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Measurement and Meaning of the Balance of Payments

  • The balance of payments (BoP) records transactions between firms, consumers, and governments of different countries.
  • UK BoP accounts specifically track transactions between UK residents and the rest of the world.
  • Transactions demanding foreign exchange are recorded as debits; transactions that produce foreign exchange are recorded as credits.
  • If recorded correctly, total credits equal total debits; the foreign exchange bought must equal the foreign exchange sold.

Components of the Balance of Payments

  • BoP accounts consist of two main components:
    • Current Account:
    • Measures purchases of goods, services, net income & transfers.
    • Capital and Financial Account:
    • Records transactions in financial assets and liabilities.
  • The two accounts must sum to zero:
    • Balance of Trade = $X - IM = Y - (C + I + G)$
    • Where $X$ = exports, $IM$ = imports, $Y$ = national income, $C$ = consumption, $I$ = investment, $G$ = government spending
    • The current account balance = $X - IM + ext{(net income from overseas assets)}$
    • Note: BoP focuses on current flows, not changes in net wealth or capital gains.

Understanding the 2017 UK Balance of Payments Accounts

  • Credits and Debits Overview:
    • Current Account Credits: £808,356 million
    • Current Account Debits: £887,315 million
    • Balance: -£78,959 million
  • Breakdown of Goods and Services:
    • Goods:
    • Credits: £338,871 million | Debits: £476,319 million | Balance: -£137,448 million
    • Services:
    • Credits: £277,039 million | Debits: £165,477 million
  • Primary Income & Secondary Income:
    • Credits and debits in both categories contribute to the overall account balance.
  • Capital Account:
    • Total of both accounts reflects international investments and transactions.

Importance of the Balance of Payments

  • Overall BoP accounts must balance; however, some discrepancies (problems) may arise:
  • Trade Deficit Implications:
    • Indicates domestic spending exceeds domestic production ($C + I + G > Y$).
    • A current account deficit suggests borrowing from abroad.
  • Effects of Borrowing:
    • Net borrowing can be beneficial if linked with investment.
    • Conversely, it may be detrimental if increasing debt without repayment capacity.

Current Account vs. Capital and Financial Account Adjustments

  • Market determined exchange rates need equal demand and supply for currency to clear.
  • When Exchange Rate Imbalances Occur:
    • Excess demand raises exchange rates; excess supply lowers it.
  • Authorities Pegging Exchange Rate:
    • Authorities may intervene by using foreign currency reserves if supply exceeds demand.
    • Devaluation of currency could be necessary if reserves dwindle.

Drivers of Exchange Rate Changes

  • An increase in demand for UK currency can result from:
    • Increased demand for UK goods/assets.
  • A decrease in demand for UK currency may arise from:
    • Decreased demand for UK goods/assets.
  • Over the long term, exchange rate changes reflect inflation differentials.
    • Purchasing Power Parity (PPP):
    • Suggests goods should have similar prices when adjusted by current exchange rates.

News Impact on Exchange Rates

  • FX market flows are influenced by professional investors assessing potential returns.
  • Exchange rate adjustments are based on unexpected and unpredictable news rather than just historical data.
  • The role of news is intrinsic and random, driving market perceptions and reactions.

Conclusion

  • Understanding the balance of payments and exchange rates is crucial for interpreting national economic health and international financial interactions.
  • Both accounts have direct implications on economic policies and status in global markets.