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CHAPTER 3 BALANCE OF PAYMENTS
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Define balance of payments.
Answer: The balance of payments (BOP) can be defined as the statistical record of a country’s
2. Why would it be useful to examine a country’s balance-of-payments data?
Answer: It would be useful to examine a country’s BOP for at least two reasons. First, BOP
provides detailed information about the supply and demand of the country’s currency. Second,
3. The United States has experienced continuous current account deficits since the early
1980s. What do you think are the main causes for the deficits? What would be the
consequences of continuous U.S. current account deficits?
Answer: The current account deficits of U.S. may be attributable to (i) the strong dollar and
undervalued currencies of trading partners such as China, (ii) high consumption and low
4. In contrast to the United States, Japan has realized continuous current account surpluses.
What could be the main causes for these surpluses? Is it desirable to have continuous current
account surpluses?
Answer: Japan’s continuous current account surpluses may have reflected a weak yen and
high competitiveness of Japanese industries. Massive capital exports by Japan prevented yen
from appreciating more than it did. At the same time, foreigners’ exports to Japan were
5. Comment on the following statement: “Since the United States imports more than it exports,
it is necessary for the United States to import capital from foreign countries to finance its current
account deficits.”
Answer: The statement presupposes that the U.S. current account deficit causes its capital
account surplus. In reality, the causality may be running in the opposite direction: U.S. capital
account surplus may cause the country’s current account deficit. Suppose foreigners find the
6. Explain how a country can run an overall balance-of-payments deficit or surplus.
Answer: A country can run an overall BOP deficit or surplus by engaging in the official reserve
transactions. For example, an overall BOP deficit can be supported by drawing down the central
7. Explain official reserve assets and its major components.
Answer: Official reserve assets are those financial assets that can be used as international
means of payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges,
8. Explain how to compute the overall balance and discuss its significance.
Answer: The overall balance is determined by computing the cumulative balance of payments
including the current account, capital account, and the statistical discrepancies. The overall
9. Since the early 1980s, foreign portfolio investors have purchased a significant portion of U.S.
treasury bond issues. Discuss the short-term and long-term effects of foreigners’ portfolio
investment on the U.S. balance of payments.
Answer: As foreigners purchase U.S. Treasury bonds, U.S. BOP will improve in the short run. But in
the long run, U.S. BOP may deteriorate because the U.S. should pay interests and principals to
10. Describe the balance-of-payments identity and discuss its implications under the fixed and
flexible exchange rate regimes.
Answer: The balance of payments identity holds that the combined balance on the current and
capital accounts should be equal in size, but opposite in sign, to the change in the official
reserves: BCA + BKA = -BRA. Under the pure flexible exchange rate regime, central banks do
11. Exhibit 3.5 indicates that in 1999, Germany had a current account deficit and at the same
time a capital account deficit. Explain how this can happen?
Answer: In 1999, Germany experienced an overall BOP deficit, which must have been
12. Explain how each of the following transactions will be classified and recorded in the debit
and credit of the U.S. balance of payments:
(1) A Japanese insurance company purchases U.S. Treasury bonds and pays out of its bank
account kept in New York City.
(2) A U.S. citizen consumes a meal at a restaurant in Paris and pays with her American Express
card.
(3) A Indian immigrant living in Los Angeles sends a check drawn on his L.A. bank account as a
gift to his parents living in Mumbai.
(4) A U.S. computer programmer is hired by a British company for consulting and gets paid from
the U.S. bank account maintained by the British company.
Answer:
_________________________________________________________________
Transactions Credit Debit
_________________________________________________________________
Japanese purchase of U.S. T bonds
Japanese payment using NYC account
U.S. citizen having a meal in Paris
_________________________________________________________________
13. Construct the balance of payment table for Germany for year 2010 which is comparable in
format to Exhibit 3.1, and interpret the numerical data. You may consult International Financial
Statistics published by IMF or search for useful websites for the data yourself.
Answer: A summary of the German Balance of Payments for 2010 (in $ billion)
Credits Debits
Current Account
(1) Exports 1,788.4
(2) Imports -1,529.5
(3) Unilateral transfer 23.1 -74.2
Capital Account
(4) Direct investment 28.0 -93.0
(5) Portfolio investment 39.8 -231.4
(6) Other investment 234.0 -162.2
(7) Statistical discrepancies -20.9
Source: IMF, International Financial Statistics Yearbook, 2012.
Note: Capital account in the above table corresponds with the ‘Financial account’ in IMF’s
balance of payment statistics. IMF’s ‘Capital account’ balance is included in ‘Other investment’
in the above table. It is noted that Germany experienced ‘divestment’ by foreigners in equity
14. Discuss the possible strengths and weaknesses of SDRs versus the dollar as the main
reserve currency. Do you think the SDR should or could replace the U.S. dollar as the main
global reserve currency?
Answer: Being a basket currency, SDR has a relatively stable exchange value. However, IMF,
that issues SDRs, has no mandate to function as the world central bank. In addition, there is no
liquid bond market for SDR. The U.S. dollar, on the other hand, has deep, liquid markets and is
PROBLEMS
1. The U.S. Balance of Payments for year 2000.
Solution:
Merchandise -1224.43
MINI CASE: MEXICO’S BALANCE OF PAYMENTS PROBLEM
Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve
holdings and a major currency devaluation in December 1994, followed by the decision to freely
float the peso. These events also brought about a severe recession and higher unemployment
in Mexico. Since the devaluation, however, the trade balance has improved.
Investigate the Mexican experiences in detail and write a report on the subject. In the
report, you may:
(a) document the trend in Mexico’s key economic indicators, such as the balance of payments,
the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.;
(b) investigate the causes of Mexico’s balance of payments difficulties prior to the peso
devaluation;
(c) discuss what policy actions might have prevented or mitigated the balance of payments
problem and the subsequent collapse of the peso; and
(d) derive lessons from the Mexican experience that may be useful for other developing
countries.
In your report, you may identify and address any other relevant issues concerning Mexico’s
balance of payment problem. International Financial Statistics published by IMF provides basic
macroeconomic data on Mexico.
Suggested Solution to Mexico’s Balance-of-Payments Problem
To solve this case, it is useful to review Chapter 2, especially the section on the Mexican
peso crisis. Despite the fact that Mexico had experienced continuous trade deficits until
December 1994, the country’s currency was not allowed to depreciate for political reasons. The
The key lessons that can be derived from the peso crisis are: First, Mexico depended too
much on short-term foreign portfolio capital (which is easily reversible) for its economic growth.
The country perhaps should have saved more domestically and depended more on long-term
foreign capital. This can be a valuable lesson for many developing countries. Second, the lack
of reliable economic information was another contributing factor to the peso crisis. The Salinas
