Hello Future Global Economist!

Welcome to one of the most exciting and relevant chapters in macroeconomics: Balance of Payments, Exchange Rates, and International Competitiveness. Don't worry if these terms sound intimidating! By the end of these notes, you’ll understand how money flows between countries, why the value of the Pound or Dollar changes daily, and what governments can do to make their businesses thrive globally.

This chapter is crucial because it links domestic economic performance (like inflation and interest rates) directly to the global stage. Understanding these mechanics is key to analyzing real-world economic policy and crises.


Section 1: Understanding the Balance of Payments (BoP)

1.1 What is the Balance of Payments?

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

  • It operates under the principle of double-entry bookkeeping. This means every transaction is recorded twice—once as a credit (inflow of money) and once as a debit (outflow of money).
  • Crucial Fact: Theoretically, the BoP must always sum to zero. The overall total balance of credits must equal the overall total balance of debits.
Analogy Alert!

Think of the BoP as your personal bank statement, but for an entire country. It tracks where the country earns money (credits) and where it spends money (debits).

1.2 The Structure of the BoP

The BoP is broken down into three main sections, plus an adjustment for errors:

  1. The Current Account
  2. The Capital Account
  3. The Financial Account
a) The Current Account (CA)

This is the most analyzed section. It measures the flow of goods, services, and income transfers.

The Current Account has four main sub-components:

  • Trade in Goods (Visible Trade): Exports of physical goods minus imports of physical goods. (e.g., selling cars to Germany).
  • Trade in Services (Invisible Trade): Exports of services minus imports of services. (e.g., selling financial advice, tourism, insurance).
  • Primary Income (Investment Income): Net earnings from assets held abroad. This includes wages, interest, profits, and dividends flowing into and out of the country.
  • Secondary Income (Current Transfers): Net transfers of money for which nothing is received in return. This includes foreign aid, EU contributions, and remittances (money sent home by migrant workers).

Quick Review: When economists talk about a "BoP problem" or "BoP deficit," they are almost always referring to a deficit on the Current Account.

b) The Capital Account

This account is relatively small in advanced economies. It records transfers related to fixed assets and intangible assets.

  • Examples: Debt forgiveness, sale/purchase of patents or copyrights, and inheritance taxes.
c) The Financial Account (FA)

This account measures the flow of financial assets (investments) across borders.

  • Foreign Direct Investment (FDI): Long-term investments where an investor gains significant influence or control (e.g., building a factory abroad).
  • Portfolio Investment: Shorter-term, passive investments in financial assets like stocks and bonds.
  • Other Investment: Includes bank loans and currency deposits.
  • Reserve Assets: Changes in the Central Bank’s holdings of foreign currency, gold, and other reserve assets.

1.3 Why Does the BoP Always Balance?

Because of the accounting identity:

\((\text{Current Account}) + (\text{Capital Account}) + (\text{Financial Account}) + (\text{Net Errors and Omissions}) = 0\)

If a country runs a Current Account Deficit (spending more abroad than it earns), it must be financed by a corresponding surplus on the Capital and Financial Accounts. This means the country is either selling off assets or borrowing money from foreigners.

Example: If the UK buys more French cheese (CA Debit), the French seller gains pounds. They must then use those pounds to buy a UK asset (FA Credit) or convert them to Euros (which involves a CB transaction), ensuring the ledger balances.

Key Takeaway Section 1

The BoP is an accounting framework that MUST balance. The Current Account tracks trade and income flows, while the Financial Account tracks asset ownership and investment flows. A deficit in one is matched by a surplus in the other.


Section 2: BoP Disequilibrium and Policy

2.1 Deficits and Surpluses (Focusing on the Current Account)

A Current Account Deficit occurs when debits (outflows) are greater than credits (inflows). A Current Account Surplus is the opposite.

Implications of a Persistent Current Account Deficit

A small, temporary deficit is usually fine, but a large, persistent deficit signals deep structural problems:

  • Increased Foreign Indebtedness: The deficit must be financed by borrowing from abroad or selling domestic assets (Financial Account surplus). This creates future repayment obligations.
  • Lower Standard of Living: In the long run, the country is consuming more than it produces (using goods/services bought with foreign loans).
  • Pressure on the Currency: Increased supply of the domestic currency (to buy imports) can lead to depreciation (or requires the Central Bank to intervene).
  • Risk of Capital Flight: If investors lose confidence, they may rapidly pull money out, exacerbating the financial pressure.

2.2 Policies to Correct a Current Account Deficit

Governments use a combination of expenditure-reducing and expenditure-switching policies, often alongside supply-side reforms.

  1. Expenditure-Reducing Policies (Reducing Demand):
    • Deflationary Fiscal Policy: Increasing taxes or cutting government spending reduces Aggregate Demand (AD), dampening import consumption.
    • Monetary Policy: Increasing interest rates reduces consumption and investment, and may also attract hot money, causing the currency to appreciate (though this is counterproductive for exports).
  2. Expenditure-Switching Policies (Encouraging Domestic/Foreign Purchases):
    • Protectionism (Tariffs/Quotas): Makes imports more expensive and less competitive. (Warning: This often leads to retaliation and violates WTO rules.)
    • Devaluation/Depreciation: Lowers the price of exports and raises the price of imports, switching expenditure towards domestic goods.
    • Supply-Side Policies (Long-Term Fix):
      • Focuses on improving productivity, efficiency, and competitiveness (e.g., better infrastructure, education, R&D spending). This makes exports more attractive regardless of price.
Quick Review Box: Deficit Financing

When a country runs a Current Account Deficit, it is essentially paying for today's consumption using borrowed money or selling off its assets. This is why financial markets care so much about a country's trade balance.


Section 3: Exchange Rate Systems

3.1 Defining the Exchange Rate

The exchange rate is the price of one currency expressed in terms of another currency.

Example: £1 = $1.25. (The price of one pound is $1.25).

3.2 The Three Main Exchange Rate Systems

a) Floating Exchange Rate System

The value of the currency is determined purely by the forces of demand and supply in the foreign exchange market.

  • Advantage: Acts as an automatic stabilizer. If the Current Account is in deficit, the currency depreciates naturally, making exports cheaper and correcting the deficit without government intervention.
  • Disadvantage: High volatility and uncertainty, which can discourage international trade and investment.
  • Terminology: A fall in value is called depreciation. A rise in value is called appreciation.
b) Fixed Exchange Rate System (or Pegged)

The government or Central Bank sets the official exchange rate against another currency (like the US Dollar) or a basket of currencies/assets (like gold).

  • Advantage: Provides stability and certainty for trade and investment. Helps anchor inflation expectations.
  • Disadvantage: The Central Bank must continuously intervene (buy or sell reserves) to maintain the rate. This limits the ability to use domestic monetary policy (loss of policy autonomy).
  • Terminology: A deliberate, official lowering of the fixed rate is called devaluation. A deliberate raising is called revaluation.
c) Managed Floating Exchange Rate (or Dirty Float)

The currency is generally allowed to float freely, but the Central Bank intervenes occasionally to prevent excessive volatility or to nudge the rate toward a desired level.

Did you know? Most major economies, including the US, UK, and Japan, operate a managed float.

Memory Aid: Fixed vs. Floating Terminology

If you FLOAT, you APPRECIATE (go up) or DEPRECIATE (go down) based on market forces.

If you are FIXED, the government must officially REVALUE (move up) or DEVALUE (move down) the rate.


Section 4: Determination of Floating Exchange Rates

4.1 Demand and Supply in the Foreign Exchange Market

The exchange rate is the intersection of the demand for the currency and the supply of the currency.

Demand for Currency (e.g., Demand for the Pound £)

Demand for the Pound comes from foreigners who need pounds to buy UK assets or goods/services.

  • Sources of Demand: UK Exports of Goods/Services, Foreign Direct Investment (FDI) into the UK, foreign buying of UK shares/bonds, tourist spending in the UK.
Supply of Currency (e.g., Supply of the Pound £)

Supply of the Pound comes from UK residents who need to sell pounds to buy foreign assets or goods/services.

  • Sources of Supply: UK Imports of Goods/Services, UK residents investing abroad (FDI outflow), UK residents buying foreign stocks/bonds, UK tourists traveling abroad.

4.2 Factors Causing Shifts in Exchange Rates

a) Relative Interest Rates (The "Hot Money" Factor)

If UK interest rates rise relative to the US rates, US investors will move their money (hot money) to UK banks to gain higher returns. This increases the demand for the Pound, causing appreciation.

b) Relative Inflation Rates

If inflation in the UK is high relative to its trading partners, UK goods become comparatively more expensive. Foreigners demand fewer UK goods (lower demand for £), and UK residents buy more imports (higher supply of £). Result: Depreciation.

c) Capital Mobility and Foreign Investment

High inflows of FDI (e.g., a foreign company deciding to build a new factory) significantly increase the demand for the domestic currency, leading to appreciation.

d) Speculation

Speculation—the expectation of future price changes—is often the most important short-term determinant. If speculators believe the Pound will rise, they buy it now, causing the actual rate to rise immediately. Self-fulfilling prophecy!

e) Current Account Balance

A persistent Current Account deficit means the supply of the domestic currency (for imports) is greater than the demand (for exports), creating downward pressure (depreciation).


Section 5: Impact of Exchange Rate Changes

5.1 Effects of Appreciation (or Revaluation)

When the domestic currency gets stronger (e.g., £1 buys more Yen):

  • Exports: Become relatively more expensive for foreigners, leading to a fall in demand and volume. (Worsens Current Account).
  • Imports: Become relatively cheaper for domestic consumers. (Worsens Current Account).
  • Inflation: Imports are cheaper (lower input costs), reducing inflationary pressure (disinflationary effect).
  • Investment: Reduces the value of income earned from assets abroad (Primary Income).

5.2 Effects of Depreciation (or Devaluation)

When the domestic currency gets weaker (e.g., £1 buys fewer Euros):

  • Exports: Become relatively cheaper for foreigners, leading to a rise in demand and volume. (Improves Current Account).
  • Imports: Become relatively more expensive for domestic consumers. (Improves Current Account).
  • Inflation: Imports are more expensive (higher input costs), increasing inflationary pressure (inflationary effect).
  • Investment: Increases the value of income earned from assets abroad (Primary Income).

5.3 The Marshall-Lerner Condition (MLC)

Don't worry if this sounds complex—it’s just about elasticity!

MLC states that for a depreciation (or devaluation) to successfully improve the Current Account balance, the combined price elasticities of demand for exports and imports must be greater than one.

\[\text{PED}_x + \text{PED}_m > 1\]

Why? If demand is elastic (\(\text{PED} > 1\)), the volume change resulting from the price change will be proportionally large, leading to higher total revenue from exports and lower total expenditure on imports. If demand is inelastic (\(\text{PED} < 1\)), the volume change is small, and the currency change actually makes the Current Account *worse*.

5.4 The J-Curve Effect

The J-Curve effect describes the time lag between a currency depreciation and the resulting improvement in the Current Account.

  1. Short Run (SR - Inelastic): Immediately after depreciation, trade volumes don't change much because contracts are fixed and consumers/firms haven't adjusted (demand is inelastic). Because imports are now immediately more expensive, the Current Account worsens.
  2. Long Run (LR - Elastic): Over time, demand becomes elastic. Consumers switch from expensive imports to cheaper domestic goods, and exporters take advantage of cheaper prices to sell more abroad. The Current Account improves.

If you plot this path on a graph (Current Account Balance vs. Time), the line dips down and then rises steeply, forming a "J" shape.

Key Takeaway Section 5

A depreciation is *not* a guaranteed fix for a Current Account deficit. For it to work, the goods traded must be price sensitive enough (MLC), and you must be willing to wait for the benefits (J-Curve).


Section 6: International Competitiveness

6.1 What is International Competitiveness?

International Competitiveness is the ability of a country's firms, industries, and economy to sell goods and services successfully on world markets.

6.2 Factors Affecting Competitiveness

Competitiveness is generally split into two types:

a) Price Competitiveness

This relates to how cheap a country’s goods are relative to its competitors. Key determinants:

  • Exchange Rate: Depreciation improves price competitiveness; appreciation harms it.
  • Unit Labour Costs (ULCs): Calculated as total labour costs divided by real output. If ULCs rise (e.g., wages rise faster than productivity), prices must rise, reducing competitiveness.
  • Relative Inflation: If domestic inflation is high, domestic prices rise relative to international prices, reducing competitiveness.
  • Productivity: Higher labour/capital productivity means lower production costs per unit.
b) Non-Price Competitiveness

This is arguably more important for high-income countries. It relates to factors other than price that encourage customers to buy the product. Key determinants:

  • Quality and Reliability: The reputation of the product.
  • Design and Innovation: Investing in Research and Development (R&D) to create unique or superior products (e.g., German engineering).
  • Marketing and Branding: Successful differentiation and global recognition.
  • After-Sales Service: Warranties, returns policy, and customer support.
  • Infrastructure: Efficient transport and reliable communications reduce costs and delivery times.

6.3 Policies to Improve Competitiveness

Improving competitiveness often requires long-term Supply-Side Policies:

  • Investment in Human Capital: Education and training improve labour skills and productivity, lowering Unit Labour Costs.
  • Deregulation and Market Liberalization: Increasing competition forces firms to become more efficient and innovative.
  • Investment in Infrastructure: Better roads, broadband, and energy grids reduce firm costs and improve delivery speed.
  • Promoting R&D: Tax breaks or subsidies for firms to innovate, improving non-price factors.
Encouragement Note!

Understanding competitiveness helps you link supply-side policies back to international trade. Always remember: long-term, sustainable trade improvements come from being better, not just cheaper!


Chapter Review: Essential Takeaways

  • The Balance of Payments records all international flows, and by definition, must balance to zero.
  • The Current Account (trade balance) is the primary focus. Deficits are financed by borrowing or selling assets (FA surplus).
  • A floating exchange rate adjusts automatically, providing stability to the BoP but causing volatility in prices.
  • A fixed exchange rate provides price stability but limits a government’s policy independence.
  • A depreciation only improves the Current Account if the Marshall-Lerner Condition (\(\text{PED}_x + \text{PED}_m > 1\)) is met, and only after the time delay explained by the J-Curve.
  • Competitiveness is driven by both price (ULCs, exchange rates) and non-price factors (quality, innovation). Supply-side reforms are key to long-term gains.

You’ve covered difficult ground here. Keep practicing those application questions, and you’ll master global economics in no time!