Balance of Payments
The Balance of Payments is a set of accounts showing the transactions conducted between the residents of one country and the rest of the world.
Table of Contents
There are three elements to the balance of payments:
Capital Account-‐ includes transactions in fixed (physical capital) assets
Financial Account-‐ includes transactions in financial assets
Current Account: Information
The current account includes:
Trade in Goods
This is the imports and exports of tangible goods. Imports are negative entries, exports are positive entries. For example, if a UK resident buys a German watch online, it is an import and counts as a negative entry on the current account.
Trade in Services
This is the movement of intangible services between countries (e.g. the UK is a major distributor of banking and insurance services).
Income
This is mainly from profits, interest and dividends that are rewards for capital investments in another country. For example, if a British person buys shares in a US company, the dividends earned will appear as a positive figure on the UK current account. Income also includes employment income of UK residents working abroad.
Transfers
This refers to the movement of funds for which there is no corresponding trade in goods and services. Examples include economic migrants send money back to families in another country, and also the payment of tax to the EU.
Imbalance in the Current Account
An imbalance in the current account indicates that there is a difference between the money gained from imports and the money lost from exports.
A deficit in the current account indicates a net outflow of money from the circular flow. A surplus in the current account indicates a net influx of money into the circular flow.
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Causes of Deficit
- Over-‐ Spending: residents of the country might be spending too much abroad
- Failure of Manufacturing Industry: the goods produced in the country are not in large demand by those in other countries. This may be due to a lack of resources (e.g. countries with plentiful natural oil supplies export to the world) or due to an inefficient allocation of resources.
- High Exchange Rate: this makes imports cheaper for residents and exports from the UK more expensive for foreigners.
Costs
An unbalanced economy – too much consumption: A large deficit in trade is a sign of an ‘unbalanced economy’ typically the consequences of a high level of consumer demand contrasted with a weaker industrial sector. Eventually these “macroeconomic imbalances” have to be addressed. Consumers cannot carry on spending beyond their means for the danger is that rising demand for imports will be accompanied by a surge in household debt.
Potential loss of output and employment: A widening trade deficit may result in lost output and employment because it represents a net leakage from the circular flow of income. This reduces spending by households, so firms produce less and therefore have to hire fewer people.
Potential problems in financing a current account deficit: A current account deficit is balanced by a financial account surplus. The financial account includes capital inflows from abroad. However, countries cannot always rely on inflows of financial capital into an economy to finance a current account deficit. Foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment. The current situation in the United States is very interesting in this respect. Such is the size of the current account deficit that the USA must rely on huge capital inflows each year (mainly from China) and eventually investors in other countries may decide to put their money elsewhere – this would put severe downward pressure on the US dollar (see below).
Downward pressure on the exchange rate: A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate. This would then increase the prices of imported goods (imported inflation) and might also cause a rise in interest rates from the central bank. A declining currency would help stimulate exports but the rise in (import) inflation and interest rates would have a negative effect on demand, output and employment.
Exam Tips: Interest & Exchange Rates
- An increase in interest rates leads to an increase in exchange rates. This is because higher interest rates makes investing in assets in the economy more desirable for foreigners, so demand for the economy’s currency increases, and hence the price (exchange rate) of the currency increases.
- Therefore a rise in interest rates leads to a rise in exchange rates, which makes increases
imports and decreases exports.
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→ What is the Balance of Payments?
The Balance of Payments is a record of all the economic transactions that take place between a country and the rest of the world over a specified period. These transactions include the imports and exports of goods and services, payments for investments, and transfers of money.
→ What is the purpose of the Balance of Payments?
The Balance of Payments provides valuable information about a country’s economic performance and its relations with other countries. It helps policymakers make informed decisions on issues such as exchange rates, trade policies, and foreign investments.
→ What are the components of the Balance of Payments?
The Balance of Payments consists of two main components: the current account and the capital account. The current account includes transactions related to the trade of goods and services, while the capital account includes transactions related to investments and financial flows.
→ What is the Current Account?
The Current Account is a component of the Balance of Payments that records a country’s imports and exports of goods and services, as well as income received and paid out to other countries. It is a measure of a country’s net trade balance.
→ What is the Capital Account?
The Capital Account is a component of the Balance of Payments that records transactions related to capital transfers, such as foreign direct investments, portfolio investments, and loans. It is a measure of a country’s net capital inflows or outflows.
→ How does the Balance of Payments affect exchange rates?
The Balance of Payments affects exchange rates by indicating whether a country is a net importer or exporter. If a country has a current account surplus (exports exceed imports), its currency may appreciate in value. Conversely, if a country has a current account deficit (imports exceed exports), its currency may depreciate in value.
→ How does the Balance of Payments affect international trade?
The Balance of Payments affects international trade by providing information on a country’s competitiveness and trade balance. If a country has a current account surplus, it may be more competitive in exporting goods and services. On the other hand, if a country has a current account deficit, it may need to adjust its trade policies to improve its trade balance.
→ How can the Balance of Payments be used to evaluate a country’s economic performance?
The Balance of Payments provides valuable information on a country’s economic performance, such as its trade balance, net capital inflows/outflows, and financial position with other countries. By analyzing the Balance of Payments, policymakers and economists can assess a country’s economic strengths and weaknesses and make informed decisions on policy measures.
→ What are some real-life examples of the Balance of Payments in action?
Real-life examples of the Balance of Payments include the United States’ current account deficit, which has been a longstanding issue due to its high level of imports, and China’s current account surplus, which has been fueled by its strong export-oriented economy. The Balance of Payments also plays a role in determining exchange rates, such as the appreciation of the Japanese yen following Japan’s current account surplus in the 1980s.
