. Somefind it counteintuitive in that a decease the in valueof the currency calledan increase the exchange is rate. Yet iust as economistsoften talk about an increase the pricesof commodities(inflation) rather in tha the equivalent depreciation money'spurchasing of power over commodities, so it is often intuitive to talk about an increase the price of foreign currency in ratherthan the equivalent decrease the valueof the domestic in currency. Ve aresimplif ing lvhenu'e speakof //reexchange rate for a country.In realit1',eachcountry has many exchange rates,one for every other currency in the rvorld.The United States, example,has the dolla/yenrate, the dollar/pound for of the movements the homecountry's in currencydepends rvhich exchange rate on is used.To'geta good idea of the value of the currencyoverall,it is necessary to usean exchange indcx,knorvnas rbeeffectiue rate exchange rate, whtch computes a rveighted average the exchange of ratesagainstechof the individual countries. Typicallv rveights the tsed the countries'shares trrde. re in !. Tse Flow oF Supply AND DEHAND FoR FoREtcN ExcxaHce In theforeign exchange market,as in other markets. are s,,ppl1'.,i1 dernand central. The proceeds from exports,and other credititemsin the balance payrnents, of generate supplyof foreignexchange foreigncurrency. the or Import spencling and othe debit itemsgenerate demandfor foreign exchange. Figure 16.1 rve the In measure quantities foreign exchange the of suppliedand demandedon the horizontalaxis,and the priceof ioreignexchange-the exchange rate E-on the vertical axis.We canthink of the supplyand demandfor foreignexchange functions as of the currency's price-the exchange rate-just as the supplyand demandfor anv

transfes "launder"illegallyacquired to funds.For example, 2, Ve heaof financial a smuggler might depositincomefrom illegalexportsin a lvliami SouhAmerican for bank, and arrange the bank to re-lendit to the smuggler investin a legitito mate activit)'. this appear the U.S.balance-of-paymenrs in a. Horv rvoutel transaction accountsifitrvere recorded correctly? Horv would it appear rheaccounts in of thr SouthAmerican country? in if b, llhat errorrvill it create the accounts rheexporter's earnings and claimon the Nliami bank arenot ecorded the exporter's in homecountrf
trnsactlonsare recorded tn t

if case thecommodityexported legal,but the exporterleaves dollar is the proceeds the Miami bank to evade in taxes.) Ifhat rvill this do to the rvorldwide current-account discrepanc,v ? in accounts the exportert if c. What emorrvill be created the nvo countries' claimon the bank is not recorded eithercountr)', the export is rein but portedin both?(To minimizethc the -l;.,iiesof gettingcaught, exporrer simplyfailsto infom the lvfiamibank that he or sheis not a U.S.citizen.) Vhat wouldthis error do to the rvorldwide current-account discrepancy?

lln the United Kingdom, example, practice to speakin termsof the dollar/pound for the is rate, anexception thegeneral because pouncl the domestic to rule the is curretrcy.