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5. Balance of Payments

The balance of payments account is a record of the value of all
transactions between one country and all other countries over a
given period of time.
Structure of the Balance of Payments
 Transaction of money entering country is called a credit item and has a
positive value. Transaction of money exiting country is called a debit item
and has a negative value.
 The current account is a measure of the income flows, from trade of
goods and services as well as other sources.
o The balance of trade in goods: also known as the visible trade
balance, the merchandise account balance, or the balance of trade.
Measures export revenue minus import expenditure on tangible
o The balance of trade in services: also known as the invisible
balance, the services balance, or net services. Measures export
revenue minus import expenditure on services.
o Income: also known as net investment incomes. Measures the net
monetary movement of profit, interest, and dividends moving into
and out of the country as a result of financial investment abroad.
o Current transfers: also known as net unilateral transfers from
abroad. Measures net payments between countries when no
goods or services change hands, including foreign aid, grants, and
foreign workers sending money back to families.
 The capital account is a measure of trivial monetary movements and
transactions in intangible assets. Smallest part of the BoP account.
o Capital transfers: measures the net monetary movements through
transfers of goods and financial assets by migrants, debt
forgiveness, transfers from sales of fixed assets, gift taxes,
inheritance taxes, and death duties, etc.
o Transactions in non-produced, non-financial assets: measures the
monetary flows from international sales of non-produced assets
like land or rights to natural resources, and of non-financial assets
such as patents, copyrights, brand names, and franchises.
 The financial account is a measure of the net change in foreign
ownership of domestic financial assets.
o Direct investment: measures purchases of long-term assets where
the purchaser hopes to gain lasting interest in a foreign company.
Includes the buying of property, businesses, or stocks or shares in
businesses. Consists largely of foreign direct investment.
o Portfolio investment: measures stock and bond purchases, which
are simply borrowing and lending on the international market and
hence do not lead to lasting interest in a company. Include
treasury bills, government bonds, and savings account deposits.
o Reserve assets: measures net change in reserves of gold and
foreign currencies which are itemized in the official reserve
account. This account ensures that the BoP is always balanced.
 When an account is positive, there is a surplus; when it is negative, there
is a deficit. A portion of an account can be in surplus or deficit without
influencing the overall account.
 The BoP account = current account + capital account + financial account
and must equal 0. Net errors and omissions are included due to recording
insufficiencies. Overall, numerically, the current account balance equals
the sum of the capital and financial account balances.
 The current and the financial accounts are interdependent because
reserves are adjusted to ensure the overall account is balanced. Hence, if
current account is in surplus, reserves decrease and financial account
decreases, and if current account is in deficit, reserves increase and
financial account increases.
Current Account and the Exchange Rate
 When there is a current account deficit, increases in the capital and
financial accounts may cover the deficit in the short run, but eventually
the currency must be devaluated in a fixed exchange rate regime
because reserves run out. In a floating exchange rate regime, there has
either been fallen demand for exports and hence less demand for
currency, or increased demand for imports and hence more supply of
currency, meaning the currency depreciates. In both regimes, current
account deficit may result in downward pressure on the exchange rate.
 When there is a current account surplus, decreases in the capital and
financial accounts may offset the surplus but other countries will be
unhappy with artificially low exchange rate, so the currency must be
revaluated in a fixed exchange rate regime. In a floating exchange rate
regime, there has either been increased demand for exports and hence
more demand for currency, or decreased demand for imports and hence
less supply of currency, meaning the currency appreciates. Either way,
 current account surplus creates upward pressure on exchange rate.
Consequences of Current Account and Financial Account Imbalances
 When current account is in deficit then the financial account will have in
surplus to balance out the deficit. This may have the following
o Foreign currency reserves may be used to increase the financial
account. However, no country is able to fund long-term current
account deficits.
o High levels of foreign purchasing of domestic assets such as
property, businesses, or stocks or shares in businesses. This must
be based on foreign confidence in the economy, so it is not
considered harmful. However, if foreign ownership of domestic
assets become too great, there may be a threat to economic
sovereignty. If confidence decreases, selling these assets would
result in increased supply of the currency and rapid fall in value.
o High levels of lending from abroad could increase financial account,
but high rates of interest will have to be paid, which will be a shortterm drain on the economy and increase the current account
deficit in future years. There is again risk of sudden drop in the
value of the currency.
 When current account is in surplus, there may the following
o A country can build up its official reserve account and purchase
assets abroad, but one country’s surplus is another’s deficit, so this
may result in protectionism by other countries.
o Upward pressure on the exchange rate makes imports cheaper
and exports more expensive, creating deflationary pressures and
harming both domestic and exporting producers.
Methods to Correct a Persistent Current Account Deficit
 Expenditure-switching policies attempt to switch domestic consumer
expenditure away from imports towards domestically produced goods
and services.
o Depreciate or devalue the currency: exports become cheaper and
imports become more expensive. Depending on PED, export
revenue rises and import expenditure falls, improving the deficit.
o Protectionism measures: by reducing availability or increasing
price of imports, governments can encourage domestic consumers
to switch expenditure from imports to domestic products.
 These measures have limitations because they tend to lead
to retaliation and are often against WTO agreements. Also,
protectionism reduces competition and efficiency.
 Expenditure-reducing policies attempt to reduce overall expenditure in
the economy, including on imports. The size of the decrease in import
spending depends on the marginal propensity to import.
o Contractionary fiscal policies can be used to reduce aggregate
demand in the economy.
o Contractionary monetary policies reduce total expenditure on final
goods and services. Also, higher interest rates attract capital flows
from abroad, leading to a surplus in the financial account, which
helps to offset the current account deficit.
 These measures are politically unpopular and have costs
such as slower economic growth and unemployment.
The Marshall-Lerner Condition
 For current account deficit to improve, export revenue must rise and
import expenditure must fall.
 When the currency’s value falls, exports are cheaper, and imports are
more expensive, so there are more exports and less imports. This
improves currency account deficit if and only if PED of exports and
imports are somewhat elastic.
 Hence the Marshall-Lerner Condition states that reducing the value of
the exchange rate will only be successful if PEDexports + PEDimports > 1.
The J-Curve
 When the value of currency is first reduced, communication is imperfect,
so countries do not realise exports are cheaper. Also, contracts inside and
outside the country restrict price changes, so in the short run, PED is
relatively inelastic.
 As a result, current account deficit worsens from X to Y.
 Upon reaching Y, countries have realized prices are cheaper and contracts
have expired, so PED for imports and exports increase, meeting the
Marshall-Lerner condition. Current account deficit improves, as shown
by the movement from Y to Z on the J-curve.
 Current Account= Capital Account + Financial Account