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©2012PearsonEducation,Inc.Chapter4TheBalanceofPaymentsQUESTIONS1.Whatarethemajoraccountsofthebalanceofpayments,andwhattransactionsarerecordedoneachaccount?Answer:Thethreemajoraccountofthebalanceofpaymentsarethecurrentaccount,thecapitalaccount,andtheofficialsettlementsaccount.Thecurrentaccountrecordsthefollowing:1.Imports,whicharepurchasesofgoodsandservicesfromforeignresidents,andexports,whicharesalesofgoodsandservicestoforeignresidents.2.Transactionsassociatedwiththeincomeflowsfromtheownershipofforeignassets(dividendsandinterestpaidtodomesticresidentswhoownforeignassetsaswellasdividendsandinterestpaidtoforeignresidentswhoowndomesticassets).3.Unilateraltransfersofmoneybetweencountries(foreignaid,gifts,andgrantsgivenbytheresidentsorgovernmentsofonecountrytothoseofanother).Thecapitalaccountrecordsthefollowing:Purchasesandsalesofforeignassetsbydomesticresidentsaswellasthepurchasesandsalesofdomesticassetsbyforeignresidents.Thedefinitionofanassetisallinclusive:Itisanyforminwhichwealthcanbeheld.Itencompassesbothfinancialassets(bankdepositsandloans,corporateandgovernmentbonds,andequities)andrealassets(factories,realestate,antiques,andsoforth).Hence,thecapitalaccountrecordsallchangesinthedomesticownershipoftheassetsofothernationsaswellaschangesintheforeignownershipoftheassetsofthedomesticcountry.Theofficialsettlementsaccountrecordsthefollowing:Transactionsinvolvingthepurchaseorsaleofofficialinternationalreserveassetsbyanation’scentralbank.Internationalreservesaretheassetsofthecentralbankthatarenotdenominatedinthedomesticcurrency.Goldandassetsdenominatedinforeigncurrencyarethetypicalinternationalreserves.2.Whyisitimportantforaninternationalmanagertounderstandthebalanceofpayments?Answer:Thebalanceofpaymentsprovidesinformationthatisusefulinunderstandingthedeterminationofexchangeratesandthegrowthprospectsofacountry.Forexample,persistent,largecurrentaccountdeficits,especiallyonesthatareprimarilyconsumerdriven,areoftenassociatedwithcurrencycrisesinwhichthecurrencyofthecountrywiththedeficitdepreciatessubstantiallyandthecountrysuffersasevererecession.KnowledgeoftheChapter4:TheBalanceofPayments©2012PearsonEducation,Inc.2officialsettlementsaccountindicateswhetherthecountryisgainingorlosinginternationalreserves,andsufficientlossesofreservesindicatealossoftheabilitytomaintainafixedexchangerate.Massiveincreasesininternationalreservesindicatethatthecentralbankisresistingpressureforthecurrencytoappreciateinvalue.Largecapitalaccountsurplusesthatareprimarilydrivenbyprivatesectorinvestmentsindicatethatforeignersfindtheassetsofthecountrytobeattractiveinvestmentopportunities.3.Whataretherulesthatdeterminetheresidencyrequirementsonthebalanceofpayments?Answer:Therulesforresidencyarethattheentityhasaprimaryeconomicinterestinthecountry.Thus,itisnotcitizenshipthatisbeingmeasured.TheseconceptsarediscussedindetailintheIMF’sBalanceofPaymentsmanualavailableonlineat:Thebalanceofpaymentsusesadouble-entrysystem.Eachtransactiongivesrisetotwoentries:Oneentryisacredit,andtheotherentryisadebitofequalvalue.AnytransactionresultinginapaymenttoforeignersisenteredintheBOPaccountsasadebit.Anytransactionresultinginareceiptoffundsfromforeignersisenteredasacredit.Inthedoubleentrysystem,theflowofmoneyfromadomesticresidenttoaforeignresidentisacreditandtheitemthatgivesrisetotheflow(eitheranimportofagoodorserviceorthepurchaseofaforeignasset)isadebit.5.Howaregiftsandgrantshandledinthebalanceofpayments?Answer:Giftsandgrantsarehandledasimportsandexportsofgoodwill.Ifadomesticresidentgivesagifttoaforeignresident,thevalueofthegiftisadebit(animportofgoodwill)andthevalueofthegiftisacreditonthedomesticbalanceofpaymentsbecauseitresultsinpaymentoffundstoforeigners.6.Whatdoesitmeanforacountrytoexperienceacapitalinflow?Isthisassociatedwithasurplusoradeficitonthecountry’scapitalaccount?Answer:Whenacountryexperiencesacapitalinflow,foreignresidentsareinvestingindomesticassetsanddomesticresidentsaresellingforeignassets.Thesetransactionsarecreditsonthebalanceofpaymentsbecausethecountryiseffectivelyexportingassets.Ifcapitalinflowsexceedcapitaloutflows,thereisasurplusonthecountry’scapitalaccount.Thissurpluswouldbeoffsettingacombineddeficitonthecurrentaccountandtheofficialsettlementsaccount.7.Ifyouaddupallthecurrentaccountsofallcountriesintheworld,thesumshouldbezero.Yetthisisnotso.Why?Chapter4:TheBalanceofPayments3©2012PearsonEducation,Inc.Answer:Thereisalarge,consistentlynegativesignfortheglobalbalanceofpaymentswhichsuggeststhatthediscrepancycannotsimplybeduetomeasurementerrorsbecauseifitwere,thebalancewouldbepositiveaboutasoftenasitisnegative.Onereasonwhythereisaconsistentnegativesignintheaggregateerrorshastodowithtaxevasion.Manyindividualstrytoescapetaxesontheincomefromtheirinvestments.Hence,theymayfailtoreporttheinterestincometheyearnontheirforeignsecurities,whichwouldconstituteacreditfortheirhomecountry’scurrentaccountbalance.Unrecord