The Balance of payments is a record of all the monetary transactions between residents of a country and the rest of the world over a given period of time. It is divided into three main accounts: the current account, the capital account and the financial account.
(In the explanation below, we’ll look at the balance of payments from the point of view of the UK)
The Current Account
The Current account records the following:
- The visible trade (in goods)
- The invisible trade (in services)
- Income received or made in payment for the use of factors of production:
- Income debits (outflows) include wages paid to overseas residents working in the UK, interests, profits and dividends paid out to overseas residents and firms who have invested in the UK.
- income credits (inflows) include wages paid to UK residents working overseas, any interest, profits and dividends earned by UK residents and firms on investments they have in other countries.
- income received – income paid = net income
- Current transfers, which include payments between governments for international co-operation and other transactions that involve no direct payment or productive activity:
- debits (outflows) will include financial aid, donations, pension payments etc. paid to overseas residents and foreign governments and tax and excise duties paid by UK residents on foreign purchases
- credits (inflows) will include financial aid, donations, grants, pension payments etc. received from overseas residents and foreign governments and tax and excise duties paid by overseas residents on UK purchases.
- transfers received – transfers paid = net transfers
A current account example:
Visible exports (Xv)
Visible imports (Mv)
Balance of trade (Xv – Mv =A)
Invisible exports (Xi)
|Invisible imports (Mi)||
|Balance on services (Xi – Mi =B)||
|Net income (C)||
|Net Current Transfers (D)||
|Current account balance (A + B + C + D)||
When the current account shows a positive number, it is in surplus – inflows exceed outflows. When the current account shows a negative number, it is in deficit – outflows exceed inflows.
Current Account Deficit
When the financial outflows in the current account exceed its financial inflows, i.e., export demand and net incomes and transfers falls and/or import demand rises.
- Higher exchange rate: if the currency is overvalued, imports will be cheaper and therefore there will be a higher quantity of imports. Exports will become uncompetitive and therefore there will be a fall in the Quantity of exports.
- Economic growth: if there is an increase in aggregate demand and national income increases, people will have more disposable income to consume goods. If producers cannot meet the domestic demand, consumers will have to imports goods from abroad. Thus faster economic growth enables the possibility of a current account deficit developing
- Decline in competitiveness: if export industries are in decline and cannot compete with foreign countries, the exports fall, ushering in a deficit. This is a major reason for many countries today experiencing current account deficits
- Inflation: this makes exports less competitive and imports more competitive
- Recession in other countries: if the country’s main trading partners experience negative economic growth then they will buy less of the country’s exports, worsening the current account
- Borrowing money: if countries are borrowing money from other countries to finance their expenditure and growth, current account deficits will develop
- Low growth: a deficit leads to lower aggregate demand and therefore slower growth
Unemployment: deficit can lead to loss of jobs in domestic industries as there demand for exports is low and demand for imports is high
- Lowers standard of living: in the long run, persistent trade deficits undermine the standard of living as demand and income fall, especially if the net incomes and transfers show a negative balance
- Capital outflow: currency weakness can lead to investors losing confidence in the economy and taking capital away
- Loss of foreign currency reserves: countries may run short of vital foreign currency reserves as more foreign currency is being spent on imports and foreign currency revenues from exports is falling
- Increased Borrowing: countries need to borrow money or attract foreign investment in order to rectify their current account deficits. In addition, there is an opportunity cost of debt repayment, as the government cannot use this money to stimulate economic growth
- Lower exchange rate: a fall in demand for exports and/or a rise in the demand for imports reduces the exchange rate. While a lower exchange rate can mean exports become more price competitive, it also means that essential imports (such as oil and foodstuffs) will become more expensive. This can lead to imported inflation
The severity of these consequences depends on the size and duration of the deficit. Persistent deficits can harm the economy in the long-run as low export growth causes unemployment.
Correcting a current account deficit:
- Do nothing because a floating exchange rate should correct it: if there is a trade deficit, a depreciation will occur as more currency is being spent than received. Depreciation will make imports more expensive and exports cheaper. As a result, domestic demand for imports will fall and foreign demand for exports will rise, reducing the deficit
- Use contractionary fiscal policy: a government can cut public expenditure and increase taxes to reduce total demand in the economy, which will reduce demand for imports and improve the trade balance. However, a fall in demand may affect firms in the economy who may cut output and employment in response.
- Use contractionary monetary policy: a higher interest rate will attract more direct inward investments and balance and nullify the trade deficit. Higher interest rates will also make borrowing from banks more expensive and increase the incentive to save, thus discouraging consumers from spending. They can also devalue the exchange rate to improve export competitiveness and demand
- Protectionist measures: these measures reduce the competiveness of imports, thereby making domestic consumption more attractive. For example, tariffs raise the price of imports while quotas limit the amount of imports in the economy.
Current Account Surplus
When the financial inflows in the current account exceed its financial outflows, i.e., export demand and net incomes and transfers rise and/or import demand falls.
- Improved competitiveness: exports have become more price competitive in the international market, due to perhaps, better labour productivity or low prices
- Growth in foreign countries: export demand may have risen due to trading partners experiencing growth and higher incomes
- High foreign direct investment: strong export growth can be the result of a high level of foreign direct investment
- Depreciation: a trade surplus might result from a country’s depreciation of its exchange rate
- High domestic savings rates: high levels of domestic savings and low domestic consumption of goods and services cause more products to be exported and imports to fall
- Closed economy: some countries have a low share of national income taken up by imports, perhaps because of a range of tariff and non-tariff barriers
- Economic growth: net exports is a component of GDP, so a rise in exports and incomes will cause economic growth
- Appreciation: as exports increase, the demand for the currency increases and therefore the value of the currency increases, which will make imports more expensive and cause its demand to fall
- Employment: since exports have increased, jobs in the export industries will have increased too.
- Better standards of living: higher net incomes and transfers and export revenue make the country’s citizens better off
- Inflation: higher demand for exports can lead to demand-pull inflation. This can diminish the international competitiveness of the country over time as the price of exports rises due to inflation
Correcting a current account surplus:
- Do nothing because a floating exchange rate should correct it: if there is a trade surplus, an appreciation will occur as more currency is being demanded. An appreciation will make imports cheaper and exports expensive. As a result, foreign demand for exports will fall and domestic demand for imports will rise, reducing a trade surplus
- Use expansionary fiscal policy: increasing public expenditure and cutting taxes can boost total demand in an economy for imported goods and services.
- Use expansionary monetary policy: lower interest rates will make borrowing from banks cheaper and increase the incentive to spend, thus encouraging consumers to spend on imports and correct a trade surplus
- Remove protectionist measures: reducing tariffs and quotas cause imports to rise and close a surplus in the current account
Notes submitted by Lintha
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