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.