File - Mr. P. Ronan

3.3. The Balance of Payments
Definition of the Balance of Payments
The Balance of Payments is a statement that summarizes an
economy’s transactions with the rest of the world for a specified time
period. The balance of payments, also known as balance of
international payments, encompasses all transactions between a
country’s residents and its nonresidents involving goods, services
and income; financial claims on and liabilities to the rest of the world;
and transfers such as gifts. The balance of payments classifies these
transactions in two accounts – the current account and the capital
account. The current account includes transactions in goods, services,
investment income and current transfers, while the capital account
mainly includes transactions in financial instruments. An economy’s
balance of payments transactions and international investment
position (IIP) together constitute its set of international accounts.
Does the “balance of payments” actually balance? In theory, a current
account deficit would have to be financed by a net inflow in the
capital and financial account, while a current account surplus should
correspond to an outflow in the capital and financial account for a net
figure of zero. In actual practice, however, the fact that data are
compiled from multiple sources gives rise to some degree of
measurement error.
Source: Balance Of Payments (BOP) Definition | Investopedia ,
accessed Saturday 17th October 2015
Debits and Credits
The balance of payments (BOP) records all financial transactions
made between consumers, businesses and the government in one
country with others
• The BOP figures tell us about how much is being spent by
consumers and firms on imported goods and services, and how
successful firms have been in exporting to other countries.
• Inflows of foreign currency are counted as a positive entry (e.g.
exports sold overseas) - credit
• Outflows of foreign currency are counted as a negative entry
(e.g. imported goods and services) – debit
Consider the following and determine if it is a debit or credit
into the BOP and how would it affect the relevant exchange rate
A U.S. household purchases a car from Japan.
A U.S. business sells a corporate bond to a British household.
The US gives wheat to Egypt.
A US citizen travels as a tourist to Germany.
The Components of the Balance of Payments
The balance of payments is made up of these key parts
i) The current account
ii) The capital account
iii) Official financing account
In the IB syllabus the capital and official financing account are
combined as the Capital and Financial Account
The current account
The current account is made up of the following payments:
1. Trade in goods
These items include the import and export of finished goods, such as
cars, and computers; semi-finished goods, such as parts and
components for assembly, and commodities, such as oil, tea and
2. Trade in services
Trade services include financial services, tourism, and consultancy.
Income from investment and employment
3. Investment income
This refers to any income made from investing abroad, and includes
profits, such as those from business activities of subsidiaries located
abroad; interest received from UK financial investments and loans
abroad, and dividends from owning shares in overseas firms.
Payments to individuals who are residents of a country, and are
employed in another, are also included in the current account.
Investment and employment income are also known as 'primary
4. Transfers
The final section of the current account includes transfer payments
(transfers) arising from gifts between residents of different
countries, donations to charities abroad, and overseas aid. Transfers
are also known as 'secondary' income.
The Capital and Financial Account
The Capital and Financial Account records the flows of capital and
finance between the UK and the rest of the world. Types of flow
• Foreign direct investment (FDI), such as a UK firm
establishing a manufacturing facility in China. Direct
investment refers to investment in an enterprise where the
owners or shareholders have some element of control of the
• Portfolio investment, such as a UK investor buying shares in
an existing business abroad. With portfolio investment, the
investor has no control over the enterprise. Financial
derivatives are any financial instrument whose underlying
value is based on another asset, such as a foreign currency,
interest rates, commodities or indices.
• Reserve assets are foreign financial assets that are controlled
by monetary authorities of the particular country. These assets
are used to finance deficits and deal with imbalances. Reserve
assets include gold, Special Drawing Rights, and foreign
exchange held by the central bank of that country.
This process is often called official financing.
Net errors and omissions
In theory, the Capital and Financial Account balance should be equal
and ‘opposite’ to the Current Account balance so that the overall
Account balances, but in practice this is only achieved by the use of a
balancing item called net errors and omissions. This device
compensates for various errors and omissions in the balance of
payments data, and which brings the final balance of payments
account to zero.
e_of_payments.html, accessed Saturday 17th October 2015
Example of a Balance of Payments
Current Account
Balance of trade in
Balance of trade in
Billions of US$
A trade deficit
A trade surplus
income i.e. due to
transfers perhaps
overseas +8
Sum of 1+2+3+4 = -19
Financial Account
Net balance of foreign +5
of +6
portfolio investment
Changes to reserves +7.5
of gold and foreign
and +0.5
Balance on capital & +19
financial account
Balance of Payments
Positive net inflow
of FDI
Positive net inflow
into equity markets,
property etc.
+8 means that this
country's gold and
reserves have been
Errors in data
Source:, accessed Saturday 17th October 2015-10-17
Difference between a current account deficit and surplus
The following variables go into the calculation of the current account
balance (CAB):
X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers
The formula is:
CAB = X - M + NY + NCT
Current deficit
Running a sizeable deficit on the current account basically means
that the UK economy is not paying its way in the global economy.
There is a net outflow of demand and income from the circular flow
of income and spending.
Current surplus
A surplus is indicative of an economy that is a net creditor to the rest
of the world. It shows how much a country is saving as opposed to
investing. What this means is that the country is providing an
abundance of resources to other economies, and is owed money in
return. By providing these resources abroad, a country with a CAB
surplus gives other economies the chance to increase their
nCa6akD, accessed Saturday, October 17th 2015
Does a current account matter?
Positive aspects
1. Partial auto-correction: If some of the deficit is due to very
strong consumer demand, the deficit will automatically
partially-self correct when the economic cycle turns and there
is a slowdown in spending
2. Investment and the supply-side: Some of the deficit may be
due to increased imports of new capital and technology which
will have a beneficial effect on productivity and
competitiveness of producers in home and overseas markets
3. Capital inflows balance the books: Providing a country has a
stable economy and credible economic policies, it should be
possible for the current account deficit to be financed by
inflows of capital without the need for a sharp jump in interest
rates. The UK ran an average annual current account deficit of
£10 billion from 1992-2004 and yet the economy has also
enjoyed one of the longest sustained periods of growth and
falling unemployment during that time.
Negative aspects
1. Structural weakness: The trade / current account deficit may
be a symptom of a wider structural economic problem i.e. a
loss of competitiveness in overseas markets, insufficient
investment in new capital or a shift in comparative advantage
towards other countries.
2. An unbalanced economy – too much consumption: A large
deficit in trade is a sign of an ‘imbalanced economy’ typically
the consequences of a high level of consumer demand
contrasted with a weaker industrial sector. Eventually these
“macroeconomic imbalances” have to be addressed. Consumers
cannot carry on spending beyond their means for the danger is
that rising demand for imports will be accompanied by a surge
in household debt.
3. Potential loss of output and employment: A widening trade
deficit may result in lost output and employment because it
represents a net leakage from the circular flow of income and
spending. Workers who lose their jobs in export industries, or
whose jobs are lost because of a rise in import penetration,
may find it difficult to find new employment.
4. Potential problems in financing a current account deficit:
Countries cannot always rely on inflows of financial capital into
an economy to finance a current account deficit. Foreign
investors may eventually take fright, lose confidence and take
their money out. Or, they may require higher interest rates to
persuade them to keep investing in an economy. Higher
interest rates then have the effect of depressing domestic
consumption and investment. The current situation in the
United States is very interesting in this respect. Such is the size
of the current account deficit that the USA must rely on huge
capital inflows each year and eventually investors in other
countries may decide to put their money elsewhere – this
would put severe downward pressure on the US dollar.
5. Downward pressure on the exchange rate: A large deficit in
trade in goods and services represents an excess supply of the
currency in the foreign exchange market and can lead to a
sharp fall in the exchange rate. This would then threaten an
increase in imported inflation and might also cause a rise in
interest rates from the central bank. A declining currency
would help stimulate exports but the rise in inflation and
interest rates would have a negative effect on demand, output
and employment.
Policies to correct a current account deficit
Policies to reduce a current account deficit
1. Devaluation
This involves reducing the value of the currency against others. (e.g.
selling pounds would cause the value of the Pound to fall)
• If there is a devaluation in the currency, the price of importing
goods increases and therefore the quantity demanded of
imports falls.
• Exports will be become cheaper and there will be an increase
in the quantity of exports.
• Therefore, assuming demand is relatively price elastic, we
would expect a devaluation to lead to an improvement in (X-M)
and therefore the current account on the balance of payments.
• However it does depend upon the elasticity of demand for
exports and imports.
The Marshall Learner Condition
This states that a devaluation will improve the balance on the current
account, on the condition that the combined elasticity’s of demand
for imports and exports is greater than one.
• If (PED x + PED m > 1) then a devaluation will improve the
current account.
• If (PED x + PED m > 1) then an appreciation will worsen the
current account.
This is because the effect on the current account depends on the total
value and not just the quantity of exports.
Numerical example of Marshall-Lerner Condition
The J Curve effect
In the short term, demand for imports and exports tend to be
inelastic. Therefore, after a devaluation, the current account tends to
get worse before it gets better. However, over time, demand becomes
more price elastic and the current account improves.
Another problem with devaluation is that it can lead to imported
inflation. Basically imports will be more expensive. Higher inflation
can reduce the countries competitiveness. Therefore the
improvement in the current account might only be temporary.
2. Deflationary policies
If an economy pursues a tightening of fiscal policy / monetary policy,
this will reduce aggregate demand. Tight monetary policy involves
increasing interest rates – this will leave people with less money to
spend so they will reduce their consumption of imports. Also, a fall in
AD and economic growth will reduce inflation and help to make UK
exports more competitive.
• The UK has a high marginal propensity to import therefore a
reduction in AD improves the current account significantly.
• Deflationary policies will also put pressure on manufacturers
to reduce costs and this will lead to more competitive exports
and so exports will increase.
• However this policy will conflict with other macroeconomic
objectives – with lower aggregate demand (AD), growth is
likely to fall causing higher unemployment. A government is
unlikely to want to risk higher unemployment just to reduce a
current account deficit.
3. Supply Side Policies
Supply side policies can improve the competitiveness of the economy
and help make exports more attractive. This can improve the current
account position, but it may take considerable time to have effect.
To attain low inflation, supply side policies can help reduce costs and
increase productivity. For example, privatization and deregulation
can help reduce costs. However, in the control of inflation, the most
significant factor is the use of monetary policy and controlling AD
through interest rates. Supply side policies will take a long time to
have any effect on reducing inflationary pressures.
Increased productivity can also help the balance of payments. If firms
become more competitive, then UK goods will be in greater demand,
increasing exports and improving the current account deficit
4. Protectionism
Increased tariffs of quotas will reduce imports and improve the
current account.
1) Protectionism leads to retaliation so exports will decrease
2) Domestic industries may become uncompetitive, because there is
no incentive.
Consequences of a current account surplus
A current account surplus means an economy is exporting a greater
value of goods and services than it is importing. A country with a
current account surplus will have a deficit on the financial / capital
account. i.e. a country with a current account surplus will have
surplus foreign exchange it can use to invest in other countries.
There is no hard and fast rule about what will happen if a country has
a current account surplus. It depends on the size of the current
account and the reasons for the current account surplus.
In theory, you could expect a current account surplus (X-M) to boost
employment because it is indicative of higher domestic demand.
• High exports (X) leads to increased employment in the export
• Lower import spending may mean people are spending more
on domestic goods rather than buying foreign goods. Greater
demand for domestic goods helps domestic employment.
Current account surplus in fixed exchange rate
One reason for a current account surplus is when a country has a
relatively undervalued exchange rate. This may be a country in a
fixed exchange rate. For example, Germany is in the Euro, but due to
better German competitiveness than its European neighbours,
Germany has had more competitive exports. The German export
sector has helped strengthen the German economy.
Ceteris paribus, this current account surplus is helping to boost
domestic employment. Because German exports are competitive,
Germany is selling a lot of exports and this is leading to higher
domestic employment in the exporting sector. Without the strong
export demand, the German economy would be weaker and we
would be liable to have higher unemployment.
If you compare it to countries with a large current account deficits in
the Euro, the German economy has done relatively better in terms of
economic growth and employment.
For example, in the mid 2000s, Euro member countries like Greece,
Spain and Portugal were uncompetitive in the Euro. This was one
factor leading to lower economic growth and lower employment in
these countries.
Economists have often argued that Germany should boost consumer
spending to help economic growth in other Euro countries.
Current account surplus and domestic demand
A current account surplus is partly due to high exports, but the other
side of the equation is imports and domestic demand.
A country may have a large current account surplus because of
relatively weak domestic demand. This weak demand leads to lower
consumer spending, and lower spending on imports. Therefore, in
this case, domestic employment will suffer from the weak economy.
The current account is often cyclical. In a boom, we see a rise in the
current account deficit because consumer spending rises, leading to
an increase in imports. During a boom unemployment falls and
inflation rises.
But, in a recession, consumer-spending falls leading to lower imports,
lower inflation, and an improvement in the current account. The
deficit may convert to a surplus, but this is due to the recession, and
therefore leads to higher unemployment
Examples of current account surplus – China, Japan
China had a record current account surplus in the mid 2000s; this
was mainly due to greater competitiveness, helped by an
undervalued Yuan. This was a factor in China’s record economic
growth, and it led to higher employment.
Japan’s current account surplus was due to weak domestic demand,
and a reluctance to buy imports. Japan’s export sector was still one of
strongest sectors of the economy, but this period of a current account
surplus was a period of low growth and weak employment growth.
A current account surplus will tend to boost domestic employment if:
• It is due to an improvement in competitiveness, leading to
higher demand for exports.
• If domestic demand is still relatively strong, but consumers are
buying domestic goods, rather than importing.
A current account surplus could lead to lower domestic employment
• The surplus is caused by a recession, which has hit domestic
demand and led to a fall in import spending.
• In a global recession where a surplus is caused by falling
exports and an even bigger fall in imports.
Source:, accessed Saturday, October 17, 2015
Components of the BOP
1: How would the following transactions affect US exports, imports and net
(a) An American art professor spends the summer touring museums in Europe.
(b) Students in Paris flock to see the latest Hollywood movie starring Keano
(c ) Your American uncle buys a Volvo
(d) A Canadian citizen shops at a store in northern Vermont (USA) to avoid
Canadian sales tax
2: Describe the difference between foreign direct investment and foreign
portfolio investment. Who is more likely to engage in foreign direct
investment – a corporation or an individual investor? Who is more likely to
engage in foreign portfolio investment?
3: How would the following transactions affect US net foreign investment?
(a) An American cellular phone company establishes an office in the Czech
(b) Harrod’s of London sells shares to the General Electric pension fund.
(c) Honda expands its factory in Ohio, USA
4: (a) How does a trade deficit affect the current-account balance?
(b) On which balance-of-payments account does tourism show up?
5: In order for Brazil to service its foreign debts without borrowing more money,
what must be true of its trade balance?
6:Suppose Lufthansa buys $400 million worth of Boeing jets in 2000 and is
financed by the U.S. Eximbank with a five-year loan that has no principal or
interest payments due until 2001. What is the net impact of this sale on the U.S.
current account, capital account, and overall balance of payments for 2000?
Current Account
7: Suppose the United States imposes import restrictions on Japanese steel. What
is likely to happen to the U.S. current-account deficit? What else is likely to
8: In the early 1990s, interest rates worldwide fell. As a net debtor nation, how
should this affect the U.S. current-account balance?
9: During the 1990s, Mexico and Argentina went from economic pariahs with
huge foreign debts to countries posting strong economic growth and
welcoming foreign investment. What would you expect these changes to do
to their current-account balances?
10: In the early 1990s, Japan underwent a recession that brought about a
prolonged slump in consumer spending and capital investment (it was
estimated that in 1994 only 65% of Japan's manufacturing was being used).
At the same time, the U.S. economy emerged from its recession and began
expanding rapidly. Under these circumstances, what would you predict
would happen to the U.S. trade deficit with Japan?
11: What is likely to happen to the value of the dollar as the U.S. current-account
deficit increases?
12: Suppose that Brazil starts welcoming foreign investment with open arms.
How is this likely to affect the value of the Brazilian real? The Brazilian
current-account balance?
13: In order for Brazil to service its foreign debts without borrowing more
money, what must be true of its trade balance?
14:"The U.S. trade deficit is a consequence of the unwillingness of the current
generation of American taxpayers to pay fully for the goods and services they
want from government." Comment.
Connection between the current account and budget position
In 1990, Japan's Ministry of International Trade and Investment (MITI)
proposed that firms be given a tax credit equal to 5% of the value of its
increased imports. The purpose of this tax subsidy is to encourage Japanese
imports of foreign products and thereby reduce Japan's persistent trade
surplus. At the same time, the Japanese government announced that it will
reduce its budget deficit during the coming year.
a. What are the likely consequences of the tax subsidy plan on Japan's trade
balance, the value of the yen, and the competitiveness of Japanese firms?
b. What are the likely consequences of a lower Japanese budget deficit on Japan's
trade balance?
16: During the Reagan era, 1981-1988, the U.S. current account moved from a
tiny surplus to a large deficit. The following table provides U.S. macroeconomic
data for that period.
198 1981 1982 1983 1984 1985 1986 198 1988
500 586 617
641 743 736 721 731 802
-30 -109
718 749
-140 -109 -125 -147 -112
-45 -100 -125 -151 -167 -129
(a) Based on these data, to what extent would you attribute the changes in the
U.S. current-account balance to a decline in the U.S. private savingsinvestment balance?
(b) To what extent would you attribute the changes in the U.S. current-account
balance to an increase in the U.S. government budget deficit?
Current account surplus
17: Currently, social security is minimal in China. Suppose China institutes a
comprehensive social security system. How is this policy switch likely to
affect China's trade surplus?
18: During 1992, Japan entered a recession. However, at the same time, its
current-account surplus hit a record. Is there a contradiction between Japan's
large trade surplus and a weak national economy? Explain.
19: A current-account surplus is not always a sign of health; a current-account
deficit is not always a sign of weakness. Comment on this statement.
Capital Account
20: What happens to Mexico's ability to repay its foreign loans if the United
States restricts imports of Mexican agricultural produce?
21: In a freely floating exchange rate system, if the current account is running a
deficit, what are the consequences for the nation's balance on capital account
and its overall balance of payments?