4.6: Balance of Payments

What is the balance of payments?

Record of all transactions between the residents of one country and the residents of other countries.

What are credits?

Inflow; payments received from other countries.

What are debits?

Outflow; payments made to other countries.

What do credits represent?

Foreign demand for currency,

What do debits represent?

Foreign supply of currency.

How many accounts does the balance of payments consist of?

Three.

What does the balance of payments consist of?

- Current account.

- Capital account.

- Financial account.

What does a plus sign represent in the balance of payments?

Credit.

What does a minus sign represent in the balance of payments?

Debit.

What is a surplus in the balance of payments?

When credits > debits.

What is a deficit in the balance of payments?

When debits > credits.

What does the current account consist of? (4)

- Balance of trade in goods.

- Balance of trade in services.

- Income.

- Current transfers.

What is the balance of trade in goods in the current account?

Exports (credit) and imports (debits).

What is the balance of trade in services in the current account?

Exports (credit) and imports (debits).

What is income in the current account?

Inflows — outflows of

- Wages.

- Rent.

- Interest.

- Profits.

What are current transfers in the current account?

Inflows — outflows of

- Gifts.

- Remittances.

- Foreign aid.

- Pensions.

What makes up current transfers? (4)

- Gifts.

- Remittances.

- Foreign aid.

- Pensions.

What does the capital account consist of? (2)

- Capital transfers.

- Transactions of non-produced, non-financial assets.

What are capital transfers?

Inflows — outflows of

- Debt forgiveness.

- Non-life insurance claims.

- Investment grants.

What makes up capital transfers? (3)

- Debt forgiveness.

- Non-life insurance claims.

- Investment grants.

What are non-produced, non-financial assets?

Purchase of natural resources which have not been produced.

What are some examples of non-produced, non-financial assets? ()

- Land.

- Mineral rights.

- Forestry rights.

- Water.

- Fishing rights.

- Airspace.

What does the financial account consist of? (4)

- Foreign direct investment (FDI).

- Portfolio investment.

- Reserve assets.

- Official borrowing.

What is foreign direct investment (FDI)?

Investment by foreign firms into productive facilities in another country.

What is portfolio investment?

Investment in financial capital (stocks and bonds).

What are reserve assets?

Foreign currency reserves that the central bank can buy or sell.

What is official borrowing?

Government borrowing from abroad.

What is error and emissions in the balance of payments?

Item added for equality; due to unrecorded transcations.

Why does the balance of payments add up to zero?

- Credits create demand.

- Debits create supply.

- Equilibrium exchange rate is determined by demand and supply of currency.

Why is there interdependence between the current account and financial account?

A trade surplus/deficit represents a current account surplus/deficit.

- Must lead to a foreign account deficit/surplus to fund excess imports or invest with excess foreign exchange.

If there is a current account surplus, there is likely to be a financial account ______.

Deficit.

Why does a current account surplus lead to a financial account deficit?

More foreign exchange is accumulated from excess imports; used to invest overseas.

If there is a current account deficit, there is likely to be a financial account ______.

Surplus.

Why does a current account deficit lead to a financial account surplus?

Must borrow in order to fund excess imports.

What causes an imbalance in the balance of payments?

Surplus or deficit without central bank intervention.

How does a current account surplus impact a fixed exchange rate?

Causes appreciation.

Why does a current account surplus lead to appreciation?

More exports; greater demand for currency

How does a current account deficit impact a fixed exchange rate?

Causes depreciation.

Why does a current account deficit lead to depreciation?

More imports; increased supply of currency.

What is the most common balance of payment issue?

Current account deficit; excess imports.

What are the consequences of persistent current account deficit? (10)

- Depreciation.

- Higher interest rates.

- Foreign ownership of domestic assets.

- Increasing level of debt.

- Pay interest on loans.

- Less imports of capital goods.

- Poor international credit rating.

- Painful demand management.

- Possibility of lower economic growth.

- Lower living standards in the future.

Why does a persistent current account deficit lead to depreciation?

Increased imports increases supply of currency, leading to depreciation.

Why does a persistent current account deficit lead to higher interest rates?

Increased in order to attract foreign investment to correct deficit.

Why does a persistent current account deficit lead to foreign ownership of domestic assets?

- Sell domestic assets to foreigners to correct deficit.

- Sold at low price; less attractive due to deficit.

- Loss of control over assets.

- Stocks, real estate, factories, natural resources, banks etc.

Why does a persistent current account deficit lead to increasing levels of debt?

Countries borrow to gain credits in financial account to finance excess imports

Why does a persistent current account deficit lead to cost of paying interest on loans?

Interest paid on loans could've been used on something more beneficial; opportunity costs; investment, merit/public goods.

Why does a persistent current account deficit lead to less imports of important capital goods?

Foreign exchange used to pay interest for loans; could have been used to import capital goods or inputs.

Why does a persistent current account deficit lead to a poor international credit rating?

Current account deficit lowers credit rating as economy becomes less attractive; investors have less confidence.

What is an international credit rating?

How likely a country is to repay loans in full on time.

Why does a persistent current account deficit lead to painful demand management?

To correct current account deficit, must pursue contractionary policies that lower incomes and could lead to recessions.

Why does a persistent current account deficit lead to lower economic growth?

Less confidence in economy reduces aggregate demand; less investment in inputs.

Why does a persistent current account deficit lead to lower living standards in the future?

Less imports; citizens consume less.

What policies can be used to correct persistent current account deficits? (4)

- Contractionary policies.

- Trade protection.

- Depreciation.

- Supply-side policies.

What TYPES of policies can be used to correct persistent current account deficits? (3)

- Expenditure reducing policies.

- Expenditure shifting policies.

- Supply-side policies.

How can contractionary policies correct a persistent current account deficit? (2)

- Lower incomes, less demand for imports.

- Lower inflation; domestic goods competitive; more exports.

What are the problems with contractionary policies to correct a persistent current account deficit?

- May cause a recession.

- Higher interest rates may attract investment; appreciation; imports become cheaper; deficit is not corrected.

How can trade protection correct a persistent current account deficit?

Reduces imports through tariffs, quotas, subsidies etc.

What are the problems with trade protection to correct a persistent current account deficit? (4)

- Domestic prices may be higher.

- Less domestic consumption.

- Global inefficiency and misallocation of resources.

- Other countries may retaliate; impacts global economy.

How can depreciation correct a persistent current account deficit?

Exports become cheaper and imports become more expensive; increases net exports.

What is the problem with depreciation to correct a persistent current account deficit?

Higher imports make imported resources more expensive, which leads to cost-push inflation.

How can supply side policies correct a persistent current account deficit?

Lower costs of production to help exports become more competitive.

What are market-based supply side policies?

Policies designed to remove barriers to 'free' markets; allows market forces to work.

What are some market-based supply side policies? (3)

- Encourage competition (privatisation, free trade).

- Labour market reforms (abolish minimum wages).

- Incentive-related policies (lower taxes).

What are interventionist supply side policies?

Policies which involve government intervention to prevent market failure.

What are interventionist some supply side policies? (3)

- Investment in human capital (training, education, healthcare).

- Investment in new technology (research and development).

- Investment in infrastructure.

- Industrial policies (support small industries/firms).

How does devaluation/depreciation affect imports?

Imports become more expensive; decrease.

How does devaluation/depreciation affect exports?

Exports become cheaper; increase.

How does devaluation/depreciation affect net exports?

Net exports increase.

What does the Marshall-Lerner condition suggest?

Price elasticity of demand for imports and exports are important for devaluation to improve current account balance.

If PEDm < 1, how will an increased price of imports affect quantity demanded?

Smaller percentage decrease in quantity demanded.

If PEDm > 1, how will an increased price of imports affect quantity demanded?

Greater percentage decrease in quantity demanded.

What PEDm is more effective to improve trade deficit by devaluation?

Higher PEDm.

Why is a higher PEDm more desirable to improve trade deficit by devaluation?

Greater decrease in imports after price increase due to devaluation.

If PEDx < 1, how will an decreased price of exports affect quantity demanded?

Smaller percentage increase in quantity demanded.

If PEDx > 1, how will an decreased price of exports affect quantity demanded?

Greater percentage increase in quantity demanded.

What PEDx is more effective to improve trade deficit by devaluation?

Higher PEDx.

Why is a higher PEDx more desirable to improve trade deficit by devaluation?

Greater increase in exports after price decrease due to devaluation.

How will devaluation effect the trade balance if PEDm + PEDx > 1?

Improves trade balance.

Why does devaluation improve the trade balance if PEDm + PEDx > 1?

Greater increase in exports and greater decrease in imports.

How will devaluation effect the trade balance if PEDm + PEDx = 1?

Trade balance unchanged.

How will devaluation effect the trade balance if PEDm + PEDx < 1?

Worsens trade balance.

Why does devaluation worsen the trade balance if PEDm + PEDx < 1?

Lower increase in exports and lower decrease in imports.

What is the Marshall-Lerner condition?

Current account balance will improve if the sum of PEDm and PEDx > 1.

What is the J-curve effect?

- Initially, depreciation/devaluation may worsen the trade balance due to a time lag.

- If M-L condition holds, trade balance will eventually improve.

Why is there a time lag between depreciation/devaluation and improved trade balance, causing the J-curve effect? (5)

- Consumers/producers need time to adjust to price change.

- Need time to become aware of price changes.

- Prior commitments.

- Time needed to place new orders.

- Preference of buyers.

What is on the x-axis of the J-curve?

Time.

What is on the y-axis of the J-curve? (3)

Trade balance (X — M):

- Trade surplus (X > M).

- Trade balanced (X = M).

- Trade deficit (X < M).

What are the consequences of a persistent current account surplus? (7)

- Low domestic consumption.

- Insufficient domestic investment.

- Appreciation.

- Inflation.

- Employment

- Reduced export competitiveness.

- Possibility of retaliation through trade barriers.

Why does a persistent current account surplus lead to low domestic consumption?

More production (exports) than consumption (imports); lower consumption level and standard of living.

Why does a persistent current account surplus lead to insufficient domestic investment?

Foreign exchange from exports used for foreign investment; not enough domestic investment; limits economic growth.

Why does a persistent current account surplus lead to appreciation?

High exports and low imports increased demand and decrease supply of currency, making it more valuable.

Why does a persistent current account surplus lead to inflation?

Greater net exports increases aggregate demand.

Why does a persistent current account surplus affect employment?

- Increased employment in all export industries.

- Decreased employment in import industries.

Why does a persistent current account surplus decrease export competitiveness?

Appreciation causes exports to become more expensive.

Why does a persistent current account surplus lead to a possibility of retaliation by trading partners through trade barriers?

Surpluses in one country mean deficits in another; deficit countries may impose trade restrictions to correct deficits.