Balance of Payments on Current Accounts

What is it?

•  It is a set of accounts that record a country’s international transactions and which (because double entry bookkeeping is used) is always in balance with no surplus or deficit shown on the overall basis.
• It serves to highlight a country’s competitive strengths and weaknesses and helps in achieving balanced economic growth.

•  Because the international market is so large it is unlikely to adhere to the business cycle.
• Therefore, a country which has a healthy BoP account will likely have balanced growth because the levels of investment, consumption and capital of the international market is unlikely to fluctuate much and will grow steadily.
• The demand from the international market is unlikely to fluctuate much and will grow steadily therefore investment and capital will also grow steadily (this growth happens because people are getting richer, world population is growing, etc.).
•  Capital in this case should indicate the money invested in businesses to generate income:
•   If investments grow so too will capital because capital is the money already invested and investments are the source of capital.

The Balance of Payments Account

•  The current account, capital account and financial account.
•  The capital and financial accounts used to known collectively as the capital account.

The BoP is always balanced

•  When the news talks about a BoP surplus or deficit they are usually referring to the net transactions of the Current Account or just the Balance of Trade.
•  Calculated by subtracting the total value of imports from the total value of exports

BoT is Balance of Trade

• Positive figure (surplus) – Value of imports < Value of exports.
• Negative figure (deficit) – Value of imports > Value of exports.
•  A negative BoP indicates that a country’s exports are not competitive enough to compete with those produced by other countries:
•  Thus there is a net leakage of wealth from the country.

 

Correcting trade imbalances

Large trade imbalances, whether a big deficit or a big surplus, can cause problems for a national economy.

Problems with a trade surplus

• There may be political and economic pressure on the government from other countries to reduce its trade surplus so they can reduce their trade deficits
• Exporting firms will enjoy significant overseas revenues – profits and wages may rise – but the increase in demand may cause demand-push inflation
• A surplus causes the value of the currency to appreciate or stay high, and may eventually reduce demand for exports and cause a loss of jobs.

Problems with a trade deficit

• If more money is paid out for imports than is earned from exports then this loss of money from an economy may mean less can be spent on domestic goods and services. Domestic firms facing a fall in demand for their products may cut back production and their demand for labour resulting in higher unemployment.
• The value of the exchange rate will fall, causing imports to become more expensive and resulting in imported inflation. If demand for price-inelastic goods or services falls, more money will be paid out for imports and the demand for domestically-produced goods/services will decrease.
• The trade deficit might be a symptom of a declining industrial base, with fewer firms in the economy over time producing goods and services for export.

Economic growth and trade balance

 

A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity of demand for traded goods and services. In the case the UK, the evidence is that consumers have a high propensity to consume imports; the income elasticity of demand is strongly positive. Say for example, real disposable incomes grow by 3% and that the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of imports. Unless there is a corresponding rise in exports, we expect to see a worsening of the balance of trade (i.e. a widening trade deficit).

 

In a recession, this effect works in reverse as demand for imported products including raw materials, components and ready to consume goods and services declines. The trade balance will improve although the root cause is a drop in economic activity.

Correcting trade balances

1. Do nothing, as a floating exchange rate will correct it.

Trade deficits and surpluses can be self-correcting if allowed to adjust freely.

 

2. Fiscal policy

A contractionary fiscal policy is when the government may cut public expenditure and raise taxes to reduce the total demand in their economy so people have less to spend on imports. This will help reduce the trade deficit. However, a fall in demand may also affect domestic firms, who may cut output and employment in response to the fall in demand

 

An expansionary fiscal policy is when the government lowers tax rates and raise public expenditure. This boosts spending on imports and help to correct a trade surplus.  However, it may also help domestic firms if demand for their goods and services also rises, and may help to halt any decline in the industrial base.

 

3. Monetary policy

An expansionary monetary policy is when the government attempt to attract more inwards investments to their economy to help offset a trade deficit by raising interest rates. Higher interest rates will also make borrowing more expensive and reduce the demand for loans by consumers and firms that may be used to pay for goods and services supplied overseas.

 

A contractionary monetary policy is when the government lowers interest rates to help correct for a trade surplus by lowering the cost of borrowing from firms and consumers, and will lower the return overseas investors can expect on their inward investments in the economy so that they invest elsewhere instead.

 

4. Protectionism

This is when a country uses trade barriers such as tariffs to make imports more expensive or limit the amount of imports in order to correct a trade deficit.