The United States of America is one of the most powerful economies in the world. With a nominal GDP of 18 trillion USD and GDP per capita of $55,000 USD, the U.S.
accounts for 25% of the gross world product. What makes the United States such a dominant and influential participant in the global economy? For one, its substantial consumerism makes up 70% of its gross domestic product. Secondly, the U.
S. is at the forefront of technological, agricultural, military, and pharmaceutical developments. Even though the U.S. has an extensive and contributable economy, they still face unemployment, rising medical costs, stagnation of wages, current account deficit, government budget deficit, and a total debt of 20 trillion USD. Monetary policy on behalf of the Federal Reserve has set a target federal funds rate of 0.25%- 0.5% through 2016.
Currently, the federal funds rate is 1.25% as of June 2017 and aims to increase to 1.50% in 2017 (Forbes, 2016).In Section I of this report, we will focus on the balance of payments of the United States. Beginning with a macroeconomic analysis of the 15 year movements in the balance of payments, we will then discern the individual components.
The current account will be analysed and its influence by private savings, investment, and the government budget deficit. The capital account and financial account are examined to view the changes in net assets. Section II continues with the analyses of exchange rates. We will utilize Germany as our reference country to examine the value of the U.
S. dollar relative to the euro. Calculations of textbook theory on interest parity condition and purchasing power parity are made to determine whether they hold in the foreign market. Also discussed is the real effective exchange rate of the dollar vis-a-vis the euro and what this implies for the competitive environment of the United States. Additionally, we will propose a short-term and long-term forecast as to the future exchange rates. Given information by the Federal Reserve to raise the federal funds rate, we know this will have an impact on the exchange rate, as well as exchange rate expectations that correspond to this proposition. Lastly, we conclude this paper with a brief summary on the most significant results that explain the past, current, and future macro-economical conditions of the United States.
Part I: Balance of Payments1.1 Evolution of Balance of PaymentThe balance of payments records transactions to foreign countries and the receipts from them. The balance of payments is divided into three main categories: the current account, the capital account, and the financial account. The current account mainly consists of the export and import of goods or services and unilateral transfers of money (international interest and dividend payments and earning of domestically owned firm operating in foreign countries). In the financial account, the purchase and sale of financial assets are recorded.
In the capital account, other transfers of non-financial wealth are registered. When there is a deficit in the current and capital account together, this must be financed by borrowing from abroad. Thus, the financial account in theory offsets the current account and capital account (Krugman et al.
, 2015). Figure 1: U.S.
Balance of Payments (Current, Capital, and Financial Account)Figure 1 illustrates the 15 year movement of the balance of payments in the United States. The capital account contributes very little to the balance of payments compared to that of the current and financial account; most years record a surplus in the capital account but very little relative to the financial account. The U.S. is characterized by a large current account deficit, which began in the 80’s. In absolute numbers, the U.S.
has the biggest current account deficit in the world, but also relatively it’s rather big in comparison to other countries. It can also be described in Figure 1 that in the first half of the first decade, the current account deficit increased even further. However, starting with the financial crisis of 2008 the current account strengthened and returned to the levels of 2000. What is most important to note from Figure 1 is that the net financial account and net current account move together throughout the 15 year time horizon. This conforms to macro-economic theory that a current account deficit must be matched by a net financial liability; in order to fund such deficit, the U.
S. needed to borrow money from foreigners and/or lend U.S. financial assets. 1.2 Current AccountThe following formulas are often used to explain the components that influence the current account: Current account = (Private Saving – Investments) – (Government revenues – Taxes), or Current account = Private savings + Government savings – Investments. Figure 2: Current account components of the USA as percentage of GDP (Source: World Bank) The government deficit (government revenues – taxes) of the USA is shown for the last 15 years in Figure 2.
We can see a steady increase in government deficit between 2000 and 2009 and a decrease in government deficit between 2009 and 2015. Note that after the year 2002 the government of the United States only recorded negative numbers. For investments (gross fixed capital formation) we see a decrease between between 2000 and 2009 from 23% of GDP to around 18.5%. After 2009 the fixed gross capital formation bounced a bit back from 18.
5% to 20% of GDP. For private savings we see a decrease from 18% in 2000 to approximately 10% in 2009 and an increase from 10% to 15% in the years following. If we add all these components together according to the formula we have the current account surplus/deficit of the USA displayed in the figure. In Figure 2 we see that there is a change in trend of the factors making up the current account. Between 2000 and 2009 private savings, governments savings and investments are all decreasing.
However, the decrease of the national savings (savings together) is larger than the decrease in investments, resulting in an increase of the current account deficit. Between 2009 and 2015, national savings (private savings and governments savings) are increasing more than investments, resulting in a decrease of the current account deficit. Having a negative current account does not necessarily have to be a bad sign. It can be caused by too many investments opportunities relative to national savings. Investments that are made will eventually result in higher GDP growth, what is good for the economy, despite resulting in a current account deficit now.
However, in the USA, the current account deficit is not because of not having enough investment opportunities. It’s mainly due to overconsumption, in other words, a lack in private savings and persistent government deficits. 1.3 Capital AccountThe capital account records international asset movements which consists of the acquisition or disposal of non-produced, non-financial, or intangible goods (Krugman et al.
, 2015). Such examples of capital account transactions are land sold to embassies, sales of leases and licenses, capital transfers, and government debt forgiveness. As shown in Figure 3, the U.S. has had a volatile net capital account balance over the past 15 years ranging from $13.
2 billion to -$1.8 billion USD. As of 2016 Q4 ending, the U.S. has a capital account deficit of -$0.
059 billion USD. Figure 3: Net Capital Flows in billions USD (Source: World Bank) Capital account surpluses result when foreign investment into the U.S. exceeds the foreign investment outside of the U.S; these payments to the U.S.
are a net balance of payments credit. A credit is recorded whenever a receipt -payment- from a foreigner is received (Krugman et al., 2015). Additionally, the observed capital account surplus helps reduce the payments to foreigners (if they are running a current account deficit), however, its’ impact is typically very small. Conversely, the lesser capital account deficits observed in few of the years implies higher asset movements into foreign countries than foreign investments into the U.S.. Consequently, capital account deficits can increase the amount of payments owed to foreigners (if you are running a current account deficit).
This reason is simple: if a country’s spending exceeds its’ income (current account deficit), this must be compensated by a net borrowing from foreigners to be matched with a negative balance to fulfill the balance of payment equation ‘current account+capital=financial’. To interpret the latest 15 years of the U.S. capital account, it is necessary to understand that the U.S. has been running a current account deficit since the early 1990s. To compensate for the excess in spending over domestically produced goods & services, the U.
S. needs to finance this deficit by borrowing from foreigners or by selling some of the country’s wealth to foreigners. Hence, this explains why the U.S. has a capital account surplus in many of the years to finance the payback of their overspending in the current account. 1.
4 Capital Flows Capital flows are referred to as transactions in financial assets between U.S. residents and foreign residents. These can be in the form of loans, government securities, investment in companies.
The capital flows demonstrates the relative strength or weakness of capital markets or maybe used to observe the growth rate to indicate potential investment risk or opportunities (Consensus Study Report, 1992). Long-run capital flows in the U.S. from 1988 to 2007, show net positive flows.
This suggests that there was an increase in foreigners buying U.S. assets and securities. Foreigners sought investment opportunities in financial assets in the U.S. causing the inflow of capital to rise. However, from 2007 to 2015, there has been a constant change between net negative and positive flows. Changes in net asset flows during this time period has shown more volatility than the period before 2007.
Capital flows in the U.S. averaged 21,508 million USD from 1988 until 2017, peaking a high of 272,938 million USD in October of 2008 and a record low of -205,366 million USD in June of 2016. What caused the low in 2016? Heavy foreign investors selling off their U.S. treasury bonds and loans.
Americans also contributed to the outflux by increasing their long-term security holdings in foreign countries. What caused the high in October 2008? Increases in long-term U.S. securities purchased by foreigners. However, following the month of October 2008, foreign interest in U.S. securities began deteriorating as financial turmoil in the United States arose given due to the crisis (Moody’s Analytics).
Long-term rates on U.S. assets (10 year Treasury Bonds) are low, but that is not surprising given the large amounts of foreign investment into the United States; also, given the low risk involved of holding U.S. long-term government bonds, a low interest rate is associated. What we’ve learned from foreign flows into long-term U.S. assets, is that they have a statistically significant impact on long-term U.
S. interest rates. As for shorter-term treasury yields, the rates are not as heavily impacted by foreign investments like that of long-term rates. Instead, short-term rates are a more closely linked with monetary policy rates (Warnock, 2009).1.
5 Financial AccountThe financial account of the United States has been negative for more than fifteen years. Over the years we have seen large fluctuations. The financial account reported -407 billion USD in 2000 and -477 billion USD in 2016. Within the time period, peaks of -809 billion USD (2006) and lows of -195 billion USD (2015) have been reached. The negative financial account means that the United States purchased more foreign assets than that it sold US assets to foreign investors.
In other words, the United States made more liabilities to foreigners than that it obtained assets from. The United States is borrowing more money than that it is lending out and this in line with the deficit on the current account. The financial account of the U.S. in percentage of GDP can be seen in Figure 4.
Figure 4: Financial Account as percentage of GDP (Source: World Bank)Components of the Financial AccountThe financial account consists of foreign direct investments, portfolio investments, financial derivatives and reserve assets. In the next session we will take a closer look to these components of the financial account in the United States. In Figure 5, we combined the foreign direct investments, portfolio investments and reserve assets in one graph to demonstrate their movements relative to each other.
1. Foreign direct investment:Foreign direct investment is an investment in a firm abroad. Key factor is that the investor acquires ownership or at least decision making control over the firm. The net foreign direct investment of the U.S. shows many fluctuations over the last fifteen years. It has been negative for five years and positive for the remaining years. Negative net foreign direct investments means that the U.
S. is investing more abroad than that foreigners are investing in the U.S. For most of the years, the net foreign direct investments have been positive.
More investments entered the U.S. than left. 2. Portfolio investment:A portfolio investment consists of a portfolio of securities such as stocks and bonds. It is a passive type of investment and the main goal is a financial return. The value of the net portfolio investment on the balance of payments has been negative for the last fifteen years, with exception of 2009.
This means that in most years U.S. investors invested more in stocks and bonds abroad than that foreigners invested in the United States. It is the other way around in 2009, foreign investors bought more U.S. securities than the American investor did outside the U.S. 3.
Financial derivative: A financial derivative is a financial instrument whose value depends on the value of an underlying instrument. Futures, options and swaps are all examples of a derivative. Net financial derivatives have been positive for the last fifteen years, meaning that the value of derivatives owned by the U.
S. is higher than the value of derivatives outside the U.S.4. Reserve assets:Assets that are held as reserve by the central bank are known as reserve assets. These reserves can be used during poor economic circumstances. The official reserve asset account is positive over the last fifteen years, but it is unstable.
The reserve account is increasing until 2012, but decreases slightly the years after.