Balance of Payments

What is the balance of payments

The difference in value of payments into and out of a country over a period

What are the sections of the BoP

Current account

Capital account

Financial account

What is the current account

There are 4 sections measuring the VALUE

The most important being Trade in goods and trade in services (Trade Balance)

Income - income leaving or entering the country (Remittances - working abroad and bringing money back to UK

Transfers - Paying fees to EU, foreign aid

Biggest aspect of the balance of payments

What is the capital account

Smallest part of BoP, quite small

Debt, forgiveness, death duties, transfer of financial assets through migration, sales of tangible assets

Will never be asked a question on capital account

What is the financial account

Second biggest account in the balance of payments

Portfolio investment - buying and selling of financial assets - (Bonds, shares)

Foreign direct investment - Factories setting up in the UK

Reserves - currency, gold

What has to happen in the balance of payments if the current account is in deficit

The other two balance it out - primarily financial will be in surplus

But if not then the net error and omission balancing tools will balance it out

What are the causes of a current account deficit

Demand side: Strong domestic growth - higher incomes higher imports

Recession overseas - Especially trading partners if they experience a recession and/or a reduction in economic growth then incomes will fall leading to less demand for imports

Strong exchange rate - Imports cheap, exports expensive (Spiced)

Supply side: Low investment, low productivity, high relative inflation, high ULC all 4 result in less competitive exports, poor quality, Depletion of resources

Supply side more long term and hard to fix

What are the consequences of a current account deficit

Negative balance of trade will decrease AD however this effect can be argued to be minimal. But this also may not be caused by a trade deficit and instead can be caused by income and transfers

A current account deficit infers a financial account surplus which is usually funded by the government borrowing or selling bonds, company shares these both increase government debt if this continues then investors will stop purchasing debt leading to panic and people will convert their pounds into foreign currency - Currency crisis possibly leading to an economic crisis

Exchange rate depreciation as pound is converted into foreign currency to purchase imports leading to higher supply of the pound which means less pressure on exchange rates leading to them decreasing and exports in higher demand HOWEVER if this country has a current account deficit due to exports not being competitive then all that’s going to happen is importing raw materials is more expensive leading to higher inflation as costs rise in price (Stagflation)

What policies can reduce a current account deficit

Expenditure reducing policies - contractionary fiscal or monetary policies reduce income which reduces the amount of exports they purchase - EVALUATION: However there will be increased unemployment and reduced economic growth. If confidence is high then AD may not decrease. If already negative output gap or marginal propensity to import is low then there will be a limited effect

Expenditure switching policy - Protectionism implementing tariffs, quotes, embargo, domestic subsidies, regulation/ red tape to reduce imports and switch expenditure onto domestic goods EVALUATION: Retaliation from other countries reducing exports , may break WTO rules - face sanctions?, Inflationary as raw materials imported are more expensive, Higher prices for consumers

Expenditure switching policy - Weaker exchange rates - Lower interest rates, Bigger money supply, sell domestic currency reserves EVALUATION: If Marshall-Lerner condition does not hold depreciation won’t improve current account, Costs of imports rise including raw materials possibly leading to costs of production rising - Inflation. Retaliation as it is technically a protectionist policy

Supply side policy - to boost international competitiveness of exports EVALUATION - time lag, big cost (Opportunity cost?), May not even succeed

What is the Marshall-Lerner condition

PED of imports + PED of exports > 1 = depreciation in exchange rates will mean improvements in the current account deficit

Evaluation of using policies to fix current account deficit

Conflict of objectives

What has caused the deficit - could even be income and transfers - these policies won’t be very effective

Times lags/ large cost - SSP can take a long time and costly - might not even succeed

Does the Current account deficit need fixing

Causes of a current account surplus

Demand side - High incomes abroad

Low incomes at home

Weak exchange rate

Supply side - Low relative inflation price competitive exports

Low labour costs - high productivity, weak trade unions, low min wages

Strong investment - Up to date capital lower cost for businesses

Large Comparative advantages

New resource discoveries

Consequences of a current account surplus

Higher AD through more exports/ less imports, economic growth, less unemployment, more inflation

Exchange rate appreciates as demand for pound increases as pound is needed to afford British exports - if Marshall-Lerner condition doesn’t hold then surplus won’t last long

Financial account deficit as BoP must balance out so government buys foreign bonds and shares and if countries that cannot pay back these debts gov could lose lots of funds

Can harm international relations - if they are using excessive protectionism or managing exchange rates , Retaliation?

Sign of an unbalanced economy - Production may be for primarily exporting instead of domestic consumers (China)