Ch04

					Chapter 4
  International Business
  Transaction: The
  Balance of Payments
 The Goals of Chapter 4
• Explain what the balance of payments (BOP) is
• Study how to analyze BOP
• Discuss the relationship between the BOP and
  the gross domestic product (GDP), the
  exchange rate, the interest rate, and the
  inflation rate
• Introduce the history of the degree of the capital
  mobility and the mechanisms for capital
  movement (postponed until I teach Ch 3)



                                                       4-2
The Balance of Payments




                          4-3
 The Balance of Payments
• The measurement of different forms of international
  economic transactions between the residents of a
  country and foreign residents is called the balance of
  payments (BOP) (國際收支帳)
  (Note that the resident is a economic concept, and it includes individuals,
  firms, nonprofit communities, and the government)
• BOP influences and is influenced by other variables,
  such as gross domestic product (GDP), employment
  levels, price levels, exchange rates, and interest rates
• Government policymakers need the data of BOP to
  evaluate the general competitiveness of domestic
  industries, to set the exchange or interest rate, to
  determine the monetary and fiscal policy, etc.
                                                                                4-4
 The Balance of Payments
• BOP data is also important for MNEs as it is a gauge of
  a nation’s competitiveness or health
• For a MNE, both home and host country BOP data is
  important because:
   – BOP is an indication of pressure on a country’s foreign
     exchange rate
   – Change in a country’s BOP may signal the imposition or
     removal of controls in various sorts of payments, e.g., removal
     of the capital outflow control may reduce the balance of the
     financial account in BOP
   – A forecast of a country’s market potential (especially in the
     short run), e.g., a country with trade deficit may welcome
     investments that can increase its exports

                                                                       4-5
 Typical BOP Transactions
• Each of the following represents an international
  economic transaction that is counted in and captured in
  the U.S. BOP:
   – A U.S. subsidiary of a foreign MNE acts as a distributor for
     the MNE’s products in the U.S. market
   – A U.S.-based firm manages the construction of a major water
     treatment facility in a foreign country
   – The U.S. subsidiary of a foreign firm pays profits (usually by
     distributing dividends to shareholders) back to the parent firm
     in its home (foreign) country
   – A Mexican lawyer purchases a U.S. corporate bond through
     an investment broker in the U.S.



                                                                       4-6
    The Accounts of the BOP




※ The classification of accounts of the BOP in this chapter follows the definition
  of the International Monetary Fund (IMF)
※ Because the IMF is the primary sources of statistics for BOPs, its terminologies
  are more wildly accepted
※ In fact, this system is also used by the Organization for Economic Cooperation
  and Development (OECD) and United Nations System of National Accounts
  (UNSNA)

                                                                                     4-7
 The Accounts of the BOP
• The BOP is composed of three primary accounts, the
  Current Account, the Capital Account, and the
  Financial Account
• In addition, the Official Reserves Account tracks
  government currency transactions
• The fourth account, the Net Errors and Omissions
  Account, is produced to preserve the balance of the BOP
   – Later, I will introduce the theoretical double-entry bookkeeping
     rule of the BOP, and you will understand that BOP should
     balance
   – However, it is impossible to record all international transactions
     associated with a nation, so in practice the organizations to
     produce BOP reports collect national data for different accounts
     separately, which could result in the imbalances of the BOP
                                                                      4-8
 The Current Account
• The Current Account (經常帳) includes all
  international economic transactions with income or
  payment flows occurring within the current year. It
  consists of the following four subcategories:
   – Goods trade
      • The export and import of goods
      • The most traditional international economic activities
      • The current account is typically dominated by this component,
        which is known as the Balance of Trade (BOT) (貿易帳)
   – Services trade
      • The export and import of services
      • Including financial services provided by banks to foreign
        importers and exporters, travel services of airlines, and
        construction services of domestic firms in other countries
      • For the major industrial countries, like the U.S., this subaccount
        grows fast in the past decade
                                                                             4-9
The Current Account
 – Income
     • The dividend income from subsidiaries is the income receipts
     • The wages and salaries paid to nonresident workers are income
       payments
 – Current transfers
     • The change in ownership of real resources or financial items is
       called a transfer
     • Any transfer between countries that is one-way–a gift or grant–
       is termed a current transfer
     • For example, funds provided by the U.S. government to aid a
       less-developed nation, or money sent home by migrants and
       permanent workers abroad
 ※Although the information of balance of trade (BOT) is so
  widely quoted in the business press in most countries, this
  number is somewhat misleading for large industrialized
  countries because the service trade is not taken into account          4-10
U.S. Trade Balance & Balance on Services &
Income, 1985-2007 (billions of US$)




※ The U.S. goods trade balance has been consistently negative, but has been
  slightly offset by the continuous surplus in the balance of services trade
                                                                               4-11
 The Current Account
• The deficits in the BOT of the U.S. in the past two
  decades have been wildly debated since merchandise
  trade is the original core of international trade
• Reasons for the deficits in the BOT of the U.S.
   – Relatively high income in the U.S. creates the import demand
   – The price of the imported products after passing the exchange
     rate is cheaper, which may be caused by that many trading
     partners of the U.S. adopt the policy of depreciating their
     currency against US$ to maintain the competitive power in
     the U.S. market
   – The biggest bilateral deficits are with China and Japan, which
     maintain relative weakness of their currencies by buying
     massive amounts of U.S. dollars (usually investing in
     Treasury bonds) while selling corresponding amounts of their
     own currencies                                                 4-12
 The Current Account
   – FYI, at the end of 2009, Japan and China held the largest
     amount of Treasury bonds in the world, each of which owns
     768.8 billion and 755.4 billion US$, respectively
   – Later, you will see the above actions will increase the cash
     inflow for the financial account and thus cause the surplus of
     the financial account of the U.S.
• The deficit in the BOT results in the decline of heavy
  traditional industries in the U.S. (steel, automobiles,
  automotive parts, textiles)
• The consistent surplus in the services trade account
  may be from travel and passenger fares, transportation
  services, expenditures by foreign students pursuing
  studies in the U.S., telecommunications services,
  financial services, etc.
                                                                      4-13
 The Capital and Financial Account
• The capital account is made up of capital transfers
  related to the purchase and sale of fixed assets such as
  real estates, plants, or equipment, etc.
   – If a U.S. firm purchases a building in another country, this is
     a cash outflow in the capital account of the U.S.
• The capital account has been introduced as a separate
  component in the IMF’s balance of payments only
  recently
• The magnitude of capital transaction is relatively
  minor, so we include it in principle in the following
  discussion of the financial account


                                                                       4-14
The Financial Account
• The financial account in the balance of payments
  measures all international economic transactions of
  financial assets
• The financial account is classified into three
  components, depending on the degree of investor
  control over the assets or operations
   – Direct Investment – in which the invested financial assets
     exerts some explicit degree of control over the real assets
   – Portfolio Investment – in which the invested financial
     assets has no control over the real assets
   – Other Financial Investment – consists of bank deposits,
     various short-term and long-term trade credits, cross-
     border loans, currency deposits,, and other A/R and A/P
     related to cross-border trade
                                                                   4-15
 Direct Investment
• This is the net balance of capital dispersed from and
  into the U.S. for the purpose of exerting control over
  real assets
• If U.S. investors hold 10% or more of the voting shares
  in a foreign company, that company is considered the
  foreign affiliate of a U.S. company, and this investment
  is classified as a direct investment
• The source of concern over foreign direct investment in
  any country focuses on two topics: control and profit




                                                             4-16
  Direct Investment
• Some countries possess restrictions on foreigners to own
  assets in their country, e.g., domestic land, assets, and
  industry should be owned only by residents of the
  country
• However, the U.S. has few restrictions on what foreign
  residents or firms can own or control assets in the U.S.
• As for profit, the concern of possible profit outflow may
  limit the foreign investment in some countries
   – There are evidences indicating that foreign firms in the U.S.
     reinvest most of their profits in their U.S. business (at a higher
     rate than domestic firms in the U.S.)
• The capital inflow in the form of direct investment is
  generally welcomed in the U.S. due to the possible
  increase of jobs, production, services, technology, etc.
                                                                          4-17
  Portfolio Investment
• This is the net balance of capital that flows in and out
  of the U.S. but does not reach the 10% threshold of
  direct investment
• The purchase of debt securities across borders is also
  classified as portfolio investment because debt
  securities by definition do not provide the buyer with
  ownership or control
• Portfolio investment is motivated by a search for
  returns rather than to control or manage the asset
• The motivating forces for portfolio investment flows
  are only return and risk, so the series of the flow of
  portfolio investment is less predictable (Exhibit 3.5)

                                                             4-18
Financial Account Balances for the United
States, 1985-2007 (billions of US$)




                                            4-19
 Transaction Bookkeeping in BOP
• Before introducing the net errors and omissions and
  reserves accounts in the BOP, the theoretical
  bookkeeping process for BOP is introduced first
• There are three main elements of the actual process of
  recording international economic activities:
   – Identifying what is and is not an international economic
     transaction (definition on Slide 4-4 and examples on Slide 4-6)
   – Understanding how the flows of goods, services, assets, and
     money create debits and credits to the overall BOP
   – Understanding the bookkeeping procedures for BOP
     accounting
• The rule of thumb aids the understand of BOP
  accounting: “Follow the cash flow.”
   – Credits (+) (貸方): cash inflow
   – Debits (–) (借方): cash outflow                                4-20
 Transaction Bookkeeping in BOP
• Ex 1: The U.S. exports $2mil. goods to the U.K., and 1)
  the importer in the U.K. pays the money into the
  account of the U.S. exporter in the U.K.; or 2) the
  importer in the U.K. uses the money in its account in
  the U.S. to pay the bill
  ※ Export of goods to foreign country will bring cash inflow for the U.S. in
     the account of Export of goods in Current Account
  1) The increase of deposits of U.S. firms in foreign banks means a cash
     outflow for the U.S in the account of Other financial items in Financial
     Account
  2) The decrease of deposits of foreign firms in U.S. means a cash outflow for
     the U.S in the account of Other financial items in Financial Account

                                            Debit (–)         Credit (+)
   Export of goods in CA                                      $2mil.
   Other financial items in FA              $2mil.
                                                                                  4-21
 Transaction Bookkeeping in BOP
• Ex 2: The U.S. imports $6mil. services from the U.K.,
  and 1) the importer in the U.S. pays the money into the
  account of the U.K. exporter in the U.S.; or 2) the
  importer in the U.S. use the money in its account in the
  U.K. to pay the bill
   ※ Import of services from foreign countries will cause a cash outflow for
      the U.S. in the account of Import of services in Current Account
   1) The increase of deposits of foreign firms in U.S. banks means a cash
      inflow for the U.S. in the account of Other financial items in Financial
      Account
   2) For the U.S., drawing money from U.K. banks by its residents means a
      cash inflow in the account of Other financial items in Financial Account

                                            Debit (–)          Credit (+)
   Import of services in CA                 $6mil.
   Other financial items in FA                                 $6mil.
                                                                                 4-22
  Transaction Bookkeeping in BOP
• Ex 3: The U.S. government transfers $1mil. goods as a
  grant to Nicaragua
   ※ Export of goods to foreign country should bring cash inflow for the
     U.S. in the account of Export of goods in Current Account
   ※ Transferring $1mil. goods as a grant to foreign country means a cash
     outflow for the U.S. in the account of Transfers in Current Account

                                         Debit (–)         Credit (+)
  Export of goods in CA                                    $1mil.
  Transfers in CA                        $1mil.




                                                                            4-23
 Transaction Bookkeeping in BOP
• Ex 4: A U.K. firm purchases $5mil. U.S. Treasury
  bonds and pays the money from its accounts in the U.S.
  banks
  ※ Purchasing U.S. Treasury bonds, which is a portfolio investment,
    brings cash inflow for the Net portfolio investment in Financial
    Account of the U.S.
  ※ The decrease of deposits of foreign firms in U.S. banks means a cash
    outflow for Other financial items in Financial Account in the U.S.

                                           Debit (–)         Credit (+)
   Net portfolio investment in FA                            $5mil.
   Other financial items in FA             $5mil.




                                                                           4-24
 The BOP as a Flow Statement
• The BOP is often misunderstood as many people infer
  from its name that it is a balance sheet, whereas in
  fact it is a cash flow statement
   – It does not add up the value of all assets and liabilities of a
     country on a specific date (as an individual firm’s balance
     sheet would do)
• By recording all international transactions over a
  period of time such as a year, it tracks the continuing
  flows of purchases and payments between a country
  and all other countries
• According to the above double-entry bookkeeping
  rule, the BOP must balance theoretically

                                                                       4-25
 Net Errors & Omissions/Official
 Reserves Accounts
• The official reserves account (or foreign exchange
  reserves) (外匯存底) is the total reserves held by official
  monetary authorities within the country
• These reserves are normally composed of the major
  currencies used in international trade and financial
  transactions (so-called hard currencies like the U.S.
  dollar, Euro, British pound, Japanese yen, gold, or SDRs)
• Since the data of the current, capital, financial, and
  official reserves accounts are collected and recorded
  separately or there are possibly illegal transfers, errors
  could occur and thus the BOP may not balance in
  practice
• The net errors and omissions account ensures that the
  BOP actually balances                                      4-26
                The U.S. BOP from 1998-2007
                                         There is a surplus on the
                                         basic balance, which
+ : cash inflow                          means a net cash inflow of
    (demand)                             45 billion US$ to the U.S.
– : cash outflow
    (supply)
                                         The U.S. government uses
                                         its official reserves to buy
                                         2 billion US$, i.e., it
                                         creates a net demand of 2
                                         billion US$ by purchasing
                                         US$ with its official
                                         reserves in the exchange
                                         rate markets

                                         The U.S. government sells
                                         4 billion US$ in exchange
                                         for increasing official
                                         reserves, i.e., providing net
                                         supply of US$ by using
                                         US$ to purchase foreign
                                         currencies
Basic balance


                                                                   4-27
The Analysis of BOP




                      4-28
 Fixed and Float Exchange Rate
 Regimes
• Fixed exchange rate regime
   – The domestic currency, guaranteed by the government, is
     convertible into a fixed amount of a foreign currency, a basket
     of currencies, or another measure of value, such as gold
   – Devaluation (revaluation): A deliberate downward (upward)
     adjustment to a country’s official exchange rate, also called
     the parity rate, relative to other currencies
   – In a fixed exchange rate regime, only a decision by a
     country’s government (i.e., the central bank) can alter the
     official value of the currency
• Float exchange rate regime
   – A currency’s value is allowed to fluctuate according to the
     demand and supply in the foreign exchange market
   – Depreciation (appreciation): refers to a drop (increase) in the
     foreign exchange value of a floating currency                     4-29
 The BOP in Total — Surplus
• A surplus in the BOP  net cash inflow for the
  domestic country  foreign residents demand the
  domestic currency to pay the cash to the domestic
  residents  the demand of the domestic currency
  exceed the supply of the domestic currency
• The domestic currency has the pressure to appreciate
• If the government wants to maintain the fixed
  exchange rate, it can intervene the market by selling
  its own currency in exchange for other currencies and
  thus building up its stores of hard currencies, i.e., its
  foreign exchange reserves
   – Selling its own currency causes a cash outflow (supply)
     which diminishes the surplus in the BOP
                                                               4-30
 The BOP in Total — Deficit
• A deficit in the BOP  net cash outflow for the
  domestic country  domestic residents demand the
  foreign currency to pay bills to foreign residents 
  an excess supply of the country’s currency in foreign
  exchange markets worldwide
• The domestic currency has the pressure to depreciate
• To maintain the fixed exchange rate, a government
  can intervene the market by purchasing it own
  currency at the expense of its foreign exchange
  reserves to support the domestic currency value
   – Buying its own currency causes a cash inflow (demand)
     which offsets the deficit in the BOP

                                                             4-31
 Official Reserves Accounts
• The significance of official reserves depends generally
  on whether the country is operating under a fixed
  exchange rate regime or a floating exchange rate
  system
   – In a fixed-rate system, the government decides the fixed
     exchange rate, also called the parity rate, to exchange for
     other foreign currencies
   – For excess supply (demand) of the domestic currency, to
     prevent the value of the domestic currency from falling
     (rising), the government should spend its official reserves
     (domestic currency) to purchase the domestic currency
     (official reserves) to support (calm down) the value of the
     domestic currency
   – Under a floating-rate system, governments have no such
     responsibility and the role of official reserves is diminished
                                                                      4-32
 Current and Financial Account
 Balance Relationships
• Since the BOP should balance, it is possible to infer the
  inverse relation between the current account and the
  financial account, which are the two major accounts in
  the BOP
• In the examples on Slides 4-21 and 4-22, it is found that
  the double-entry bookkeeping in theory requires that the
  current and financial accounts offset for each other
• Intuitively, countries experiencing current account
  deficits “finance” these purchases through equally large
  surpluses in the financial account (like the U.S.)
   – For the U.S., both real and financial assets possessed by
     foreigners increases, the country become a “net debtor”
   – On the other hand, for Japan, the current account surplus is
     matched against a financial account deficit                    4-33
  Current and Financial/Capital Account Balances
  for the U.S., 1992-2007 (billions of US$)




※ The above figure shows the inverse relationship between the balances
  of the current account and the capital/financial account in the U.S.
                                                                         4-34
 Current and Financial Account
 Balance Relationships
• The surplus or deficit in the current account cannot be
  the signal for the performance of the economy
   – For the U.S., the well investment environment attracts capital
     and financial investments and this cash inflow finances the
     deficits in the current account
   – For Latin America
       • In 1980s, there was surplus in the current account, but the
         pessimistic prospects of the economy caused deficits in the
         capital and financial accounts
       • In 1990s, there are better expectations of the future economy, so
         there are surpluses in the capital and financial accounts, but
         together with the deficits in the current account
   – For rapidly growing countries (countries in recession),
     importing more (less) goods and services will decrease
     (increase) the balance of the current account or even generate
     deficits (surpluses) in the current account                             4-35
             The China BOP from 1998-2007
                                      There is a surplus on the
                                      basic balance, which
                                      means a net cash inflow of
+ : cash inflow                       US$437 billion to China
    (demand)
– : cash outflow                      The China government
    (supply)                          sells Renminbi equivalent
                                      to 461 billion US$ in
                                      exchange for increasing
                                      official reserves, i.e.,
                                      providing net supply of
                                      Renminbi by using
                                      Renminbi to purchase
                                      foreign currencies

                                     ※ Due to maintain the
                                     fixed exchange rate or said
                                     to diminish the appreciation
                                     pressure, the China
                                     government intervenes
                                     foreign currency markets by
                                     issuing more Renminbi to
                                     purchase foreign currencies
                                     ※ The results are the
                                     increase of foreign
                                     exchange reserves and a
                                     possible inflation problem
                                                               4-36
Current and Financial Account
Balance Relationships for China
• The double surplus in China
   – Surpluses in both the current and financial accounts is
     called the double surplus phenomenon
   – This unusual phenomenon reflects how exceptional the
     growth of the Chinese economy is
   – Although the current account surplus should create a
     financial account deficit, the positive prospects of the
     Chinese economy have drawn such massive capital inflows
     in recent year and thus the financial account becomes in
     surplus
      • The underestimated value of Renminbi strengthens the capital
        inflows
      • This phenomenon also reflects that China is a world factory–
        attract international capital, build factories, produce goods,
        and export them
                                                                         4-37
Current and Financial Account
Balance Relationships for China
 – The China government conduct a lot of intervention to
   maintain its balance of payment and thus the relatively fixed
   exchange rate against the U.S. dollar
 – The appropriate solution is to allow the Renminbi to float
   and appreciate. However, it is not in line with China’s
   current political plan




                                                                   4-38
The BOP Interaction with
Macroeconomic Variables




                       4-39
 The BOP Interaction with Key
 Macroeconomic Variables
• A nation’s balance of payments interacts with nearly
  all of its key macroeconomic variables
• Interaction means that the BOP affects and is affected
  by key macroeconomic factors such as:
   –   Gross Domestic Product (GDP)
   –   Exchange rates
   –   Interest rates
   –   Inflation rates




                                                           4-40
  The BOP and GDP
• In a static (accounting) sense, a nation’s GDP can be
  represented by the following macroeconomic
  accounting identity:
            GDP = C + I + G + X – M
  where
     C = consumption spending
     I = capital investment spending
     G = government spending
     X = exports of goods and services
     M = imports of goods and services
     X – M = the sum of balances of the first two subaccounts in
     the current account, which is close to the total balance on the
     current account and thus used to “approximate” the balance
     on the current account                                            4-41
 The BOP and GDP
• In the same period, a positive current account balance
  (surplus) contributes directly to increasing the measure
  of GDP, but a negative current account balance (deficit)
  decreases GDP
• Taking multiple periods into account
   – GDP ↑  disposable income ↑  consumption ↑  import ↑
      balance of current account ↓
   – GDP ↑  capital investment ↑  export ↑  balance of
     current account ↑
   ※Thus, in a dynamic sense, the relationship between GDP and
     balance of the current account is uncertain
   ※BTW, GDP↑  capital investment ↑  employment rate ↑
     (could be offset by the foreign sourcing, i.e., the import of
     cheaper goods and services from foreign countries), so the
     BOP also influences the employment rate                         4-42
 The BOP and Exchange Rates
• A country’s BOP can have a significant impact on the
  level of its exchange rate and vice versa, depending on
  that country’s exchange rate regime
• In fact, the value of BOP has predicting power for
  exchange rates on the long-term trend, but performs
  poor on the short-term movement
• Fixed Exchange Rate Countries
   – Under a fixed exchange rate system, the government is
     responsible to ensure that the BOP is near zero by intervening
     markets and matching the demand and the supply of the
     domestic currency
   – When there is a deficit for the overall balance, if the country
     run out of foreign exchange reserves, it will be unable to buy
     back its domestic currency and will be forced to devalue
                                                                       4-43
   The BOP and Exchange Rates
• Floating Exchange Rate Countries
   – Under a floating exchange rate system, the government has no
     responsibility to peg its foreign exchange rate
   – Surplus on the BOP  currency appreciation  price of export
     goods ↑, price of import goods ↓  export ↓, import ↑  BOT ↓
      BOP ↓
   – Deficit on the BOP  currency depreciation  price of export
     goods↓, price of import goods↑ export ↑, import ↓  BOT ↑
      BOP ↑
   ※Thus, the floating exchange rate regime can adjust the BOP
     automatically
   – However, the effect of the change of the exchange rate will not
     affect the BOP in the right direction immediately
   – For deficits in the BOP, the effect of currency depreciation will
     let the deficits get worse in the short run, but moves back toward
     equilibrium in the long run (J-curve effect discussed later)
                                                                      4-44
  The BOP and Exchange Rates
• Managed Floating Regime
  – Countries adopting this regime have desired exchange rates,
    but they allow the exchange rate to derivate from the desired
    level to some extent
  – They often find that it is necessary to take action to maintain
    their desired exchange rate levels
  – In addition to intervening the foreign exchange market, they
    usually try to alter the exchange rate by influencing the
    motivations of market participants
  – For example, to deal with the depreciation pressure from the
    deficit in the BOP, governments may raise domestic interest
    rate to attract additional capital from aboard, which creates
    additional demand for the domestic currency and alleviates the
    depreciation pressure (in the meanwhile, diminishes the deficit
    in the BOP)
                                                                      4-45
   The BOP and Interest Rates
• Apart from the use of interest rates to intervene the
  foreign exchange market, the overall level of a country’s
  interest rates compared to other countries DOES have
  impact on the financial account of the BOP
• Relatively low real interest rates should normally
  stimulate an outflow of capital seeking higher rates
  elsewhere
• In the case of the U.S., even with low real interest rates,
  the opposite has occurred due to perceived growth
  opportunities and political stability, which allows it to
  finance its large fiscal deficit
• However, it is beginning to appear that the favorable
  inflow on the financial account is diminishing while the
  current account balance is worsening                          4-46
 The BOP and Inflation Rates
• The effect of increasing imports
   – Due to the comparative advantage theory in international
     trade, imports of goods and services are usually cheaper and
     have the potential to lower a country’s inflation rate
   – Imports ↑  balance on current account ↓  BOP ↓
   ※If the BOP declines with the increase of the import, the
     inflation rates may decrease in the meantime
   – In addition, imports ↑  foreign competition substitutes for
     domestic competition  domestic production ↓, employment
     rate ↓  GDP ↓ (this argument is consistent with the
     macroeconomic accounting identity, i.e., imports ↑  GDP ↓)




                                                                    4-47
 Trade Balances and Exchange Rates
 J-Curve Adjustment
• A country’s import and export of goods and services
  are affected by changes in exchange rates
• The transmission mechanism is in principle quite
  simple: changes in exchange rates change relative
  process of imports and exports, i.e., changing prices in
  turn result in changes in quantities demanded through
  the price elasticity of demand




                                                             4-48
    Exhibit 4.8 – The J-Curve Effect




※ There are three stages to adjust the deficit of the balance of trade
※ The adjustment path of the trade balance is like the shape of a flattened “J”
※ In the pass-through period, import prices ↑ and export prices ↓ due to the currency
  depreciation (explained on the next slide)
※ In the quantity adjustment period, import demand ↓ and export demand ↑, so the
  balance of trade–exports less imports–improves eventually
                                                                                        4-49
 Trade Balances and Exchange Rates
 J-Curve Adjustment
• The reason why the sudden depreciation of the
  domestic currency deteriorates the trade deficit
  immediately in the J-curve adjustment
   – Most exports were priced in US$, but most imports were
     contracts denominated in foreign currency
   – Sudden depreciation: because all the contracts of exports and
     imports are in effect and the cost to U.S. importers rise as they
     spent more dollars to buy foreign currencies, whereas the
     revenues earned by U.S. exporters remain unchanged, it
     deteriorates the trade deficit immediately
• The “J-curve” adjustment path gives the reason that
  many countries, e.g., Taiwan in 1997, adopted the
  devaluation strategy to improve the trade balance

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