International Finance
Econ 371: Answer Key for Problem Set 1
(Chapter 12-13)
Instructor: Kanda Naknoi
September 14, 2005
1. (2 points) Is it possible for a country to have a current account deficit at the same time and has a surplus in its balance of payments? Explain your answer using hypothetical figures.
ANSWER: (1 point) Yes. The balance of payments (BoP) is the sum of current account (CA), capital account (KA) and financial account (FA). Theoretically, because of the double-entry bookkeeping practice, the sum is supposed to be zero.
BoP = CA + KA + FA = 0
(1 point) Given a current account deficit, the theory predicts that the sum of the capital account and the financial account must be surplus. However, in practice, the balance of payments may deviate from zero because of statistical discrepancy, particularly in recording financial transactions in the financial account. Suppose the current account deficit is 100 billion dollars, a combined surplus of the capital account and the financial account must be greater than 100 billion dollars to produce a surplus in the balance of payments.
(Optional note) Sometimes the term ”balance of payments” is used to describe the official settlements balance with the opposite sign. This balance indicates the payments gap covered by the official reserve transactions. For example, the U.S. official settlements balance in 2003 is 250 billion dollars. In this case, some newspapers may say that ”the U.S. balance of payments in 2003 is -250 billion dollars.” When it is a large negative number, it is often a subject of concern because it indicates an excessive role of the central bank in financing the current account deficit.
2. (2 points) Suppose that the U.S. net foreign debt is 25 percent of U.S. GDP and that foreign assets and liabilities alike pay an interest rate of 5 percent per year.
What would be the drain on U.S. GDP (as a percentage) from paying interest on the net foreign debt? What if the net foreign debt were 100 percent of GDP? At
(Chapter 12-13)
Instructor: Kanda Naknoi
September 14, 2005
1. (2 points) Is it possible for a country to have a current account deficit at the same time and has a surplus in its balance of payments? Explain your answer using hypothetical figures.
ANSWER: (1 point) Yes. The balance of payments (BoP) is the sum of current account (CA), capital account (KA) and financial account (FA). Theoretically, because of the double-entry bookkeeping practice, the sum is supposed to be zero.
BoP = CA + KA + FA = 0
(1 point) Given a current account deficit, the theory predicts that the sum of the capital account and the financial account must be surplus. However, in practice, the balance of payments may deviate from zero because of statistical discrepancy, particularly in recording financial transactions in the financial account. Suppose the current account deficit is 100 billion dollars, a combined surplus of the capital account and the financial account must be greater than 100 billion dollars to produce a surplus in the balance of payments.
(Optional note) Sometimes the term ”balance of payments” is used to describe the official settlements balance with the opposite sign. This balance indicates the payments gap covered by the official reserve transactions. For example, the U.S. official settlements balance in 2003 is 250 billion dollars. In this case, some newspapers may say that ”the U.S. balance of payments in 2003 is -250 billion dollars.” When it is a large negative number, it is often a subject of concern because it indicates an excessive role of the central bank in financing the current account deficit.
2. (2 points) Suppose that the U.S. net foreign debt is 25 percent of U.S. GDP and that foreign assets and liabilities alike pay an interest rate of 5 percent per year.
What would be the drain on U.S. GDP (as a percentage) from paying interest on the net foreign debt? What if the net foreign debt were 100 percent of GDP? At