3.

3 Balance of Payments
 
Balance of payments: records financial transactions made between consumers, businesses
and the government in one country with others
 
The BOP figures tell us about how much is being spent by consumers and firms on imported
goods and services, and how successful firms have been in exporting to other countries
 
 Debit items: payments
 Credit items: receipts
 
Components of the Balance of Payments

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Current transfers are transfers of money where nothing is received in return, such as workers
remittances, pensions, aids and donations
 
 Non financial asset transfers include the purchase or use of natural resources that have not
been produced. 
 
Capital transfers include things like debt forgiveness, non- life insurance claims and
investment grants
 
Reserve assets are foreign currencies purchased to be used by the central bank in its
monetary policy
 
Portfolio investment is the purchase of shares and bonds
 
Direct investment includes investment in physical capital usually undertaken by
multinational corporations
 
Current account balance: equal to the sum of the capital account and financial account
balances
 
Current account surplus: this indicates that the country is a net leader to the rest of the
world as it usually implies that the current account is large and therefore the country is a
major exporter. Overall it means that more income is flowing into the country than outwards.
 
Current account deficit:  this indicates that the country is a net borrower to the rest of the
world as it usually implies that the current account is small and therefore the country mainly
imports products. Overall it means that less income is flowing into the country than
outwards. 
 
Current Account Surplus
 
If there is a current account surplus, then exports tend to exceed imports, this means that the
demand for the currency has risen as people have bought products in that country’s currency.
This then causes an upward pressure on the exchange rate and the relative value of the
currency to rise, appreciation. 
 
The increase in relative exports causing appreciation is shown in the adjacent diagram. 
 
Implications of a persistent current account surplus
 
 Appreciation: as exports increase, the demand for the currency increases and therefore
the value of the currency increases.
 
 Reduced export competitiveness: as the currency appreciates, in a floating exchange
rate, exports become comparatively more expensive so demand for exports fall.
 
 Lower domestic consumption and investment: as the currency appreciates, imports
will become more affordable compared to domestic products so consumption of domestic
products falls. The appreciation can also deter foreign investment from abroad as it
becomes more expensive. 
 
Current Account Deficit
 
If there is a current account deficit, then imports tend to exceed exports, this means that the
supply of the currency has risen as people have bought fewer products in that country’s
currency. This then causes a downward pressure on the exchange rate and the relative value
of the currency to fall, depreciation. 
 
The relative increase in imports causing depreciation is shown in the adjacent diagram. 
 
 
 
 
Implications of a persistent current account deficit
 
 Exchange rates: the currency should automatically depreciate, which will then help to
rectify the deficit as exports become cheaper relative to imports.
 
 Interest rates: the central bank may decide to increase these in order to encourage
foreign direct investment, however, this may reduce domestic investment and consumption
as there is a greater incentive to save than spend which could lead to lower levels of growth.
 
 Indebtedness: if the country is having to borrow in order to finance the current
account deficit then they may accumulate so much debt that they are unable to pay it back
and so default. This undermines confidence in the economy, so they may be unable to get
any future loans. 
 
 International credit ratings: a persistent current account deficit may cause the
international credit rating agencies to lower their rating which may lead to even lower
expectations about the economy’s future.
 
 Demand management: in order to rebalance the account deficit they make take
measure to reduce demand which can be very painful for the economy as a whole. 
 
Methods to resolve a current account deficit
 
Expenditure switching policies: these may include devaluing the exchange rate, tariffs and
polices to reduce inflation. The aim is to reduce the demand and supply of imports, rather
than reducing overall consumption.
 
Expenditure reducing policies: these policies aim to reduce the real spending of consumers.
Such policies include fiscal and monetary polices. For instance, the government may
increase taxes and reduce spending, whilst the central bank may increase interest rates to
incentivise saving.
 
Supply-side policies: policies may be needed in order to improve the country’s productivity
in order to improve its exports competitiveness in the international markets. These policies
including lowering production costs by reducing the minimum wage, trade union power,
business taxes and implementing deregulation.