CHAPTER 3 BALANCE OF PAYMENTS
ANSWERS & SOLUTIONS TO END-OF-CHAPTER QUESTIONS AND PROBLEMS
QUESTIONS
1. Define balance of payments.
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
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, Japan, and euro-zone (ii) high
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
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 can be running in the opposite direction: U.S. capital
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
7. Explain official reserve assets and its major components.
Answer: Official reserve assets are those financial assets that can be used as international
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
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
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
11. Exhibit 3.6 indicates that in 1999, Germany had a current account deficit and at the same
time a capital account deficit. Explain how this can happen?
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
_________________________________________________________________
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.
Credits
Debits
Current Account
(1) Exports
1,788.4
(1.1) Merchandise
1,282.5
(1.2) Services
253.6
(1.3) Factor income
252.3
(2) Imports
–1,529.5
(2.1) Merchandise
–1,073.1
(2.2) Services
-276.2
(3.3) Factor income
–180.2
(3) Unilateral transfer
23.1
–74.2
Balance on current account
207.8
[(1) + (2) + (3)]
Capital Account
(4) Direct investment
28.0
–93.0
(5) Portfolio investment
39.8
–231.4
(5.1) Equity securities
–3.1
–30.4
(5.2) Debt securities
(5.3) Derivatives
65.9
–23.0
–200.9
—–
(6) Other investment
234.0
–162.2
Balance on capital account
-184.8
[(4) + (5) + (6)]
(7) Statistical discrepancies
-20.9
Overall balance
2.1
Official Reserve Account
–2.1
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
security investment in 2010. It is also noted that the above numbers may be affected somewhat
by the government updating of the economic data. One salient feature of the above table is that
Germany realized a significant merchandise trade surplus but a deficit in service trade,
suggesting that Germany’s comparative advantage may be in the manufacturing sector, not in
service sector.
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,
PROBLEMS
1. The U.S. Balance of Payments for year 2000.
Solution:
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.;
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
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
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crisis. Third, it is important to safeguard the world financial system from the peso-type crisis. To
this end, a multinational safety net needs to be in place to contain the peso-type crisis in the
early stage.