Unit 6, Current account of the balance of payments, exchange rates and policies to correct imbalances in the current account of the balance of payments

balance of payments

a record of a country’s economic transactions with the rest of the world over a year, consists of the current account, the capital account and the financial account

current account

a component of the balance of payments that records trade in goods and services, primary income, and secondary income.

capital account

a component of the balance of payments that records the sale and purchase of copyrights, patents, and trademarks, and money brought into the country by immigrants and taken out by emigrants

financial account

a component of the balance of payments that records the transfer of financial and capital assets between the country and the rest of the world

trade in goods (current account balance)

the revenue earned from exports of goods minus the expenditure on imports of goods, also known as the visible balance and merchandise balance, exports give rise to credit items while imports give rise to debit items.

trade in services (current account balance)

the revenue earned from the export of services minus the expenditure on the import of services, also known as the invisible balance, reflecting the transactions in sectors such as tourism, finance, and consultancy.

primary income (current account balance)

includes income in the form of profits, interest and dividends earned on direct investment abroad minus foreign earnings on investment in the country

secondary income (current account balance)

includes payments made and receipts received for which there is no corresponding exchange of an actual good or service, they include government transfers such as payments to and receipts from international organisations and foreign aid, as well as transfers by private individuals such as remittances

remittances

money transferred from people working in a foreign country for a year or more, back to their relatives at home

imbalance in the current account

debit items in the current account not equalling credit items

current account deficit

the value of debit items on the current account exceeding the value of credit items

current account surplus

the value of credit items on the current account exceeding the value of debit items

balance in the current account

debit items on the current account equalling credit items

causes of a current account deficit

a growing domestic economy, declining economic activity in a country’s trading partners, structural problems

a growing domestic economy causing a current account deficit

when firms are increasing their output, they may buy more raw materials and capital goods from abroad, leading to rising import expenditure while export revenue declines as exports are diverted from the foreign to the domestic market, this deficit is however likely to be short-term and self-correcting

declining economic activity in a country’s trading partners causing a current account deficit

if the countries that buy a country’s imports experience recessions or slowdowns in economic growth, their import expenditure may rise more slowly or even fall, this is a cyclical deficit and is not usually considered to be a problem as it is relatively short-term and self-correcting

cyclical deficit

a current account deficit that arises from either change in the economic cycle of the domestic economy or the economies of trading partners

structural problems causing a current account deficit

a current account deficit that lasts over the long run indicates that domestic firms are not internationally competitive and that the country may have to borrow to finance the surplus spending, this can occur due to factors like an overvalued exchange rate maintained by government intervention and a relatively high inflation rate, this deficit is a cause for concern as it will not be self-correcting

causes of a current account surplus

a declining domestic economy, increasing economic activity in the country’s trading partners, structural advantages

a declining domestic economy causing a current account surplus

if an economy is experiencing a recession, demand for imports is likely to fall, consumers will buy fewer goods and services and firms will buy fewer raw materials and capital goods as output will fall, such a cause of a current account surplus will not be beneficial

increasing economic activity in the country’s trading partners causing a current account surplus

if the country’s trading partners are doing well, they are likely to buy more of the country’s exports, the country’s people who are working in trading partner countries may also earn higher wages, some of which they can send back to their relatives at home

structural advantages causing a current account surplus

a country’s firms may be competitive due to good education and training and a high level of investment and innovation leading to a country being successful in selling more goods and services than it buys from other countries

consequences of a current account deficit

a current account deficit allows the residents of a country to consume more goods than the country produces, however the country will have to finance the deficit by attracting investment into the country or by borrowing, both of which involve an outflow of money in the form of investment income, an increase in a current account deficit may also reduce aggregate demand, which may slow down economic growth and may cause unemployment

consequences of a current account surplus

indicates that the country’s residents are not enjoying as high a standard of living as possible, the high level of demand combined with additions to the money supply may generate inflationary pressure and those countries experiencing current account deficits may also put pressure on the country to change its policies in order to reduce its surplus

Foreign exchange rate

the price of one currency in terms of another currency

floating exchange rate

an exchange rate that is determined by the market forces of demand and supply

reasons that currency traders buy domestic currencies

to enable customers to purchase goods and services from the country, to invest in the currency, and to speculate on making a profit if the currency should rise in the future. Financial institutions also speculate on future currency movements on their own behalf

depreciation

a decrease in the international price of a currency caused by market forces, caused by an increase in supply of the currency

appreciation

an increase in the international price of a currency caused by market forces, caused by an increase in demand and / or a decrease in supply

causes of changes in a country’s foreign exchange rate

demand for the currency will rise if a higher value of exports are being sold, due to the country’s relative inflation rate having fallen, relative productivity having risen, the quality of products produced has risen or incomes abroad have increased, additionally foreigners may purchase more of the currency if they wish to purchase shares in the country’s firms due to the country’s economic prospects improving, and foreign firms may purchase a greater value of the currency in order to set up branches in the country

hot money flows

flows of money moved around the world to take advantage of changes in interest rates and exchange rates

the impact of depreciation on the economy’s national income and real output

a fall in the value of the exchange rate will make exports cheaper, in terms of foreign currencies, and imports more expensive, in terms of the domestic currency, this may enable domestic firms to sell more products both at home and abroad, causing a rise in net exports and increasing aggregate demand which may result in a rise in output and national income

the impact of a depreciation on the domestic price level

a rise in aggregate demand due to an increase in net exports may give rise to inflationary pressure, as the economy approaches full capacity, resources will become increasingly scarce and their prices will be bid up, in addition finished imported goods that are still purchased will be more expensive and some of these will count in the consumer price index, costs of production will be pushed up due to a rise in the cost of imported raw materials and domestic firms may also feel less competitive pressure to keep costs and prices low

the impact of a depreciation on the domestic economy

if a depreciation results in higher aggregate demand, firms producing for both the domestic economy and the external economy will be more likely to take on more workers to expand their output. This may cause a decrease in cyclical unemployment

The impact of an appreciation on the domestic economy’s national income and real output

An appreciation will make exports more expensive in terms of foreign currencies and imports cheaper in terms of the domestic currency, this is likely to result in a fall in demand for domestic products which would result in a slowdown in economic growth or possibly even a recession. With lower real output, incomes are likely to fall.

The impact of an appreciation on domestic inflation

An appreciation may cause a reduction in inflationary pressure if the economy is operating close to to or at maximum capacity, by reducing the growth of aggregate demand and so lowering the inflation rate, additionally by shifting the supply curve to the right due to lower costs of imported raw materials and a fall in the price of imported finished products there would be increased pressure on domestic firms to restrict prices in order to maintain sales at home and abroad, reducing inflationary pressure

The impact of an appreciation on unemployment

An appreciation may increase unemployment, as if aggregate demand decreases, firms may not replace workers who retire and may make some workers redundant

Government policy objective of stability of the current account

Most governments seek to achieve balance of payment stability with money entering the country equalling money leaving the country. In the short-run however, government may welcome a deficit if it arises from more raw materials and capital goods being imported, and may encourage a surplus in order to boost aggregate demand and to provide funds to pay external debt

The effect of fiscal policy on a current account surplus

If a government is seeking to reduce a current account surplus, it could use expansionary fiscal policy by lowering income tax and increasing government spending, such as on state pensions, will increase consumer expenditure increasing the amount of imports purchased

The effect of fiscal policy on a current account deficit

In order to counteract a deficit on the current account, a government can use contractionary fiscal policy to reduce demand for goods and services, including imports by increasing income tax or reducing government spending.

Evaluation of fiscal policy on the current account

Fiscal policy measures may alter a country’s current account position in the short term but are unlikely to be a long-term solution as once the measures are stopped households and firms are likely to spend the same amount on imports relative to export revenue earned, additionally taxation may also have adverse side affects increasing unemployment and slowing economic growth through lowering demand as well as creating a disincentive effect and reducing aggregate supply

The effect of monetary policy on a current account deficit

If an economy has a low rate of inflation and a current account deficit, its central bank may reduce the interest rate in an attempt to put downward pressure on a floating exchange rate, makin the country’s products more internationally competitive, however, this may generate inflationary pressure. A central bank may also use a higher interest rate as a way to cut consumer expenditure, reducing demand for imports and reducing inflationary pressure

The effect of monetary policy on a current account surplus

To reduce a current account surplus a government may seek to increase consumer expenditure using expansionary monetary policy through raising the money supply and cutting the rate of interest, as well as trying to encourage an appreciation of the exchange rate.

Issues with monetary policy on the current account

Most monetary policy tools are not likely to be effective in reducing imbalances in the current account of the balance of payments in the long term as they are unlikely to be tackling the structural weaknesses in the economy, such as low productivity, which are causing a current account deficit

The effect of supply-side policy on the current account

Supply-side policy tools may reduce a current account deficit by making domestic products more price competitive and by making domestic markets more attractive to invest in

Issues with supply-side policy on the current account

Supply-side policy is unlikely to be a quick way of correcting imbalances in the current account of the balance of payments and is also not designed to reduce a current account surplus as it seeks to increase the quantity and quality of the country’s resources. It does however have the potential to correct a deficit in the current account in the long run

The effect of protectionist policy on the current account

Protectionist policy can be used as a way of encouraging domestic consumers and firms to switch to domestic products, for example by imposing a tariff or increasing a tariff on imports, such a measure works more effectively when high quality substitutes produced by domestic firms are available

Issues with protectionist policy on the current account

Imposing tariffs against partners in a trading bloc is not an option, imposing or increasing tariffs against other countries may provoke retaliation and may reduce the pressure on domestic firms to become more efficient.