Economics HL - Balance of Payments

Balance of Payments (BoP)

Record of all monetary inflows and outflows of a country (transactions in trade, income, transfers and capital flows) and the rest of the world over a given period of time

• The three main components of the balance of payments are the current account, the capital account and the financial account

BoP Equation

BoP = Current account + Capital account + Financial account + balancing item (statistical errors) = O

Current Account: Definition

Record of transactions in exports, imports, transfers, and income flows between one country and the rest of the world over a given period of time

• Current Account = Balance of trade in goods + Balance of trade in Services + Net Income Flows + Net Transfers

• Either a surplus or deficit

Current Account: Balance of Trade

1. Balance of trade in goods = visible balance and refers to the difference between physical exports and physical imports

2. Balance of trade in services = invisible balance consisting of the balance of trade of services, such as tourism, flights, banking, architecture, website subscription, etc

Current Account: Income

Factor payments for the factors of production: profits, interest payments (from capital), dividends (gains from stocks)

• Also called “net income” or “net factor income from abroad”

Current Account: Current Transfers

Payment between one government and another that is not in exchange for any good or service

• Also called “net unilateral transfers”

• Example: foreign aid, remittances (workers sending wages back home, acts as a support for developing nations to fight poverty), grants

Current Account: Deficit

Inflow revenue < outflow payments

When revenue from the sale of exports, inflowing income, and transfers is less than funds flowing overseas to pay for imports, outgoing income, and transfers

Current Account Deficit Consequences

1. Currency Depreciation & Inflation

   • A deficit means more imports than exports, reducing demand for the domestic currency

   • This can weaken the exchange rate, making imports more expensive

   • Higher import costs may lead to cost-push inflation, especially if the economy relies heavily on imported goods or raw materials.
     

2. Sovereignty Concerns

   • Persistent deficits often require financing through foreign investment or selling domestic assets to foreigners

   • Over time, this could mean that a large share of national businesses, land, or infrastructure is foreign-owned, potentially raising economic sovereignty issues
     

3. Higher Interest Rates & Risk of Recession

   • Governments may ask the central bank to raise interest rates to attract foreign capital (“hot money”)

   • While this can temporarily finance the deficit, higher interest rates can slow down borrowing and investment domestically, leading to lower economic growth or even recession
     

4. Debt Burden

   • Financing deficits through borrowing overseas increases the country’s external debt

   • Servicing this debt requires future interest payments, putting further pressure on government finances and the balance of payments
     

5. Credit Rating Downgrades

   • Repeated or large deficits can damage a country’s perceived creditworthiness

   • A downgrade in sovereign credit ratings makes it more expensive and difficult to borrow, reducing investor confidence
     

6. Pressure on Foreign Exchange Reserves

   • To stabilize the currency, governments may use foreign exchange reserves to finance imports or defend the exchange rate

   • Over time, this depletes reserves, leaving the economy vulnerable to external shocks and speculative attacks
     

7. Threshold Risk (Sustainability Issue)

   • A current account deficit exceeding 5–6% of GDP is widely seen as unsustainable

   • Long-term large deficits usually lead to a balance-of-payments crisis, currency collapse, or IMF intervention

Current Account: Surplus

Inflow revenue > outflow payments

When revenue from the sale of exports, inflowing income, and transfers is more than funds flowing overseas to pay for imports, outgoing income, and transfers

Current Account Surplus Consequences