CHAPTER 3 BALANCE OF PAYMENTS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
1. Define Balance of Payments.
Answer: The Balance of Payments (BOP) is a statistical record of a country’s international transactions
over a certain period of time presented in the form of double-entry bookkeeping.
2. Why would it be useful to examine a country’s balance of payments data?
Answer: It is useful to examine a country’s BOP for at least two reasons. First, the BOP provides detailed
information about the supply and demand of the country’s currency. The trade statistics in the Current
Account, for example, show the composition of trade – what a country imports and what it exports. The
Capital Account shows inflows and outflows of capital in various categories. Second, viewed over time,
BOP data can shed light on important developments in a country’s comparative advantage and
3. The United States has run current account deficits continuously since the early 1980s. What do you
think are the main causes for the deficits? What are the global consequences of continuous US current
The current account deficits of US may be linked to factors such as
i. the relative ease by which the United States could borrow abroad to finance Current
ii. the high US rate of consumption (and correspondingly low savings rate) associated
with large government deficits
iii. US monetary policy that sustained relatively high US interest rates and a high value for
the US dollar.
IM-1 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 (purchases of US Securities,
especially Treasury Bills) prevented yen from appreciating more than it did. At the same time,
foreigners’ exports (of goods and services) to Japan were hampered by closed nature of Japanese markets.
Sustained Current Account surpluses sometimes reflect export-promotion, import-discouraging policies in
the deficit country. Such surpluses are inconsistent with free-trade to the extent that they are brought
about by the mercantilist policies.
5. Comment on the following statement: “When Canada imports more than it exports, it is necessary for
Canada to import capital from foreign countries to finance its Current Account deficits.”
Answer: The Balance of Payments must balance. A deficit on Current Account ( “When Canada imports
more than it exports ..”) means that Canada has spent more on imported goods and services than it has
received in sales of (Canadian exported) goods and services. The Current Account deficit must be
financed with an inflow of foreign capital involving the purchase of Canadian securities by foreigners
who have more Canadian dollars than they know what to do with ( … “it is necessary for Canada to
import capital from foreign countries to finance its Current Account deficits.”) which, of course, is a
surplus on Capital Account.
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, Canada could run an overall BOP deficit by drawing down The Bank of
Canada’s reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central
bank’s reserve holdings. The Bank of Canada generally does not intervene – by using or accumulating
foreign exchange reserves – to establish a specific value for the Canadian dollar vis-à-vis, say, the US
dollar. The Bank of Canada is committed to a flexible exchange rate. As a result, the foreign exchange
reserves of the Bank of Canada are relatively small unlike, say, Asian countries that hold substantial
reserves in order to protect their currencies in the face of excess volatility.
IM-2 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, (iii) special drawing
rights (SDRs), and (iv) reserve positions with the IMF. F