Econ 171: International Finance

A note on balance of payment

Tasneem Raihan

Definition: Balance of payment= Current account balance + Capital account balance + (non-reserve
portion of) Financial Account balance + Statistically Discrepancy

Assume, Current account balance= Capital account balance=Statistical discrepancy= 0.

Therefore, Balance of payment= (non-reserve portion of) Financial Account balance.
Also assume initially, Balance of payment= (non-reserve portion of) Financial Account balance= 0.

Now, consider the following scenario:

Suppose you are a US investor who wants to invest $1000 in a British firm. To invest, you need pounds.
Therefore, you go to your own bank, say Wells Fargo to convert $1000 into equivalent pounds. Suppose
the current exchange rate is E1=$2/€1 and at this exchange rate, Wells Fargo is unwilling to hold any
more dollars (or equivalently, unwilling to sell any more pounds). Perhaps because the market is already
at an equilibrium. As a result, you cannot sell your dollars to buy pounds. This creates an excess supply
of dollars in the market.

Case 1: Flexible/floating exchange rate regime

Since the supply of dollars is greater than the demand, the price of dollars will fall. Another way of
looking at is dollar will depreciate against Euro as there is excess demand for Euro at the current
exchange rate1. As a result, the foreign exchange market will reach a new equilibrium E2 with lower price
of dollars. This adjustment of exchange rate will allow Wells Fargo to buy that $1000 from you. But
where will Wells Fargo get the pound equivalent of $1000 to pay you? It will sell off its pound
denominated asset to give you pounds equivalent of $1000.

Balance of payment entries: Your investment in the British firm is a $1000 debit entry in the (non-
reserve portion of) financial account and Wells Fargo’s sale of pound denominated asset is a $1000
credit entry in the (non-reserve portion of) financial account. These two entries in the financial account
offset each other. Therefore, balance of payment= 0. We call this a balance of payment equilibrium.

Case 2: Fixed exchange rate regime

Since the supply of dollars is greater than the demand, the price of dollars “needs to” fall to equilibrate
the foreign exchange market. But since we are in a fixed exchange rate regime, dollar cannot depreciate.
What will happen now? Wells Fargo will not sell pounds to you at the current exchange rate. How can
you convert your dollars into pounds to invest in the British firm? This is where the central bank comes
into play. Under a fixed exchange rate regime, the US central bank is obligated to buy the excess supply

1
Demand for Euro increases from D1€ to D2€ in the graph drawn on the board.
of dollars (i.e. provide you the excess demand for euros) from you at the fixed exchange rate of $2/€1.
Essentially, the Fed will give you pounds worth $1000 from its foreign currency reserve.

Balance of payment entries: Your investment in the British firm is a $1000 debit entry in the (non-
reserve portion of) financial account and the US central bank’s sale of foreign currency reserve (i.e.
pounds) is a $1000 credit entry in the financial account’s Official reserve asset. Notice that the credit
entry is NOT in the non-reserve portion of the financial account, rather in the financial account’s Official
reserve asset. So no credit entry in the non-reserve portion of financial account offsets the debit entry in
the non-reserve portion of the financial account.2 Therefore, Balance of payment= - $1000 < 0. We call
this a balance of payment (BOP) deficit. Similarly, balance of payment > 0 is a BOP surplus.

We talked about Official settlement balance in the lecture. This is actually the negative of balance of
payment. In the above example, official settlement balance= + $1000.

Lessons:

1. BOP is always in equilibrium in a floating exchange rate regime. Exchange rate adjustment
ensures this.
2. Strictly speaking, disequilibrium in BOP can occur only under a fixed exchange rate regime.
3. When BOP < 0, central bank has to deplete its foreign currency reserve to buy $ from people.
4. When BOP > 0, central bank has to buy foreign currencies from people i.e. increase its foreign
currency reserve.

2
But of course, a credit entry in the reserve portion of the financial account offsets the debit entry in the non-
reserve portion of the financial account.