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Flashcards in Balance of Payments Deck (30)
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1

Balance of Payments Definition

a record of a country’s economic transactions with the rest of the world over a year.

2

Balance of Payments consists of:

1) The current account
2) The capital account
3) The financial account
4) Net errors and omissions (the balancing item)

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The current account consists of:

1) Trade in goods
2) Trade in services
3) Income
4) Current transfers

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Trade in goods

Covers the export and import of goods (visibles) e.g. cars, laptops, clothing.
- Trade in goods balance = Revenue from exported goods - Revenue from imported goods

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Trade in services

Covers the export and import of services (invisibles) e.g. tourism, shipping, banking.
- Trade in services balance = Revenue from exported services - Revenue from imported services

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Income

Covers income (dividend, interest and profit) earned from domestic investments abroad and foreign investments domestically.

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Credit (export) of income

- Dividends received by domestic residents from their shares in foreign firms
- Interest received by domestic residents from their savings in foreign bank accounts
- Profit received by domestic firms from their investments made abroad

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Debit (import) of income

- Dividends received by foreigners from their shares in domestic firms
- Interest received by foreigners from their savings in domestic bank accounts
- Profit received by foreign firms from their investments made domestically

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Current Transfers

Covers payments made and received for which there is no corresponding exchange of goods and services.

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Credit (export) of Current Transfers

- Payments received from international institutions (e.g. IMF or World Bank)
- Receipt of foreign aid
- Domestic workers in foreign economies sending money home (worker remittances)

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Debit (import) of Current Transfers

- Payments made to international institutions (e.g. IMF or World Bank)
- Payment of foreign aid
- Foreign workers in the domestic economy sending money home (worker remittances)

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Current Account Balance

- Current account balance = (X - M)
- Current account surplus = (X > M)
- Current account deficit = (X < M)

13

The Capital Account

A relatively small part of the BoP, it records capital transfers and the acquisition and disposal of non-produced, non-financial assets.

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Examples of Capital Account

- Government debt forgiveness.
- Money brought in / out by migrants.
- Purchase and sale of copyrights, patents and trademarks.

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The Financial Account

A record of the transfer of financial assets between the country and the rest of the world.

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The Financial Account consists of:

1) Direct investment
2) Portfolio investment
3) Other investments
4) Reserve assets

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Net errors and omissions

Also known as the balancing item, this is a figure included to ensure the BoP balances.

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BoP equilibrium

The overall balance of the current account, capital account and financial account should equal zero.

19

BoP disequilibrium

when there is a large imbalance in one of the accounts
- etc. Large current account surplus or deficit
- etc. Large financial account surplus or deficit

20

Causes of Current Account Deficit

1) Strong exchange rate: price of exports rise in foreign economies and the price of imports fall in the domestic economy (EV: J-Curve, Marshall-Lerner).
2) Strong domestic growth: rising incomes results in more spending (including on imports), especially if domestic firms cannot meet the demand (EV: marginal propensity to import).
3) Declining competitiveness: low levels of investment in capital and labour cause domestic firms to struggle with imports and exporters to struggle abroad (EV: comparative advantage changes over time)
4) Higher inflation: affects competitiveness of domestic products at home and exports abroad (EV: underlying cause of inflation).
5) Recession in other economies: less spending on everything, including foreign imports (our exports) (EV: marginal propensity to import)
6) Decline in the export sector: structural change of the economy resulting in less manufacturing of goods (easier to trade) and more services (more difficult to trade) (EV: protectionism)

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Consequences of Current Account Deficit

Positive
- Domestic consumers can purchase more products than the country produces (higher standard of living).
Negative
- Lower AD: when X < M, this reduces AD, which leads to lower GDP.
- Rising unemployment: jobs will be lost due to: lower AD, the uncompetitive export sector, and the domestic industries replaced by imports.
- Fall in foreign currency reserves: imports will need to be purchased using foreign currency.
- Fall in confidence: current account deficit can be seen as a sign of economic weakness.

22

Financial Account Deficit consequences

Not a concern because:
- It will lead to an inflow of profits, interest and dividends in the future.
- It is the short term result of hot money flowing out of the economy in search of higher interest rates elsewhere.
A concern if:
- It results from a long-term lack of confidence in the economy’s prospects, possibly leading to capital flight.
- The movement out of foreign firms reduces tax revenues and employment, which might cause a recession.

23

Policies to correct balance of payments disequilibrium

1) Expenditure switching policies (protectionism / trade barriers)
2) Expenditure reducing policies (contractionary fiscal and monetary policies)

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Expenditure switching policies definition

policies that attempt to bring about a change in the pattern of demand in an economy by reducing demand for imports and increasing demand for domestic products and exports.

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Methods of Expenditure switching policies

protectionism (trade barriers

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Problems of Expenditure switching policies

- Disrupts free trade and specialisation according to comparative advantage.
- Higher prices and less choice for consumers
- Living standards fall.
- Retaliation.
- Opposed by the World Trade Organisation (WTO).

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Expenditure reducing policies definition

policies that attempt to bring about a reduction in the level of aggregate demand.

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Methods of Expenditure reducing policies

1) Contractionary (deflationary) monetary policy: increase in interest rates and/or decrease in money supply → decrease in C of all goods (including M) → negative multiplier effect → decrease in AD.
2) Contractionary (deflationary) fiscal policy: increase in taxation and/or decrease in government spending → decrease in C of all goods (including M) → negative multiplier effect → decrease in AD.

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Impacts of Expenditure reducing policies

- Contractionary fiscal and monetary policies result in less consumption of all goods, including imports, therefore less demand for M.
- Also, due to falling domestic consumption, domestic firms will be encouraged to export more.

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Problems of Expenditure reducing policies

- People are poorer.
- Living standards fall.
- Unemployment rises.
- Economic growth slows.