Economics (9640) | The balance of payments

Welcome to the Balance of Payments!

Hello future economists! The Balance of Payments (BoP) might sound intimidating, but it's really just a comprehensive financial report card for an entire country. It tells us exactly how much money is flowing in and out of an economy over a specific period.

Understanding the BoP is crucial because it helps governments see if their economy is living within its means, borrowing too much, or struggling to sell its products globally. It links directly to exchange rates and national economic health, so let's dive in!

What is the Balance of Payments (BoP)?

The Balance of Payments is a systematic record of all economic transactions between the residents of a country and the rest of the world over a specific period (usually a year).

Think of it as a double-entry bookkeeping system for the nation, meaning that for every transaction, there is a credit (an inflow of money) and a debit (an outflow of money). Theoretically, the entire BoP must always balance to zero, but in practice, statistical errors occur.

Did you know? When economists talk about "the Balance of Payments problem," they usually aren't referring to the whole account, but specifically to a large deficit on the Current Account.

The Structure of the Balance of Payments

The BoP is divided into three main accounts (though we will focus primarily on the Current Account, as required by the syllabus):

1. The Current Account (The Day-to-Day Finances)

The Current Account tracks the movement of goods, services, and income transfers. It is the most important measure of a country’s trade position.

Memory Aid for Current Account Components (G-S-P-S):

The Current Account is made up of four sub-components:
1. Trade in Goods (Visible Trade)
2. Trade in Services (Invisible Trade)
3. Primary Income (Investment Income & Wages)
4. Secondary Income (Transfers)

1. Trade in Goods (Visible Trade)

This covers the import and export of physical, tangible items. If a country exports cars (money flows in), it's a credit. If it imports oil (money flows out), it's a debit.

2. Trade in Services (Invisible Trade)

This covers the import and export of intangible items. Examples include tourism, financial services (like banking fees), and shipping costs.

3. Primary Income (Net Factor Income)

This tracks money earned from factors of production (Land, Labour, Capital, Enterprise) held abroad. This includes:

• Wages earned by citizens working abroad (inflow).
• Interest, Profits, and Dividends (IPD) earned from investments made overseas (inflow).
• The reverse (payments to foreigners for their factor services) are outflows.

4. Secondary Income (Net Transfers)

These are one-way transactions where money moves without an exchange of goods or services. Examples include foreign aid, remittances (money sent home by migrant workers), or contributions to international organisations like the UN.

Key Takeaway for Current Account: The Current Account Balance = (Trade in Goods + Trade in Services) + (Primary Income + Secondary Income). If the total is negative, the country has a Current Account Deficit. If positive, it has a Current Account Surplus.

2. The Capital Account (Brief Mention)

This covers very specific, small transactions, such as the transfer of ownership of non-financial, non-produced assets (like patents or trademarks) or debt forgiveness.

3. The Financial Account (Tracking Assets)

This tracks the movement of financial assets (investments). It is closely linked to the Capital Account structure, though detailed knowledge of this structure is not required for this unit.

The Financial Account includes two critical types of private international investment:

i) Foreign Direct Investment (FDI)

This is investment made to acquire a lasting interest or controlling influence in an enterprise in another economy. Example: A German car company building a new factory in Mexico. This is generally seen as beneficial as it brings jobs, technology, and long-term stability.

ii) Portfolio Investment

This involves buying financial assets like shares (stocks) or bonds, without gaining management control. Example: An investor in Japan buying shares in a US technology firm. These flows are often called "hot money" because they are highly responsive to changes in interest rates and can move quickly, leading to volatility.

Deficits and Surpluses and Their Significance

A country runs a deficit on its Current Account when the total money flowing out (debits) is greater than the total money flowing in (credits).

A country runs a surplus when the total money flowing in (credits) is greater than the total money flowing out (debits).

Significance of a Persistent Current Account Deficit

Don't worry if your country has a small, temporary deficit, but persistent, large deficits raise serious concerns:

• Increased Foreign Debt: To finance a Current Account Deficit, a country must borrow from abroad or sell off assets (recorded as a surplus on the Financial Account). This increases the country's liability to the rest of the world.
• Loss of Aggregate Demand (AD): A deficit means (M > X). Net exports (\(X-M\)) is a component of AD (\(C+I+G+(X-M)\)). A persistent deficit acts as a withdrawal from the circular flow, reducing national income and growth.
• Pressure on Exchange Rate: High imports increase the supply of the domestic currency on the foreign exchange market, putting downward pressure on the currency's value. This can increase import prices (inflation).

Significance of a Persistent Current Account Surplus

A surplus (X > M) is often seen as a sign of strength, but even this has downsides:

• Risk of Protectionism: If one country runs a massive surplus (like China or Germany), other countries may accuse it of unfair trading practices and respond by imposing tariffs or quotas.
• Under-Consumption: A large surplus can indicate that the country is consuming too little and saving/investing too much, potentially limiting domestic living standards in the short run.
• Inflationary Pressure: A high net export value is a large injection into the circular flow, potentially increasing AD and causing demand-pull inflation.

Key Takeaway: Neither a permanent massive surplus nor a massive deficit is ideal. Governments typically aim for a stable balance on current account over the economic cycle.

Factors Influencing the Current Account

The Current Account balance is influenced by both domestic and global conditions:

• 1. Productivity and Competitiveness: If a country's firms have high productivity, their costs are lower, allowing them to sell goods and services abroad at competitive prices. This boosts exports and improves the Current Account.
• 2. Inflation Rate: If domestic inflation is high relative to trading partners, domestic goods become expensive, reducing exports (X) and making imports (M) cheaper, leading to a worsening deficit.
• 3. Exchange Rate: A depreciation (or devaluation) of the currency makes exports cheaper to foreigners and imports more expensive domestically. This should improve the balance (assuming demand is responsive—see the policy section!).
• 4. Economic Activity (Home and Abroad):

  At Home: If the domestic economy experiences an economic boom (high income), people buy more, including more imports. This worsens the Current Account.

  Abroad: If key trading partners experience a boom, their demand for our exports increases, improving our Current Account.

Policies to Deal with Balance of Payments Problems (Deficits)

When a country faces a persistent Current Account deficit, the government must implement policies designed to rebalance the trade flow. These policies fall into two main categories:

1. Expenditure-Reducing Policies

These policies aim to reduce overall Aggregate Demand (AD) in the economy. By reducing national income, consumption falls, and therefore, demand for imports also falls.

• Monetary Policy: Increasing interest rates. This reduces borrowing and investment, and increases the incentive to save, thereby reducing consumption and import demand.
• Fiscal Policy: Increasing taxes or reducing government spending. This reduces disposable income, causing consumption (and imports) to fall.

Common Conflict: While effective at reducing imports, expenditure-reducing policies often conflict with other key macroeconomic objectives, such as economic growth and full employment, as they deliberately slow down the economy.

2. Expenditure-Switching Policies

These policies aim to switch consumer and firm spending away from imports and towards domestically produced goods and services, and/or encourage exports.

• Protectionism: Imposing tariffs (taxes on imports) or quotas (limits on import quantity). This directly makes imports more expensive or less available.
• Exchange Rate Depreciation (or Devaluation): Allowing the currency to fall in value. This makes exports cheaper and imports more expensive, naturally switching demand.
• Supply-Side Policies: Policies that boost productivity, reduce business costs, and improve the quality of domestic goods. This is the best long-term solution, as it makes exports more competitive without slowing down the domestic economy.

The Role of Elasticities in Policy Effectiveness

Don't worry if this seems tricky at first—this is a high-level point, but it's essential for evaluation!

When using expenditure-switching policies (like a currency depreciation or devaluation), their effectiveness depends entirely on how responsive demand is to the resulting price changes:

• For Exports (X): If the demand for exports is price elastic (PED > 1), the fall in price caused by depreciation will lead to a proportionally larger increase in quantity demanded, boosting export revenue.
• For Imports (M): If the demand for imports is price elastic (PED > 1), the rise in price caused by depreciation will lead to a proportionally larger drop in quantity demanded, cutting the import bill.

Summary: For a currency depreciation/devaluation to successfully reduce a BoP deficit, the demand for both exports and imports must be highly elastic (responsive).

Quick Review: Key Terms to Master

• Balance of Payments (BoP): Financial record of international transactions.
• Current Account Deficit: Outflow of money (debits) on goods, services, and income is greater than inflow (credits).
• FDI: Long-term, asset-creating investment abroad (e.g., building a factory).
• Portfolio Investment: Short-term, volatile investment in stocks and bonds.
• Expenditure-Reducing Policies: Policies (like high interest rates) used to cut AD and thus lower import demand.
• Expenditure-Switching Policies: Policies (like depreciation or tariffs) used to redirect spending away from imports to domestic products.