•
• analyse the causes of imbalances on the balance of payments;
• evaluate policies to correct imbalances on the balance of payments;

• The Balance of Payments is a record of all economic transactions between an economy and the rest of the international economy over a period of time
Money coming in is shown as a credit (positive) and money leaving the country is shown as a debit
(negative).

(called the financial account in the UK)

• Current account deficit or surplus

+
+
=
CURRENT ACCOUNT BALANCE
The current account is concerned with money incomes

INVESTMENT (direct and portfolio)
+
OTHER FINANCIAL FLOWS (deposits in banks, loans)
+
RESERVE ASSETS (foreign exchange reserves, reserve position in IMF, Special Drawing Rights and gold.)
=
CAPITAL ACCOUNT BALANCE
The capital account is concerned with the purchase and sale of assets

• Account that reflects the actual investments by domestic residents abroad and investments by non-
residents in the country (Inward Foreign investment is a credit, Investment abroad is a debit)
• Direct investment – transfer of ownership of domestic and foreign businesses e.g. the setting up of a UK company abroad and the expansion of a foreign-owned firm in the UK
• Portfolio investment – covers purchases of government bonds, treasury bills, stocks and shares
• Other investment – bank deposits and loans between banks and governments

• Reserve assets – changes in government reserve assets (foreign exchange reserves, reserve position in IMF, Special Drawing Rights and gold.)
• Drawing on reserves represents a credit , money drawn from the reserves represents an inflow
(even though it is an outflow from the reserve account)
• The reserves can be used to support a deficit elsewhere in the BofP
• Conversely if there is a surplus elsewhere in the
BofP, the Central Bank (Gov) can use it to build up the reserves

• Capital transfers – government investment, grants overseas and debt forgiveness
• Acquisition/disposal of fixed assets – eg, land purchased or sold by foreign embassy, purchases and sales of patents, copyrights, trademarks, franchises and leases
• Transfers of funds by migrants

If all transactions are included, the payments and receipts of each country are, and must be, equal.
+
CAPITAL ACCOUNT BALANCE
+
=
+
NET ERRORS AND OMISSIONS
(BALANCING ITEM)
= 0
Balance ensured by balancing item – Net errors and omissions.

‘The Balance of Payments always balances’
• If a family spends more than its income (debits are greater than credits) it will be in deficit.
• It cannot spend more than its income unless it borrows, reduces its savings or sells some of its assets
• These transactions are included as credit items, thus the account will balance
• Similarly if credits are greater than debits there will be a surplus.
• A balance sheet simply records where the surplus goes- eg increases savings, repays loans…
• These transactions are included as debit items, thus the account will balance

• If outflows exceed inflows (i.e. there is a deficit), the account will be balanced by withdrawals from the foreign currency reserves, by borrowing from overseas, or by the sale of external assets
• These count as inflows
• If inflows exceed outflows (i.e. there is a surplus(, the account will be balanced by items which show how the surplus has been distributed, for example, by
• Additions to the foreign currency reserves, the repayment of overseas loans or the purchase of external assets

Ensures the Bof P balances
Also known as the ‘balancing item’
Necessary due to human error, the volume of transactions coupled with differing time periods involved, exchange rate conversion errors and accounting/recording procedures in different countries.

Balance of Payments – Full Account (2007)
CURRENT ACCOUNT (A)
£m
–52 568
CAPITAL ACCOUNT (B) 2 641
FINANCIAL ACCOUNT (C)
OVERALL BALANCE = A + B + C =
NET ERRORS AND OMISSIONS (BALANCING FIGURE)
39 830
-10 097
10 097
Balance of payments – Current Account
Net Trade in Goods (Visible)
Net Trade in Services (Invisible)
£m
–89 252
41 772
NET TRADE (Visible & Invisible) (A) –47 480
TOTAL INCOME (Net Income from abroad) (B)
CURRENT TRANSFERS (C)
CURRENT ACCOUNT BALANCE = A + B + C =
8 606
–13 694
–52 568

• P224 Q1

50
Components of the UK Balance of Payments
Annual balances for each component, £ billion
50
-50
-75
25
Trade in Services
0 Investment income
-25 Current account
Transfers
Trade in Goods
25
-100
97 98 99 00 01 02 03 04 05
-100
06 07
Source: Reuters EcoWin
0
-25
-50
-75

UK Balance of Trade in Goods and Services
Seasonally adjusted, quarterly trade balance, £ billion
15
10
5
0
-5
Trade in services
Trade in goods
15
10
5
0
-5
-10 -10
-15 -15
-20 -20
-25 -25
88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08
Source: Reuters EcoWin

USA and UK BoP - Current Account
As a percentage of GDP
1
0
-1
-2
-3
USA
UK
1
0
-3
-4
-5
-6 -6
-7 -7
95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
Source: Reuters EcoWin
-4
-5
-1
-2

• Handout- Deficits and surpluses

• Undesirable to have a deficit on all accounts- would have to be covered by borrowing from abroad (or attracting investment maybe by increasing i/r) or drawing on reserves- all undesirable options
• Can be seen as undesirable to have a
CA deficit (even if surplus on other accounts)

• High consumer demand for imports- eg. as incomes rise imports of luxury goods tend to increase
• High level of investment spending- imports of capital
• Shifts in comparative advantage in the international economy – eg. the rapid growth of
China as a source of exports of household goods causing it to be cheaper to import goods and services rather than produce them domestically

• A high exchange rate- imports become cheaper thus demand for imports rises, exports become more expensive, thus demand for exports falls
• Structural weaknesses in the economy- domestic firms experiencing reduced international competitiveness due to lack of investment, high labour costs or low productivity meaning reduced exports

• A CA deficit means there is a net outflow of demand and income from the circular flow of income
• A worsening deficit means a fall in AD
(increased withdrawals (M))
• Likely to increase unemployment and put downward pressure on prices
• A fall in business confidence and investment
• A depreciation of the e/r as less £ are demanded for UK exports

Interpreting Balance of Payments figures
• When looking at the significance of a
deficit on the trade in goods and services balance, you need to consider its
• Size
• Duration
• Cause

Interpreting Balance of Payments figures
• A large deficit that has persisted for a long time is likely to be more serious than a small short term deficit
• If a country imports more than its exports
(and this is due to products which are not price competitive and/or of poor quality), then the deficit is unlikely to be selfcorrecting
• If the deficit is due to a country importing a large amount of raw materials to be converted into finished products (and some of these products end up being exported), then the deficit, will probably be short-lived

The balance of payments and living standards
• Current account deficits are not always bad for an economy.
• In the short term, a deficit can boost living standards, as consumers buy a higher level of consumer durables etc.
• In the long term, may be a symptom of a weak economy, reflecting lack of international competitiveness. If imports keep on rising, domestic jobs, income and hence living standards can fall

• Using your books and the article explain how a CA deficit can be reduced
• Expenditure Switching Policies
– Eg. Devaluation/depreciation and/ or protectionism
• Expenditure Reducing Policies
– Eg. Deflationary fiscal and/ or monetary policies

• Handout

• Allows countries to have a deficit on financial and capital account, by building up official reserve account or purchasing assets abroad- can lead to international disagreements and protectionism
• A CA surplus normally leads to an appreciation of a currency- can be good for imports and contribute to lower inflation, bad for exporters