VII. Open Economy: International Trade and Finance
Balance of Payments Accounts
The balance of payments accounts is a record of all international transactions that are undertaken between residents of one country and residents of other countries during some period of time. These transactions include payments for the country's exports and imports of goods, services, and financial capital, as well as financial transfers. The BOP summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items.


text{BOP} = text{current account} - text{capital account} pm text{balancing item} ,
text{BOP} = text{current account} - text{capital account} pm text{balancing item} ,




Graph of Current-Account Balance and Its Components: Quarterly Data
Graph of Current-Account Balance and Its Components: Quarterly Data


Balance of Trade
The balance of trade (net exports) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports. The trade balance is identical to the difference between a country's output and its domestic demand or the difference between what goods a country produces and how many goods it buys from abroad; this does not include money re-spent on foreign stock, nor does it factor in the concept of importing goods to produce for the domestic market. It is also part of the current account.

Trade Surplus = when there is more exports than there are imports
Trade Deficit = a trade gap, or when there are more imports than exports


Current Account
The current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse.
The Current Account includes:
  • Merchandise trade, which consists of all raw materials and manufactured goods bought, sold, or given away.
  • Services:
    • travel and tourism,
    • labor,
    • transportation,
    • engineering,
    • business services, such as law, management consulting, accounting, and fees from patents and copyrights on software, books, and movies.
  • Income receipts include income derived from ownership of assets, such as stock dividends and bond interest.
  • Unilateral transfers are one-way transfers of assets, such as worker remittances from abroad and direct foreign aid. Aid and gifts count as a debit to the capital account of the donor nation.

current account

changes in net foreign assets=

Capital Account
The capital account (also known as financial account) is one of two primary components of the balance of payments, the other being the current account. Whereas the current account reflects a nation's net income, the capital account reflects net change in national ownership of assets.

The Capital Account includes:

  • Capital transfers:
    • debt forgiveness,
    • migrants’ transfers (goods and financial assets accompanying migrants as they leave or enter the country),
    • title transfer of fixed assets,
    • transfer of funds linked to the sale or purchase of fixed assets,
    • gift and inheritance taxes,
    • death duties,
    • uninsured damage to fixed assets,
    • legacies.
  • Acquisition and disposal of real or intangible assets:
    • transactions of real assets, such as the rights to natural resources,
    • intangible assets, such as patents, copyrights, trademarks, franchises, and leases.

The Financial Account

The financial account, a subdivision of the capital account, consists of financial instruments or investments, including:
  • U.S.-owned assets abroad:
    • official reserve assets,
    • government assets,
    • private assets, including gold, foreign currencies, foreign securities, reserve position in the International Monetary Fund, U.S. credits and other long-term assets,
    • direct foreign investment,
    • U.S. claims reported by U.S. banks.
  • Foreign-owned assets in the United States:
    • foreign official assets and other foreign assets in the United States, including U.S. government, agency, and corporate securities, direct investment, U.S. currency, and U.S. liabilities reported by U.S. banks.
begin{align}mbox{Capital account} & = mbox{Change in foreign ownership of domestic assets} & - mbox{Change in domestic ownership of foreign assets} end{align}
begin{align}mbox{Capital account} & = mbox{Change in foreign ownership of domestic assets} & - mbox{Change in domestic ownership of foreign assets} end{align}

Foreign Exchange Market
The foreign exchange market is a global, worldwide decentralized over-the-counter financial market for trading currencies. The foreign exchange market determines the relative values of different currencies. Its primary purpose is to assist international trade and investment, by allowing businesses to convert one currency to another currency.

Demand for and Supply of Foreign Exchange
Demand and Supply of Foreign Exchange influences the determination of exchange rates and vice versa. The demand for foreign exchange is inversely proportional to the rise of exchange rate. As the exchange rate goes up the demand for foreign exchange declines. The quantity of foreign exchange demanded falls. The supply of foreign exchange shifts depending on demand and not on the exchange rate. If the supply aspect of transaction is plotted on a graph it will be vertical since the supply of foreign currency deposits available at any time is fixed.

Supply and Demand of Foreign Exchange
Supply and Demand of Foreign Exchange



Exchange Rate Determination
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.
The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date.
Example
An inter-bank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91.

Currency Appreciation and Depreciation
Appreciation
Appreciation of an asset is an increase in its value. Applied to a currency, appreciation is a rise of its value in a floating exchange rate. In times of high inflation, appreciation of assets will be common to all balance sheet assets. In any viable modern economy, such property tends to increase in value over the years.
Depreciation
Depreciation of an asset is a decrease in its value. Depreciation is just the inverse of Appreciation in terms of the value of currency.

Net Exports and Capital Flows
The Net Exports (Balance of Trade) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports.

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Links to Financial and Goods Markets
A financial market is a mechanism that allows people to buy and sell/trade financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other property of a good or a commodity of value at low transaction costs and at prices that reflect the efficiency of the market.

In finance, financial markets facilitate:
  • The raising of capital (in the capital markets)
  • The transfer of risk (in the derivatives markets)
  • The transfer of liquidity (in the money markets)
  • International trade (in the currency markets)

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