2.1.4 Balance of Payments (Macro)

BALANCE OF PAYMENTS

The balance of payments is a record of all economic transactions between a country and the rest of the world over a given period of time, including trade in goods and services, income flows, and financial transfers.

THREE ELEMENTS OF BALANCE OF PAYMENTS

1. The current account- measures trade flows

2. The capital account

3. The financial account- measures trade in assets stock

CURRENT ACCOUNT OF THE BoP

It records payments for trade in goods and services plus net flow of primary and secondary income.

PRIMARY INCOME

Primary income is income earned from the direct use of factors of production, such as wages and salaries from work, profits, rent, and interest from investments

WHICH MONEY FLOWS APPEAR IN PRIMARY

Income on Direct Investment: This includes profits, dividends, and interest earned by residents from their direct investments in foreign companies and vice versa.

Income on Portfolio Investment: This is income such as dividends and interest earned by residents from portfolio investments in foreign securities and vice versa.

Compensation of Employees: This represents wages, salaries, and other compensation earned by foreign workers employed in a country and by residents working abroad.

Taxes on Income and Wealth: This includes taxes on income and wealth paid to foreign governments and taxes paid by foreign residents to the domestic government.

SECONDARY INCOME

Secondary income is income that is redistributed between countries without a direct exchange of goods or services, such as foreign aid, remittances, and government transfers.

 

WHICH MONEY FLOWS APPEAR IN SECONDARY

 

 

Remittances: Money sent by foreign workers (migrant workers) back to their home countries.

Foreign Aid: Grants, concessional loans, and other forms of assistance provided by one country to another for developmental, humanitarian, or other purposes.

Diaspora Contributions: Contributions made by a country's diaspora to support projects or family members in their home country.

Payments made to international institutions: When the UK was a member of the European Union, the UK was a net contributor to the EU budget. These payments were treated as a negative on the secondary income account.

CAUSE OF DEFICIT

If there is more money leaving the economy to pay for goods and imports then there is coming into the country. A current account deficit can lead to rising foreign debt, increased reliance on foreign investment, and downward pressure on the exchange rate.

CAUSE OF SURPLUS

Export more goods and services then you import. A current account surplus may cause upward pressure on the exchange rate, making exports less competitive.

WHAT MIGHT CAUSE A DEFICIT OR SURPLUS ON THE CURRENT ACCOUNT

Overvalued exchange rate, Economic growth, Decline in competitiveness/export sector, Higher inflation, Recession in other countries,  Borrowing money, Financial flows to finance current account deficit, Lots of consumerism

CAUSE: OVERVALUED EXCHANGE RATE

If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of imports. Exports will become uncompetitive as price of goods and services is more expesive, and therefore there will be a fall in the quantity of exports. Countries in the Eurozone (e.g. Greece, Portugal and Spain) experienced an overvalued exchange rate (and they couldn’t devalue). In 2007, these three countries had a current account deficit equal to 10% of GDP.

CAUSE: ECONOMIC GROWTH

If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. In the UK we have a high marginal propensity to imports (mpm) because we do not have a comparative advantage in the production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports and a deterioration in the current accoun

CAUSE: DECLINE IN COMPETITIVENESS/ EXPORT SECTOR

In the UK, there has been a decline in the exporting manufacturing sector because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade.

CAUSE: HIGHER INFLATION

If UK inflation rises faster than our main competitors then it will make UK exports less competitive and imports more competitive. This will lead to deterioration in the current account. However, inflation may also lead to a depreciation in the currency to offset this decline in competitiveness.

CAUSE: RECESSION IN OTHER COUNTRIES

If the UK’s main trading partners experience negative economic growth, then they will buy less of our exports, worsening the UK current account.

CAUSE: BORROWING MONEY

If countries are borrowing money to invest e.g. third world countries, then this will lead to deterioration in current account position

CAUSE: LOTS OF CONSUMERISM

High consumerism means the country will need more resources in order to meet these demands.