Global Economic Balances: Deficits, Surpluses, and Interest Parity
Balance of Payments: Deficits & Surpluses
If we sum all debits and credits in the current account, private capital account, and public capital account, the total should theoretically be zero. However, this seldom happens in practice. Numerous transactions are missed or intentionally hidden from the accounting process.
If the sum of credits and debits in the current account, private capital account, and public capital account is not zero, an offsetting entry, known as the *statistical discrepancy*, appears in the Balance of Payments (BOP).
Understanding the Statistical Discrepancy
The overall Balance of Payments (BOP) is the sum of credits and debits in the current account, public/private capital account, and the statistical discrepancy. Because debit entries offset every credit entry, and the statistical discrepancy offsets any errors, the overall BOP necessarily equals zero.
Defining a Trade Surplus: X > M and S > I
A trade surplus is defined as (X − M) > 0, which implies X > M. Via the identity (X − M) = (S − I), this also implies S > I.
This situation can be described by the following scenarios:
- Trade Flows: Large Exports (X), Small Imports (M)
- Capital Flows: Large Savings (S), Small Investment (I)
Implications of Large Exports & Small Imports
A *large X and small M* scenario can have both positive and negative implications. If a country has a high living standard with effective production of goods and services, this might be a positive indicator. However, for a developing country with poor living standards, a trade outflow (large X, small M) is generally not desirable.
It could also stem from a mercantilist approach, protecting domestic companies. This can hinder efficiency in domestic markets and implicitly harm domestic residents. Conversely, a large X can also indicate economic strength, suggesting high domestic production leading to excess supply for export, or strong performance by export firms. Strong production allows domestic firms to pay higher wages, increasing consumption and stimulating the economy.
Conversely, a large X might indicate low domestic demand due to a recession and high unemployment, forcing firms to export goods and services to maintain sales.
Implications of Large Savings & Small Investment
A *large S and small I* scenario is not necessarily positive. A large S could result from uncertainty in the structural system, where residents do not trust the government to manage their savings effectively.
Covered Interest Parity Condition Explained
Why Interest Parity (R = R*) Fails to Hold
Interest parity (R = R*) often fails to hold in the international money market because spot exchange rates are not always equal to forward exchange rates. Covered interest parity (CIP) implies that total investment returns on identical assets will be equalized, regardless of risk attitudes. Thus, the *Law of One Return* (LOOR) should hold over time.
Assumptions & Issues with Covered Interest Parity
There are some problems with the covered interest parity condition that lie in its underlying assumptions:
- Assumes high capital mobility.
- No taxes or transaction costs.
- Foreign and domestic assets are identical, except for their country of origin.
- An active spot market.
- An active forward market.