Balance of Payments
The Balance of Payments is a record of a country’s financial transactions with the rest of
the world over a given period of time (usually 12 months). It basically measures all of the
imports into, and all of the exports from, a particular country.
In the past, governments placed considerable emphasis on achieving a satisfactory B of P
position. Nowadays, a government may not be too concerned in the short term if import
expenditure exceeds export revenue.
The structure of the current account of the Balance of Payments
The main elements of the B of P are the current account, the capital and financial
accounts and net errors and omissions.
The
receives the most media attention. It includes trade in goods,
trade in services, income and transfers. Trade in goods records the earnings from exports
and the expenditure on imports of goods (eg cars, food and chemicals). In recent years,
the UK has had a growing deficit in trade in goods. This means that it has spent more on
imports of goods than it has earned from selling goods to other countries. Trade in goods
used to be known as the visible balance. This term emphasises that the items in this
section can be seen and touched and have a tangible existence.
Trade in services includes such items as tourism, insurance, banking and financial
services. This part is sometimes called the invisible balance. This reflects the fact that
these services cannot be seen. The UK performs well in services and has recorded a
surplus for over 40 years.
The income part of the current account mainly covers investment income. The UK usually
has a surplus on income. This means that its residents earn more in terms of profit,
interest and dividends on their investments abroad than foreigners do on their investments
in the UK.
Transfers cover the transfer of money made and received by the government and
individuals (eg government payments to and from the E.U. and money sent out of the UK
by foreigners working in the UK to relatives abroad).
The
show the movement of direct investment (eg the
purchase of a factory) and portfolio investment (eg the purchase of shares and bank loans)
between the country and abroad.
The last section,
, is added to ensure that the B of P does
balance. As the B of P is based on information relating to a vast number of transactions, it
is not surprising that some mistakes are made and some items are initially left out.
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The causes of a deficit on the current account of the B of P.
A deficit on the current account occurs when the country’s expenditure abroad exceeds its
revenue from abroad. The 2 main situations why this occurs are :
1) the country’s inhabitants have spent more on goods and services from abroad than
overseas residents have spent on the country’s goods and services.
2) there has been a net outflow of investment income.
Among the causes of a deficit on the trade in goods and services are :

Changes in income at home or abroad. If incomes abroad are falling, then demand
for a country’s exports will probably fall too. A rise in incomes in a country will
probably lead to a rise in imports entering that country and, in turn, leading to a
deficit on the current account. This is because the country’s inhabitants are likely to
buy more products, some of which will probably be imports.

Changes in exchange rates. A rise in the exchange rate may also result in a deficit,
as it will raise export prices (making the country’s goods appear more expensive
overseas) and lower import prices (making goods from overseas appear cheaper).

High prices and low quality products. This will lead to a fall in exports from a
country, as its products are not internationally competitive and demand for its
products overseas will fall.
An outflow of investment income will occur if the investments that foreign residents have
made in the country earn more than the investments the country’s inhabitants have made
in other countries. Whether this happens will be influenced by a number of factors,
including the number of investments made, and the level of profit, interest and dividends
earned on their investments.
The causes of a deficit on the current account of the B of P.
A surplus on the current account is experienced when a country’s revenue from abroad
exceeds its expenditure abroad. It may occur due to the country’s revenue from exports
exceeding its expenditure on imports and/or because the country is a net earner of
investment income.
Care has to be taken in interpreting a surplus on trade in goods and services. This is
because it may arise from the strength of the economy, from a change in its exchange
rate, or from a weakness of the economy.
The country is likely to have surplus if its products are of a high quality, are produced at a
low cost and reflect what households and firms at home and abroad want to buy. A fall in
the exchange rate will lower export prices (making the country’s goods appear less
expensive overseas) and raise import prices (making goods from overseas appear more
expensive).
However, there could also be a surplus on the current account because the country is in a
recession. A country’s inhabitants may not be buying many products (including imports)
and its firms, finding it difficult to sell their products at home, may be competing more
vigorously overseas.
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The consequences of a deficit, or a surplus, on the current account of the B of P.
A deficit means that a country is consuming more than it is producing. The income from
this extra output, however, is going to people abroad. If a deficit increases, it will reduce
A.D., as shown in the diagram below :
This will lower the economy’s output, be likely to raise unemployment and may put
downward pressure on the price level. A rise in the deficit is also likely to lead to a fall in
the exchange rate (see later notes) and increase the debt of the country.
In contrast, a surplus means that a country is consuming less than it is producing and it is
experiencing a net inflow of money and income. The increase in the money supply will
mean that banks will have more money, which can increase bank lending. A rise in a
surplus means that net exports are increasing. This will raise A.D. and be likely to push up
the exchange rate.
The significance of a current account deficit.
How significant a current account deficit is depends on :
a) Its
b) its
c) its
d)
A deficit that forms a small percentage of real G.D.P. or one that lasts a short time is
unlikely to be very significant (eg a deficit equivalent to 2% of G.D.P. that continues for
several years, or a deficit equal to 6% of G.D.P. that last for 3 few months will not have
much impact on the country’s A.D.
A deficit may, indeed, indicate a growing and healthy economy (eg high disposable
incomes, with some of this income being spent on foreign-made luxury goods).
However, a deficit can also indicate an economy with structural problems (eg high inflation
and a desire to purchase cheaper, overseas products).
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The effect of a current account deficit on an economy is also influenced by what is
happening to the other main sector of the B of P. In 2006, the UK had a current account
deficit of £47,781m (£47.7bn). However, the country had no difficulty in attracting foreign
direct investment (F.D.I.). Indeed, the UK was the main destination for F.D.I in the E.U.
and it also had a net inflow of portfolio investment.
Determination of exchange rates
An exchange rate is the price of one currency expressed in terms of another currency. The
Bank of England Monetary Policy Committee’s (M.P.C.’s) main indicator of the pound’s
value is the Bank’s trade-weighted index. This measures the pound’s exchange rate
against a basket of currencies, giving each country’s currency a weight in proportion to the
amount of trade in both goods and services (eg because we trade more with the U.S.A.
than with Switzerland, the U.S. dollar has a larger weighting than the Swiss franc). The
currency weights are regularly updated to reflect changes in the UK’s pattern of trade.
Most countries’ exchange rates are determined by the market forces of demand and
supply. If the demand for the currency rises, then this will increase the exchange rate
(called an appreciation in the currency), whereas if the supply of the currency increases,
then the exchange rate will fall (called a depreciation in the currency). This is shown in the
2 diagrams below :
A rise in the exchange rate of a currency means that each unit of the currency will buy
more units of another currency. It also, of course, means that more units of the other
currency will have to be paid to buy the currency. For example, if the exchange rate of the
pound rises from £1 = $1 U.S to £1 = $1.50 U.S., then the value of the pound has risen
(appreciated) against the U.S. dollar. Each pound now buys more dollars. In turn, more
dollars have to be sold to buy a pound.
A number of factors influence the demand for, and the supply of, a currency and,
therefore, its exchange rate :
1)
2)
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3)
4)
5)
6)
The relationship between the exchange rate and the interest rate.
Changes in the exchange rate and the interest rate are closely linked. If, for instance, the
UK’s exchange rate rises (eg from £1 = $1 U.S. to £1 = $1.50 U.S.), then export prices
expressed in terms of foreign currencies will rise (eg a UK good selling for £100 will see its
price in the U.S.A. rise from £100 to $150). Demand for exports will fall and this will reduce
A.D. Lower A.D. will reduce inflationary pressure. This may mean that the M.P.C. will lower
the interest rate.
A reduction in the interest rate will tend to reduce the exchange rate. This is because it will
reduce the return on money kept in UK financial institutions. There will probably be an
outflow of funds from the UK to other countries (seeking higher interest rates overseas).
These funds are sometimes referred to as hot money flows. This is because these funds
are moved quickly to take advantage of changes in interest rates overseas. An outflow of
funds will mean that more of the currency is being sold. The increase in the supply of the
currency will reduce the exchange rate.
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The effect of a change in the exchange rate on export and import prices.
A fall in the exchange rate (called a depreciation) will reduce the price of exports in terms
of foreign currencies. For example, if £1 = $2 U.S., then a £100 export would sell in the
U.S.A. for $200. If the value of the pound then fell, say, to £1 = £1.50 U.S., then the export
from the UK would now sell in the U.S.A. for $150. This is then likely to lead to an increase
in the demand from U.S. citizens for UK goods. This will improve the current account
position of the balance of payments and probably lead to an increase in A.D.
Most exporters would be likely to let their export prices fall in line with the change in the
exchange rate. Selling at a lower price in their export markets should enable them to
increase their sales. Those exporters facing inelastic demand for their products may
decide to leave their prices unchanged abroad. This would enable the exporters to earn
more revenue, as they will gain more money when they convert their foreign earnings back
into pounds. For example, an exporter may decide to keep the price of its £100 product at
$200 in the U.S. when the exchange rate changes from £1 = $2 U.S. to £1 = $1.50 U.S.
This would mean that the exporter would now receive £133.33 for the product (200/1.5).
While a fall in the exchange rate causes a fall in export prices, it will increase the price of
imports in terms of domestic currency. For example, if initially £1 = $2 U.S., then a $30
U.S. import would sell in the UK for £15. A fall in the value of the pound to £1 = $1.50 U.S.
would lead to the price of the import rising to £20 (30/1.5). If producers in the U.S.A.
decide to keep the price of their products unchanged in the UK, then they would
experience a reduction in revenue per unit. In this case, selling a product in the UK for £15
would mean receiving a revenue of $22.50 U.S.
In contrast to a fall in the exchange rate, a rise in the exchange rate increases export
prices and lowers import prices.
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