14.3 - The balance of payments

What is the balance of payments?

A record of all the currency flows into and out of a country in a particular time period

What are the three main accounts of the transactions?

- The current account

- The capital account

- The financial account

What is the currency account?

Measures all the currency flows into and out of a country in a particular time period in payment for exports and imports of goods and services, together with primary and secondary income flows

What is the capital account?

Capital transfers involve transfers of the ownership of fixed assets.

What is the financial account?

The part of the balance of payments which records capital flows into and out of the economy

What is the balance of trade in goods?

The part of the current account measuring payments for exports and imports for goods.

What is the balance of trade in services?

Part of the current account which is the difference between the payments for the exports of services and the payments for the imports of services

What are causes of balance of payments disequilibrium?

- Appreciation of the currency

- Economic growth

- More competitive

- Deindustrialisation

- Membership of trade union

- Attractiveness to foreign investors

Why does appreciation of the currency cause a balance of payments disequilibrium?

A stronger currency means imports are cheaper and exports are relatively more expensive, which means the current account deficit would worsen.

Why does economic growth cause a balance of payments disequilibrium?

When consumer incomes increase, demand increases. This could increase demand for imports. This is especially true of a country such as the UK, where consumers have a high propensity to import.

Why does competition cause balance of payments disequilibrium?

If a country becomes more internationally competitive, such as with lower inflation or if there is economic growth in export markets, exports should increase. This also occurs when a country becomes more productive, since that causes average unit costs to fall. This could cause the current account deficit to improve, or increase the current account surplus.

Why does deindustrialisation cause balance of payments disequilibrium?

In the UK, the manufacturing sector has been declining since the 1970s. The goods that the UK previously made domestically now have to be imported, which worsens the deficit.

Why does trade union membership cause balance of payment disequilibrium?

The UK has traditionally had negative current transfers, since fees are paid for membership of the EU.

Why does attractiveness to foreign investors cause balance of payment disequilibrium?

A capital account surplus could be caused by incoming finance from investors buying UK bonds, securities and financial derivatives. This could help fund a current account deficit.

What are the consequences of investment flows between countries?

FDI can help create employment, encourage the innovation of technology and help promote long term sustainable growth. It provides LEDCs with funds to invest and develop.

Portfolio investments are passive such that control over the company is not gained. The investment aims to make a financial gain. FDI, on the other hand, allows the investor to gain some control over the firm. It includes finance such as pension funds, hedge funds and stock market money flows.

Do current accounts deficits pose problems?

A persistent imbalance may cause problems. However, the nature of any resulting problem depends on the size and cause of the deficit: the larger the deficit, the greater the problem is likely to be.

Do current account surpluses pose problems?

It can also lead to problems. One country's surplus is another country's deficit as it is impossible for all countries to run surpluses simultaneously. A surplus can also be inflationary because it is an injection of aggregate demand which increases the equilibrium level of nominal or money national income.

What are the three factors that influence a country's current account balance?

- Productivity

- Inflation

- Exchange rate

How does productivity influence a country's current account balance?

Improving labour productivity is critical to the success of supply side policies to improve both the price competitiveness and the quality competitiveness of a country's exports in international markets.

How does inflation influence a country's current account balance?

If a country's inflation rate is higher than the inflation rate of competitor nations, the country's exports will lose their price competitiveness, which will lead to a deterioration in the country's current account balance. However, the price elasticities of demand for exports and imports may complicate things.

How do exchange rates influence a country's current account balance?

A rising exchange rate increases the foreign currency prices of the country's exports and reduced their competitiveness. Meanwhile, imports become more price competitive.

How might fiscal policy be used to correct a balance of payments deficit or surplus?

If there is a deficit on the current account, income tax could be increased. This will reduce the amount of disposable income consumers have, which will reduce the quantity of imports. However, it might also impact domestic growth, since consumers will also spend less on domestic goods.

Governments could also reduce their spending. This would reduce AD and lead to less imports. It forces domestic firms into increasing exports, which helps improve the disequilibrium.

How might fiscal policy create problems when being used to correct a balance of payments deficit or surplus?

If taxes are imposed on trading partners, there is the risk of retaliation, which could reduce demand for exports, too.

Governments might have imperfect information about the economy, so it could lead to government failure.

If 'green taxes' are implemented, such as carbon taxes, or if there are minimum prices on pollution permits, the competitiveness of domestic firms could be compromised. This could reduce exports from domestic firms.

What is expenditure reducing policy?

A government policy which aims to eliminate a current account deficit by reducing the demand for imports by reducing the level of aggregate demand in the economy.

What is expenditure switching policy?

A government policy which aims to reduce a current account deficit by switching domestic demand away from imports to domestically produced goods.

How might monetary policy be used to correct a balance of payments deficit or surplus?

Reducing the growth of the supply of money in an economy can be expenditure- reducing or expenditure-switching. If there is a current account deficit, the bank might lower interest rates to cause depreciation in the currency. This causes exports to become cheaper, but it could be inflationary for the domestic economy. Moreover, hot money might flow out of the country, since investors are not receiving a high return on their investment. High interest rates could be expenditure-reducing, since the demand for imports falls and inflation might fall. Changing the exchange rate could be government expenditure-switching policy.

How might supply side policy be used to correct a balance of payments surplus or deficit?

Supply-side policies could help increase productivity with increased spending on education and training, which could result in the country becoming more internationally competitive. This could lead to a rise in exports. However, this incurs a significant time lag, so it is not effective as an immediate measure. In the long term, this can be an effective policy.

What is the significance of deficits and surpluses for an individual economy?

If imported raw materials are expensive, there could be cost-push inflation in the domestic economy, since firms face higher production costs.

International trade has meant countries have become interdependent. Therefore, the economic conditions in one country affect another country, since the quantity they export or import will change.

A surplus or deficit on the current account could indicate an unbalanced economy, and it could mean the country is too reliant on other economies for their own growth.

It could be difficult to attract sufficient financial flows in order to finance a current account deficit. This could make it unsustainable in the long run.