2.1.4: The Balance of Payments

1. Components of the Balance of Payments (BoP)

The BoP is a record of all financial transactions between consumers, firms, and the government of one country with the rest of the world.

A. The Current Account

This is the most important component for your exam. It measures the day-to-day flow of money. It consists of four sub-sections:

  1. Trade in Goods (Visible): Export revenue minus Import expenditure ($X - M$). Example: Selling a Mini Cooper to France vs. buying a Ferrari from Italy.

  2. Trade in Services (Invisible): Example: Banking, tourism, insurance, and education (international students).

  3. Primary Income: Flows of profits, interest, and dividends from investments overseas.

  4. Secondary Income: Transfers between countries with no "output" in return. Example: UK contributions to the UN, foreign aid, or workers sending money to family abroad (remittances).

Key Distinction: The Balance of Trade is just (1 + 2). The Current Account is the sum of all four (1+2+3+4).

2. Current Account Imbalances

B. Deficits and Surpluses

  • Current Account Deficit: When the value of imports > value of exports. Money is "leaking" out of the circular flow.

  • Current Account Surplus: When the value of exports > value of imports. Money is "injected" into the circular flow.

Causes of a UK Deficit:

  • Structural: Poor price and non-price competitiveness (low productivity or poor quality goods).

  • Cyclical: Strong domestic growth. As UK incomes rise, we buy more imports (high Marginal Propensity to Import).

  • Exchange Rate: A strong Pound (SPICED) makes exports expensive and imports cheap.

3. The Relationship with Other Macro Objectives

Imbalances in the current account don't exist in a vacuum; they trade off against other goals.

C. Major Macroeconomic Conflicts

  1. Growth vs. Current Account: Fast economic growth usually leads to a worsening deficit because consumers spend their higher wages on imported luxury goods and electronics.

  2. Unemployment vs. Current Account: To fix a deficit, a government might use "Expenditure Reducing" policies (e.g., higher taxes). This lowers the deficit but increases unemployment as $AD$ falls.

  3. Inflation vs. Current Account: Low inflation makes UK exports more competitive, helping the trade balance. However, if we devalue the Pound to fix a deficit, import prices rise, causing cost-push inflation.

4. Interconnectedness of Economies

D. International Trade and Globalisation

Modern economies are "open" and highly interdependent. A "shock" in one country ripples through to others:

  • The "Export-Led Growth" Model: Countries like China and Germany use trade surpluses to fuel their entire GDP.

  • Global Supply Chains: If China enters a recession, UK firms that rely on Chinese components will see their costs rise or production stall (SRAS shift left).

  • Financial Contagion: A banking crisis in the US or EU affects UK liquidity because capital flows freely across borders.

Evaluation: Is a Deficit a Problem? (The "It Depends" Points)

  • The Size: A deficit of 1% of GDP is manageable; 5% or more is a major "red flag."

  • The Duration: Is it a temporary "blip" (cyclical) or a long-term decline in manufacturing (structural)?

  • The Financing: If a country has a deficit, it must have a surplus on the Financial Account. Is the UK "selling the family silver" (selling off UK assets/businesses to foreigners) to pay for today's imports?

  • Investment vs. Consumption: If the deficit is caused by importing high-tech machinery (capital), it will increase future LRAS. If it's just importing flat-screen TVs (consumption), it adds no long-term value.