MACROECONOMICS II

BALANCE OF PAYMENTS
INTRODUCTION
 South is an open economy: High degree of openness makes the SA economy to be
vulnerable to external shocks and foreign factors often dominate the economic news.
 BOPs is an accounting record of a country’s involvement in International Trade
(exports and imports) and International Capital flows.
 Current Account (Exports and Imports): Financial Account (Inflows and Outflows of
capital finance).
 Exchange Rate: Value of one currency in terms of another: indirect quotation
($1=R12): [Direct quotation—R1=$0.10].
 The Price Ratio is another important variable: The ratio of prices between the
domestic economy and the foreign economy we trading with
𝑃 𝑠𝑎 /(𝑃(𝑓𝑜𝑟𝑒𝑖𝑔𝑛)
 Exchange rates and the price ratio can be combined into one concept, the real
effective exchange rate, which we define as

𝟏 𝑷𝒔𝒂
Ѳ= ∗
𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒆𝒙𝒄𝒉𝒂𝒏𝒈𝒆 𝒓𝒂𝒕𝒆 𝑷𝒇𝒐𝒓𝒆𝒊𝒈𝒏
WHY DO COUNTRIES TRADE?
 Scarcity of resources means countries cannot be self sufficient.
 Need to access larger markets and exploit locally abundant resources
more profitably.
 Better quality products, comparative advantage, relative factor
endowments (some countries have some factors better than others)
 International trade enables specialization in the production process:
specialization enables countries to gain comparative advantage (low
opportunity cost pf production)

Advantages of Trade
 Specialization leads to a comparative advantage leading to production
effectiveness and efficiency at the lowest opportunity cost.
 Countries can benefit from economies of scale through a more focused
production for the domestic and foreign markets.
 Increases competition and lowers market prices, raising purchasing
powers and consumer surplus
 Trade breaks down monopolies in domestic markets, therefore they
have to adapt or die
 Technology transfer leading to innovation
 Increased employment which is related to production.
Disadvantages of International Trade
 Trade can lead to overspecialization
 Fierce competition can destroy industrial sectors especially in developing
and low income countries.
 Countries are on different levels of development, which confers advantage on
some economies over others in a variety of ways including, government
support for export sectors—subsidies, tax incentives, export credits, and
preferential and premium market access.
 Domestically produced goods unique to local market might be choked by the
generalized cheap imports.
 IMPORTS, EXPORTS AND CAPITAL FLOWS
 Exports (X)—injection of expenditure by foreigners into the domestic
expenditure flow and imports (M) imply a leakage from the expenditure flow
to the rest of the world.
 Net Exports—Trade Balance—Constitute a direct component of total
expenditure: C + I + G + (X – M).
 Main export categories for South Africa are mineral products (26%),
precious metals and stones (21%), base metals (13%), machinery and
equipment (9%), vehicles (9%) & chemical products (6%).
 Main import categories: machinery and equipment (25%), mineral products
(23%), chemical products (9%) & vehicles (10%)
 Imports concern purchase of foreign products (both consumer and capital
goods)

𝑷𝑺𝑨
𝑴 = ƒ(+𝒀𝑫𝑺𝑨; + ; +𝒓𝒂𝒏𝒅; … )
𝑷𝑭𝑶𝑹𝑬𝑰𝑮𝑵
Import expenditure depends positively on Disposable income (YD): thus there
is an autonomous share of imports and a part dependent on changes in total
income i.e.
M = ma + mY + …
 Where m represents the marginal propensity to import: An increase in
income increase demand for imports. Imports also increase or decrease
concurrent with the business cycle.
 Price of imported goods relative to prices of locally produced goods is
important: the price ratio is an import signal.
 The expected relationship is positive: A higher price ratio (due to increasing
South African prices) is likely to encourage imports (and discourage exports).
 Exchange rates determine the price of imports and exports: If the Rand
strengthens against other currencies: Imports become cheaper, than when the
rand weakens.
 The real exchange rate can increase for two reasons: either there is an
increase in the external value of the rand [THE RAND STRENGTHENS] and/or an
increase in the price ratio [SOUTH AFRICAN PRICE LEVEL RISES]—m will
increase and vice versa.
 Changes in the real effective exchange rate will affect a country’s willingness
to import goods from abroad.
 Other factors that can influence imports as well include: Trade policy (import
taxes, import tariffs or non-tariff barriers—quotas etc.), trade sanctions or
boycotts.
 Thinking in terms of the real exchange rate:
M = ma + m(Ѳ)Y
 An increase in (Ѳ) due to a strengthening of the rand and/or a higher
price ratio, will encourage imports—import propensity, m will be higher.
 On the 45 degree income and expenditure diagram the import function is
positively sloped, an increase in income, ceteris paribus increases import
preference.
Increases in income (Y) causes a movement along the import function/curve.
 An increase in Ѳ implies a more steeper imports function. If any of the
elements of the real effective exchange rate—the price ratio or the exchange
rate—changes, the import function will rotate.
 Trade policy steps such as an import tax , tariff or quota or trade sanctions
will shift the import curve up or down.

EXPORTS
 Exports depend on foreign income levels (Yforeign) and on the price ratio,
what we call Terms of Trade and the exchange rate.
𝑷𝒔𝒂
X = ƒ (𝒀𝒇𝒐𝒓𝒆𝒊𝒈𝒏; ; 𝑹𝑨𝑵𝑫; … )
𝑷𝒇𝒐𝒓𝒆𝒊𝒈𝒏

 When foreign income rises, demand for SA exports rises, higher domestic
prices will discourage exports, a strengthening of the rand will discourage
exports.
 When the South African price ratio rises, the rand weakens, which favors
export growth.
𝑿 = 𝒗𝒂 + 𝒗(Ѳ)Yƒ + …
 The parameter V indicates the home country’s share of world trade. A
higher value of V will indicate a higher share of world trade, if Yf represents
world income.
 Increases in Ѳ (stronger rand/higher price ratio) discourages exports thus
reduce SA’s share of world trade, v.
 Graphically in the 45 degree diagram, the X curve is a horizontal line.
 A change in foreign income levels (business cycles in economies of major
trading partners) will shift export function up (upswing) and down
(downswing)
 A change in the trade share V (due to changes in the real effective
exchange rate Ѳ) will also shift the export curve.
 Net Exports (X-M) any change in one or more of the factors that
determine X and/or M will imply a change in (X-M), which is a direct
component of total expenditure—will cause a change in the real economy.
 Injections or leakages are all affected by expenditure multipliers effects.

Rand Appreciates (rand strengthens) ⇛ effective price of imports declines

(and the effective price of SA exports for foreigners increases) ⇛ imports are
encouraged and exports discouraged ⇛ (X-M) declines ⇛ total expenditure
declines ⇛ production is discouraged ⇛ GDP & Y falls (declines)
 Trade Balance (X-M): X > M—Trade Surplus; X<M—Trade Deficit.
 Net Exports = Trade Balance + Trade in Services (payments and receipts for
services such as International Tourism, transport, financial and insurance
services)
 Net exports exclude inflows and outflows of income payments (compensation of
employees as well as returns on investment—dividends and interest earned
abroad)
 Income payments reflect trade in factors of production
 Current Account ⇨ Broadest Measure: NET EXPORTS + NET INCOME FROM
FACTORS PAYMENTS AND RECEIPTS + NET CURRENT TRANSFERS
(INTERNATIONAL TRANSFERS)
 A POSITIVE net inflow of payments for goods and services implies that the
current account is in surplus (and vice versa).
 A current account deficit means that a country is importing more goods,
services and factors than it exports: total expenditure buys up all the
domestic production and more.
 Extent to which the current account will deteriorate when Y increases will
depend on the marginal propensity to import (m)—A high m will cause
imports to react strongly to an increase in GDP, causing the Current Account
Balance to deteriorate significantly.
 Exchange rate depreciation, improves exports and improves CA Balance
while appreciation of a currency worsens the CA Balance.
 CAPITAL FLOWS
 Capital inflows—inflows of foreign funds for the purpose of fixed investment (fixed
assets) as well as financial investment (purchase of financial assets)
 Financial account records inflows and outflows of capital into a country.
 Capital flows across national borders because capital owners are seeking the highest
possible real rates of return on investments whether real or financial investments.
 Main factors determining capital inflows: Relative Interest Rates (on financial
investments), relative rates of return (on real investment), the exchange rate and
economic (Business Confidence Index and GCI) and political expectations.
𝒓𝑺𝑨
𝑲 = ƒ( ; 𝐑𝐄𝐋𝐀𝐓𝐈𝐕𝐄 𝐑𝐀𝐓𝐄𝐒 𝐎𝐅 𝐑𝐄𝐓𝐔𝐑𝐍; 𝐑𝐀𝐍𝐃; 𝐄𝐗𝐏𝐄𝐂𝐓𝐀𝐓𝐈𝐎𝐍𝐒)
𝒓𝑭𝑶𝑹𝑬𝑰𝑮𝑵

 Optimism about expected real rates of return on real investment (economic growth
possibilities) should attract foreign investors
 Local Interest rates that increase relative to foreign rates should induce inflows of
foreign capital (and strengthen financial account).
 Exchange rates determine the main cost to an investor of the purchase of an
asset, a strengthening of the RAND therefore discourages Capital Inflows. [An
inverse relationship between the rand exchange rate and capital inflows]
HOW DO FOREIGN CAPITAL FLOWS AFFECT THE ECONOMY?
 Not being a direct component of AE, an inflow of foreign capital (eg foreign loans)
has no direct impact on aggregate spending and hence no direct or immediate
effect on real income.
 If funds are used to purchase existing shares, there is no new real investment and
hence no direct real impact: foreign capital inflows have no direct real effect on
the economy [where foreign capital is used to finance real investment, we analyze
real investment separately].
 Net inflow of funds will expand the domestic money supply. A Net outflow will
contract the domestic money supply.
BOPS AND EXCHANGE RATES
 BOP = CA Balance + Financial Account Balance
 Current Account Bal = [Merchandise Exports + Net Gold Exports +
Service Receipts + Income Receipts – Merchandise Imports – Payments
for Services – Income Payments + Net Transfers]
 Financial Account Balance = [Net Direct Investment + Net Portfolio
Investment + Other Net Investment + Unrecorded Transactions]
 BOP = CA BAL + Capital Transfer Ac + Financial Acc Bal.
 BOPs position depends on all factors that determine the international
flow of goods and capital: domestic and foreign income levels, interest
rates and rate of return, price levels and exchange rates, expectations
and perceptions of risk)
 CHANGE IN THE MS OR REPO RATE: An increase in the Repo Rate causes
an increase in market interest rates and a decrease in real income
 Higher interest rates are likely to attract an inflow of foreign capital
which affects the financial account of the BOPs, a financial account
surplus will develop.
 Drop in income will likely lead to a fall in imports which affect the
current account of the BOPs: A current account surplus will
develop.
 Changes in Aggregate Expenditure (disturbances in the domestic goods
market): Net effect of an increase in government expenditure is an
increase in real income accompanied by an increase in interest rates.
 The higher interest rates are likely to attract an inflow of foreign
capital which strengthens the financial account of the BOPs
 The upswing in income is likely to lead to a rise in imports, which
negatively affects the Current Acc of the BOPs.
 A change in Exports (disturbance in the Foreign sector) lets say due to
economic growth in the US (South Africa’s Trading Partner).
 Net effect of an increase in exports in an increase in real income
accompanied by an increase in interest rates
 Increasing exports are directly reflected in an improved current
account.
 Increased export earnings imply an expenditure injection in the
economy, which causes income Y to increase.
 The upswing in income is likely to lead to a rise in imports (some
imports are necessary in expanding exports—eg capital equipment)
which is a negative impact on the current account.
 The increase in income Y is likely to lead, via increased money
demand, to higher interest rates. These are likely to attract foreign
capital, which strengthens the financial (or capital) account.
 Surplus on the BOPs [BOP > 0] implies a net inflow of payments
 Deficit on the BOPs [BOP < 0] implies a net outflow of funds, i.e. outflows
exceed inflows (in a given period).
 BOP has a direct impact on 3 key reserves
 Foreign Currency Reserves
 Money Supply (monetary liquidity) &
 The exchange rate
 BOP surplus increases foreign currency reserves, deficits will cause a
decline in foreign currency reserves.
 Foreign reserves are important since they are essential in paying for
imports
 BOPs influences nominal Money Supply: When Foreigners buy SA goods
and services, they buy rand from the SARB, then uses these to pay
exporting companies. When funds are deposited in the Exporting
Company’s Bank Account, total amounts of deposits in the Country
Increases (Giving CBs leverage for credit extension—MS grows via the
Money Multiplier process, thus
 BOPs>0: increase in nominal (and real) Ms
 BOPs<0: decrease in nominal (and real) Ms