Edexcel A Level Economics A

Revision Notes

A LevelEconomics AEdexcelRevision Notes4. A Global Perspective4.1 International Economics4.1.7 Balance of Payments

4.1.7 Balance of Payments

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Components of the Balance of Payments

  • The Balance of Payments (BoP) for a country is a record of all the financial transactions that occur between it and the rest of the world

  • The BoP has two main sections:
    • The current account: all transactions related to goods/services along with payments related to the transfer of income
    • The financial & capital account: all transactions related to savings, investment and currency stabilisation

  • Money flowing into the country is recorded in the relevant account as a credit (+) and money flowing out as a debit (-)


The Current Account of the Balance of Payments

  • The Current Account is often considered to be the most important account in the BoP
    • It records the net income that an economy gains from international transactions

An Example of the UK Current Account Balance For 2017

Component 2017
Net trade in goods (exports - imports) £-32.9bn
Net trade in services (exports - imports) £27.9bn
Sub-total trade in goods/services £-5bn
Net income (interest, profits & dividends) £-2.1bn
Current transfers £-3.6bn
Total Current Account Balance £-10.7bn
Current Account as a % of GDP 3.7%

  • Goods are also referred to as visible exports/imports
  • Services are also referred to as invisible exports/imports
  • Net income consists of income transfers by citizens and corporations
    • Credits are received from UK citizens who are abroad and send remittances home
    • Debits are sent by foreigners working in the UK back to their countries
  • Current transfers are typically payments at government level between countries e.g. contributions to the World Bank

The Capital Account

  • The Capital Account records small capital flows between countries and is relatively inconsequential
    • E.g. debt forgiveness by the government towards developing countries
    • E.g. capital transfers by migrants as they emigrate & immigrate

The Financial Account

  • The Financial Account records the flow of all transactions associated with changes of ownership of the UK’s foreign financial assets & liabilities

  • It includes the following sub-sections
  1. Foreign Direct Investment (FDI): flows of money to purchase a controlling interest (10% or more) in a foreign firm. Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
  2. Portfolio Investment: flows of money to purchase foreign company shares & debt securities (government & corporate bonds). Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
  3. Financial derivatives: are sophisticated financial instruments which investors use to speculate & return a profit. Money flowing in is recorded as a credit (+) and money flowing out is a debit (-)
  4. Reserve Assets:  are assets controlled by the Central Bank & available for use in achieving the goals of monetary policy. They include gold, foreign currency positions at the International Monetary Fund (IMF) & foreign exchange held by the Central Bank (USD, Euros etc.)

Causes of Deficits & Surpluses on the Current Account

  • It is called the BoP as the current account should balance with the capital & financial account & be equal to zero
    • If the current account balance is positive, then the capital/financial account balance is negative (and vice versa)
    • In reality, it never balances perfectly & the difference is called 'net error & omissions'

  • If there is a current account deficit, there must be a surplus in the capital & financial account
    • The excess spending on imports (current account deficit) has to be financed from money flowing into the country from the sale of assets (financial account surplus)

  • If there is a current account surplus, there must be a deficit in the capital & financial account
    • The excess income from exports (current account surplus) is financing the purchase of assets (financial account deficit) in other countries

Causes of Current Account Deficits


Relatively low productivity


Relatively high value of the country’s currency


Relatively high rate of inflation

  • Low productivity raises costs
  • Exporting firms with low productivity may find themselves at a price & cost disadvantage in overseas markets which will decrease competitiveness & the level of exports
  • With higher domestic prices, consumers may also buy abroad thus increasing the imports
  • Falling exports & rising imports creates a deficit

  • Currency appreciation makes a country's exports more expensive relative to other nations
  • Foreign buyers look for substitute products which are priced lower
  • Exports fall & the balance on the current account worsens
  • Similarly, currency appreciation makes imports cheaper
  • Domestic consumers may switch demand to foreign goods & as imports rise, the balance on the current account worsens

  • A relatively high rate of inflation makes a country's exports more expensive than other nations
  • Foreign buyers look for substitute products which are priced lower
  • Exports fall & the balance on the current account worsens
  • Similarly, high inflation may mean that goods/services are cheaper in other countries
  • Domestic consumers may switch demand to foreign goods & as imports rise, the balance on the current account worsens


Rapid economic growth resulting in increased imports


Non-price factors such as poor quality and design

  

  • Rapid economic growth raises household income
  • Households respond by purchasing goods/services with a high-income elasticity of demand (income elastic)
  • Many of these goods are imported & as imports rise, the balance on the current account worsens

  • When a country develops a reputation for poor quality & design, its exports fall as foreign buyers look for better substitutes elsewhere
  • Domestic buyers who are able to shop abroad also choose to buy better quality products elsewhere & the level of imports rise
  • A fall in exports & a rise in imports worsens the balance on the current account
  

Measures to Reduce Imbalances on the Current Account

  • The Government has several options available to them in order to tackle a current account deficit
    • They could do nothing, leaving it to market forces in the foreign exchange market to self-correct the deficit
    • They could use expenditure switching policies
    • They could use expenditure reducing policies
    • They could use supply-side policies

  • The choice of any policy - or any combination of policies generates both costs & benefits

Costs & Benefits of Policies Used to Tackle Current Account Deficit

Policy Option Benefit Cost

Do nothing

Floating exchange rates act as a self-correcting mechanism. Over time a higher level of imports will end up depreciating the currency causing imports to decrease (they are now more expensive) & exports to increase (they are now cheaper). This improves the deficit 

There may be other external factors that prevent the currency from depreciating. It may take a long time for self-correction to happen & many domestic industries may go out of business in the interim. The longer it takes to self-correct, the more firms will delay investment in the economy

Expenditure Switching

This is often successful in changing the buying habits of consumers, switching consumption on imports to consumption on domestically produced goods/services. This helps improve a deficit

Any protectionist policy often leads to retaliation by trading partners. This may consist of reverse tariffs/quotas which will decrease the level of exports. This may offset any improvement to the deficit caused by the policy

Expenditure Reducing

Deflationary fiscal policy invariably reduces discretionary income which leads to a fall in the demand for imported goods & improves a deficit

Deflationary fiscal policy also dampens domestic demand which can cause output to fall. When output falls, GDP growth slows & unemployment may increase

Supply-side

Improves the quality of products & lowers the costs of production. Both of these factors help the level of exports to increase thus reducing the deficit

These policies tend to be long term policies so the benefits may not be seen for some time. They usually involve government spending in the form of subsidies & this always carries an opportunity cost

Significance of Global Trade Imbalances

  • As global trade is a net sum game where the value of global exports = global imports, it follows that if one country is running a current account surplus then another country is running a deficit

  • Persistent deficits can be problematic as it means that finance from abroad (in the form of loans or foreign direct investment) is required in order to fund continued imports
    • This may mean that a country is gradually selling its assets
    • Owning money to a foreign entity creates vulnerabilities
      • The 2008 Global Financial Crisis demonstrated the impact of fast changing conditions in which creditors were insisting on being repaid quickly e.g. Greece owed creditors (including Germany) significant sums & was required to pay these back creating numerous problems in their economy

  • Persistent surpluses can be problematic as it means that the focus of the allocation of a nation's resources is on meeting foreign demand as opposed to meeting domestic demand
    •  This can limit availability of goods/services in the local economy which can possibly decrease the standard of living for some households
    • It can also create instability in the foreign exchange market if there is a floating exchange rate mechanism in operation
    • E.g. China ran a surplus for years but did not allow its currency to float freely. In recent years they have switched their focus to increasing domestic demand
      • This surplus has resulted in significant foreign direct investment by Chinese firms & the level of foreign asset ownership is high

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