4.6 balance of payments

Balance of payment:

a financial record of a country's transaction with the rest of the world for a given time period, usually over one year

- ONLY IN OPEN ECONOMIES → y = GDP = C+I+G+(X-M)

- domestic countries purchasing goods ( outflow/debit)

- dom. sale of exports (inflow or credit)

Credit items:

Credit: payments received from consumers, firms institutions or governments located outside of the economy = increase balance

eg. When money is deposited into a bank count = credited into an account

Positive as they create demand for the domestic currency

Debit items

outflow or debit = money leaving the economy

Import expenditures are debit items → leakages

Payments made to consumers, firms institutions or governments located outside of the economy

When money is withdrawn from an account = debited → balance of the account decreases

Negative = increases the supply of the domestic currency

What is balance in the balance of payment:

the sum of the current account is matched by the sum of the capital account and financial account to equal zero

If we import goods + services = we need and inflow of capital (financial flows) to be able to pay for them

eg. if the Chinese deposited $1m of Chinese yuan into British banks = foreign currency comes to the UK and this is how we afford the goods

This bank deposit would be included in the financial account as a credit item → balances the debit on our trade in goods.

Surplus:

An account exists when the total value of credit items exceeds the total value of debit items over a given period of time

Positive balance

Deficit:

When the total value of debit items exceeds the total value of credit items over a period of time

Negative balance → The account holder is in debt

The value of exports exceeds the value of imports

the total value of withdrawals in a personal bank account exceeds the total amount of deposits

Cause of current account deficit:

High income elasticity of demand for imports (excessive growth)

Long-term decline in capacity of manufacturing industry because of de-industrialization

Trade balance is vulnerable to shift

Non-price competitveness

Low levels of investment in human capital

Poor productivity

Low levels of investment in real capital

low levels of alternative global suppliers

Rise of alternative global suppliers

eg. The U.S. has a current account deficit, largely driven by high imports of consumer goods and a reliance on foreign capital.

High income elasticity of demand for imports (excessive growth)

When consumer spending is strong, the volume of imports grow quickly - above trand rate = incom elasticity of demand for luxury imports such as motor cars (import above exports)

Long-term decline in capacity of manufacturing industry because of de-industrialization

Shift of manufaccturing to lower-cost emerging market countries who then export products ack into the developef country - businesses have out-sourced assembly of goods to other countries whilst retaining other aspects of the supply chain such as makreting and research within the home country

Trade balance is vulnerable to shift

due to shifts in world commodity prices and exchange rates - high export prices: country's inflation is higher than its competitiors or currency is over-values = reduce competitiveness

Non-price competitveness

Non-price factors can discourage exports = poor product designed products, poor marketing or a worsening reputation of reliability

Low levels of investment in human capital

lack of investment in eduction and training = reduce skill levels relative to competitior countries and forces countries to produce low value exports

Poor productivity

scarce FOP, labour productivity which is defined as output per worker = plays an important role in competitiveness and trade performance

Low levels of investment in real capital

Excessive long-term interest rates or low levels of research + development

low levels of alternative global suppliers

Lack investment in education and training → reduce skill level relative to competitor countries + force countries to produce low value exports

Rise of alternative global suppliers

eg. UK slow deindustrialized, emerging economies like China and India = increased their share of world trade (benefit from access to technology + economies of scale) - reduced likelihood of smaller UK manufactures selling abroad

Is a current account deficit always bad?

If No:

Not always, if it is funded by investments in the financial account then it is not bad.

Those investments could be good for the economy. If however the surplus on the financial account is made up by borrowing then it is unsustainable

deficit is small, counterbalanced by capital inflows

other countries are continuously willing to finance the deficit (relationship)

reflects a growing economy + higher living standards

Automatic correction of a deficit under a floating exchange rate system

Components of the balance of payments

Current account

Capital account

Financial account

Current account

A record of trade and income flows across countries.

-exports (X) - imports (M).

1. Balance of trade in goods: Imports and exports of physical goods (cars, computers, etc.)

2. Balance of trade in services: Imports and exports of services (consulting, tourism, etc.)

3. Net income: Money flowing in and out of the economy as part of people's incomes (inflow-outflow)

4. Current transfers: Money transfers as part of programs such as international aid (foreign aid)

Balance on current account: sum of total items listed in the current account

Capital account

A record of capital inflows and outflows across countries. This includes:

1. Capital transfers: The movement of money as a result of debt forgiveness or people moving countries.

2. Rights: Includes intellectual property rights, land rights, etc.

Financial Account

Investments abroad:

1. Foreign Direct Investment (FDI): Investment into capital abroad done by international companies.

- MNCs setting up/expanding in foreign markets

- net FDI = FDI inflow - FDI outflow

2. Portfolio investment: Trading of international investment assets, such as stocks and bonds/government debt

3. Reserve assets: Stockpiles of currency and other investments held by the central bank.

- Reserve assets must be readily available to the central or monetary authorit

4. Official borrowing: Government borrowing from other countries' governments or institutions

- short run: loans represent a credit to the financial account (inflow)

Interdependence between the accounts:

The relationship between the three accounts in the balance of payments relates to an accountancy technique = double entry

- long-run: there should be a balance, a coumtry can spend only what it earn = no deficit

- 3 accounts should balance each other out and equal 0

- Current account = capital + financial account

- credit idems should = debit items

- deficit should match surplus

Net errors and omissions

since the sum of all credits and debits must be equal, this corrects any discrepancy

If the sum of credits is larger than the sum of debits, then there will be debit items here to make it balance

Turns into → Current account = Capital + financial account + errors and omissions

Current account and exchange rate: graph

current account should be balanced by the exchange rate

- Deficit will make currency depricate = more exports, causing a surplus and then causing currency to appreciate

(cycle)

does not happen in fixed exchange rates, as the currency will neither appreciate nor depreciate. Instead, the government can choose to devalue its currency, increasing exports and reducing imports, and hence maintain a current account surplus.

Stronger vs weaker exchange rate

Stronger exchange rate:

imports cheaper, exports expensive

currency appreciate = exports are more expensive for foreign buyers = decrease in export volumes

imports become cheaper for domestic consumers = increase import volume

Weaker exchange rate:

imports expensive, exports cheaper

depreciate: exports are cheaper for foreign consumers = increase export volume

imports are more expensive for domestic consumers = decrease

Financial account and exchange rate

Financial account surplus: caused by investment in the economy from other countries

- Local currency will be demanded (appreciating) it relative to others

- Local currency increase in comparison to others

Deficit: investment being pulled out of the economy

Local currency is sold, increasing supply, depreciating it value decreases

Implications of a Persistent Current Account Deficit

1. Exchange rates: more currency supplied = deprecitation

- increase overseas demand (surplus)

2. Interest rates: More imports than exports -> Government may try to encourage investment by raising interest rates (so foreigners deposit more) -> AD decrease

3. Foreign ownership of domestic assets: Deficit = currency depreciate.

- domestic assets look cheaper to foreigners = domestic assets bought by foreign companies

4. Debt: the government has to finance it, and has to take out loans

5. Credit ratings: indicate economic troubles for a country, meaning credit rating agencies downgrade them = interest rates on loans the gov takes out will be higher.

6. Demand management: Current account deficits may occur in times of rapid growth in demand, and the government may try to impose contractionary demand-side policy (fiscal and monetary) to stop this

7. Economic growth: consequences have negative effects on economic growth, as either consumption (C) or investment (I) is affected.

Methods to correct a persistent current account deficit + effectiveness

Expenditure switching

Expenditure reducing:

Supply-side

Do nothing:

Expenditure switching:

government may decide to encourage consumers and businesses to buy domestic products over imports.

- they still spend money, but the deficit will be smaller.

- eg. imposing tariffs, quotas, or subsidies, as well as devaluing the currency (makes foreign goods look more expensive)

- Changes in relative prices of exports and imports = cause changes in spending away from imports and towards domestic export production

(-) Many consumers may have preferences regardless of price, and may still choose to buy imported goods

(-) The imposition of trade barriers such as tariffs and quotas may cause retaliations in other countries, decreasing exports

(-) Devaluing the currency will mean important imported goods (such as oil and electricity) will be more expensive, causing inflation

(+) successful in changing the buying habits of consumers

(+) switching consumption from imports to domestic can help the import deficit

Expenditure reducing:

- impose measures meant to cut expenditure as a whole.

- contractionary fiscal or monetary policy AD shifts left, PL decreases, output decreases → Prices become cheaper and more competitive in the foreign market + encourage rising private sector saving

Control demand and limit spending on imports

(-) Expenditure-reducing policies basically aim to hurt the economy to decrease demand. This will decrease economic well-being and growth

(-) causes output to fall = slows down economic growth and higher unemployment

(+) deflationary fiscal policy reduces income = falls in demand for imported goods

Supply-side

impact production

The government may decide to improve the economy's export competitiveness instead, by investing in or deregulating industries.

eg. improving infrastructure, investing in education, and providing tax breaks for startups.

(-) it takes a very long time for its effects to show, and will not be very useful in the short run

(-) involves government spending to form subsidies = opportunity cost

(+) improve the quality of products and lower the cost of production

(+) help the level of exports increase to elevate the deficit

Do nothing:

leaving it to the market force in the foreign exchange market to self-correct the deficit

(+) floating exchange rates act as a self-correcting mechanism

High levels of imports = depreciate the currency causing imports to decrease as they are more expensive → Exports increase as they are now cheaper

(-) external factors that prevent the currency from depreciating = long time to self-correct

Many domestic industries may go out of business (long time), and more firms delay investment

The Marshall-Learner condition and the J-curve effect (HL)

Devaluation of a currency will help in creating a current account surplus

Due to your currency being worth less compared to others (your goods are cheaper abroad) More of your goods will be demanded abroad = surplus

Marshall-Learner condition

states that a devaluation or depreciation of a currency will help reduce a current account deficit

- if the sum of the price elasticity of demand PED for exports and imports is greater than 1 (price elastic) = correct current account deficit

- When a country devalues its currency / depreciates = it has a lower cost of exports and a higher cost of imports

- If your goods are price inelastic = the price difference does not really change demand, beither will devaluation change demand

- The relative values of PED will determine if the change in the price of imports and exports will affect the quantity demanded enough to alter the balance of trade of goods + services = balance of the current account

Marshall-learner conditions:

sum of the PED for x and m > 1, devaluation/depreciations → improve balance of trade

sum of the two PED < 1 = worsen balance of trade

sum of two PED = 1 ⇒ trade balance unchanged

If: PED for imports (PED M) + PED for exports (PED X) > 1 = country could devalue its currency to improve trade deficit

Marshall-learner conditions: Short run

short run = inelastic

• demand for the more expensive imports (and demand for exports which are cheaper abroad using foreign currencies) = remain price inelastic

• Due to time lags in the consumer’s search for acceptable, cheaper alternatives (might not exist)

- Due to pre-existing trade contracts that have been honoured = volume of X and M will remain unchanged

Marshall-learner conditions: Long-run

long-run = more elastic

- depreciation in the exchange rate = improve the current account balance

- domestic consumers might switch their expenditure to domestic products, away from expensive imported goods + services

= assuming equivalent domestic alternatives exist

- Many foreign consumers may switch to purchasing produces being exported into their country = now cheaper in foreign currency instead of domestic goods+services

J-curve effect: graph

explains the effect devaluation has on a country's current account

- as consumers take time to adjust to the depreciation of the currency (domestically + internationally) = effects is shown in J-curve

Trade balance will initially worsen then improve due to currency depreciation/devaluation

- Trade balance will initially worsen then improve due to currency depreciation/devaluation (imports>exports)

- devaluation = reduces the price of its exports → level of exports gradually recovers + country moves back to a trade surplus

1. A devaluation = currency is worth less compared to other currencies = more money is needed to buy imports, which causes an initial trade deficit

- short-run: sum of PED for x and m < 1 (inelastic) deficit increases, (marshall-learner condition was not fulfilled)

2. Overseas consumers/firms start to notice your cheaper goods → start to adjust their consumption and purchase more of your products ⇒ improves the deficit situation

3. After: foreign consumers have noticed the opportunity to buy cheaper things = increased demand for exports → will lead to a budget surplus

- long-run: marshall-learner condition is met = surplus

Implication of persistent current account surplus

Inflation & Domestic Consumption and Investment:

Exchange rates:

Employment:

Export competitiveness:

Inflation & Domestic Consumption and Investment:

Although a current account surplus means firms export more, hence economic growth occurs, this can lead to inflationary pressures which cause domestic C and I to contract.

Exchange rates:

a current account surplus = currency is more demand, causing appreciation. This can in turn reduce overseas demand, causing an account deficit.

Employment:

More overseas demand means more jobs are demanded domestically to produce everything, increasing employment levels domestically (but potentially increasing unemployment abroad)

Export competitiveness

- persistent surplus = currency to appreciate, making goods more expensive abroad + reducing competitiveness.

- Higher demand for exports and higher exchange rate = higher export prices (current account surplus) = diminish competitiveness

Unbalanced economy → relying heavily on exports and consumer spending is low