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Balance of Payments Definition

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


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)


The current account consists of:

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


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


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



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


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


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


Current Transfers

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


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)


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)


Current Account Balance

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


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.


Examples of Capital Account

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


The Financial Account

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


The Financial Account consists of:

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


Net errors and omissions

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


BoP equilibrium

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


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


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)


Consequences of Current Account Deficit

- Domestic consumers can purchase more products than the country produces (higher standard of living).
- 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.


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.


Policies to correct balance of payments disequilibrium

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


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.


Methods of Expenditure switching policies

protectionism (trade barriers


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).


Expenditure reducing policies definition

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


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.


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.


Problems of Expenditure reducing policies

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