Chapter 10: Balance of Payments and exchange rates

Account of all the ins and outs of the economy, most transactions in the balance of payments also appear in the financial accounts. (double entry bookkeeping) means balance of payments sums to zero

financial entry opposite sign to resource entry.

Every movement of goods or services creates a record on the financial and capital accounts of the balance of payments

Note changes that increase country’s assests are by convention, awarded a negative sign those that increase a country’s external liabilities are a positive sign.

Credit items in the current account create a demand for the currency e.g exports

deficit in current account means country is losing reserve assets and vice versa.


Change in the balance of payments often creates a change in the value of a currency however deficit in current account need not change the currency always as if financial transactions grow not related to physical goods.

  • FDI increases demand for currency

  • Hot money through bonds if central bank increases interest rates

  • Safety of country’s e.g the US which investors flock to with their bonds

10.1 Definition of BOP

objective is to identify and record transactions between residents of a domestic economy and all other economies could be the movement of goods, services or property incomes , between the domestic and foreign as well as changes in foreign assets and liabilities or transfer payments.

three broad areas of transaction

  • accounts relating to the flows of goods and services currently being produced by the domestic economy or owned by residents of the domestic economy

  • Accounts relating to the changes in the stock of assets or liabilities of permanent residents of that country

  • An Account of the total holdings by residents of assets abroad and of holdings by overseas residents in the country ( international investment position)

10.2 Structure of the current account:

1) current account: transactions of trade in goods, the visibles and the trades in services investment incomes and transfers, the invisibles

2) Capital and Financial Accounts: record changes in flows of portfolio investment , direct investment , transactions by banks and the gov general account(changes in reserves, borrowing and lending of currencies and take up of IMF loan repayments)

3) Net errors and and omissions represent the net total of errors and omissions arising throughout the account. mainly through timing errors and erros of recording capital flows.

Compnents of each Account:

Current Account:

  • Visible Trade balance

  • Services trade balance

  • Investment income balance (profits, dividends, interest payments, in and out)

  • Secondary Income: Gov payments abroad ± and private reciepts ±

Capital account:

  • capital transfers

  • acquisition/disposal of non-produced, non financial assets

Financial account:

  • Direct investment (UK companies investing abroad (+) and foregin companies investing in UK (-))

  • Portfolio Investment (UK residents purchasing financial assets in foreign countries (-) and foreign residents purchasing financial assests in UK (+))

Financial account much larger than the current account in the UK in 2013 current account generated, e.g. exports were 204 billion but direct investment b UK residents was 1,228 billion, over 2500 billion portfolio and 3,500 billion other.

Main point is that currency movements much more influenced by financial account than the current or capital accounts.

Note: intra EU trade can’t be tracked due to customs union

Free on Board (FOB): Value of goods as they are loaded onto the ship

CIF: cost insurance and freight (valuation of goods as they arrive)

IMF asks to measure trade of goods in current account as FOB so have to subtract extra seen in CIF

If a country has large maritime fleet then payments for freight and insurance go into the positive section of the services section.

Examples of trades in services

  • transport including sea transport

  • insurance services

  • financial services

Sea Transport Account

Doesn’t measure the the total value of shipping for three reasons

  • transactions recorded on an expenditure basis not adjusted to measure the value added of each sector

  • transactions associated with shipping services are recorded elsewhere

  • do not allow for the downstream effects of shipping on additional domestic jobs.

Figures Divided into passenger, dry, wet cargo (in UK BOP)

Credits include: fleet owned or chartered by UK residents, freight on Uk exports, passenger revenue collected from abroad, foreign ship payments to UK ports

Debits: opposite of the above including chartering foreign vessels, port dues and payments to service vessels.

Reasons for UK long term decline in transport account of two decades

  • heavy commitment to sterling area trade which has not grown as much

  • 50% traded with EU close neighbour less shipping

  • freights related to cargo and UK tonnage as been decreasing

  • Disappearance of re export in UK as Antwerp and Rotterdam have cornered the market

Key thing to note current account refers to flows of expenditure that directly cause flows of goods and services, influenced by levels of income and prices of goods at home and abroad.

Capital and financial accounts relate to changes in national stock of assets influenced by rates of return