Balance of Payments
The balance of payments
The balance of payments is a financial record of a country’s transactions with the rest of the world for a given time period, usually over I year. This includes the country’s trade in goods and services with other countries.
The current account
One of the components of the balance of payments is the current account, which is a record of all exports and imports of goods and services between a country and the rest of the world.
The current account is structured in three parts.
Visible trade balance
The visible trade balance is a record of the export and import of physical goods. It is also known as the balance of trade in goods. It is the trade in goods, such as raw materials, semi-manufactured products and manufactured goods. Visible exports are goods that are sold to foreign customers, with money flowing into the domestic economy.
Invisible trade balance
The invisible trade balance is a record of the export and import of services (intangible products), such as banking, insurance, shipping and tourism. It is sometimes called the balance of trade in services.
Net income flows and transfers
Net income flows and transfers arc a record of a country’s net income earned from capital flows. Examples include:
• interest, profits and dividends paid to foreigners who own assets in the country
• income earned on foreign assets owned by domestic residents and firms
Examples of transfers include:
• money spent on foreign aid
• money sent home by people working abroad
• taxes received by the government from foreign residents and firms
• bank deposits held in overseas banks.
Current = visible trade balance + invisible trade balance + net income flows and transfers
Net income flows and transfers = income flows and transfers – income flows and transfers sent overseas
Current account deficit
A country is said to have a current account deficit if its financial outflows are greater than its financial inflows. Hence, the current account has a negative balance. By contrast, a current account surplus exists if the financial inflows are greater than its financial outflows. This means the country will have a positive balance on its current account.
Causes of current account deficits
A deficit on the current account can occur due to a combination of two factors:
Lower demand for exports – This could be caused by a decline in manufacturing competitiveness, perhaps due to higher labor costs in the domestic economy.
Another factor is declining incomes in foreign markets, perhaps due to an economic recession. This means households and firms have Jess money available to spend on another country’s exports. A third cause of low demand for exports is a higher exchange rate
Increased demand for imports – Domestic buyers tend to buy more imports if they are cheaper or of better quality.
Consequences of current account deficits
Reduced aggregate demand – A trade deficit means the economy is spending more money on imports than it receives from the exports of goods and services. This can cause aggregate demand in the economy to fall, thus triggering a recession
Unemployment – As the demand for labor is a derived demand, a fall in aggregate demand is likely to cause unemployment in the economy. Workers may also have to take a pay cut in order to correct the deficit.
Lower standards of living- If current account deficit is caused by a negative balance on net income flows and transfers, this means monetary outflows exceed monetary inflows for the country. An economy with less income is likely to suffer from lower standards of living. In addition, to cut the current account deficit, households and firms may need to reduce their spending.
Increased borrowing- Just like an individual cannot spend more than he or she earns in the Jong run, countries need to borrow money or attract foreign investment in order to rectify their current account deficits. In addition, there is an opportunity cost of debt repayment, as the government cannot use this money to stimulate economic growth.
Lower exchange rate – A fall in demand for exports and/or a rise in the demand for imports (causing the current account deficit) reduces the exchange rare. While a lower exchange rate can mean exports become more price competitive, it also means that essential imports (such as oil and foodstuffs) will become more expensive.
Dealing with current account deficits
There are four main policies that can be used to import a country’s current account balance:
Fiscal policies – These measures use a combination of higher taxes and reduced government spending in order to reduce the amount of money available to spend on imports.
Monetary policies – Higher interest rates make new and existing loans more expensive for households and firms. Therefore, this reduces their demand for imports.
Supply-side policies – These policies strive to raise the productive capacity of the economy. Examples are:
- investment in education and health care to improve the economy’s human
capital, productivity and international competitiveness
- investment in infrastructure to support businesses and industries, especially
those engaged in export markets
- measures to encourage export-driven business start-ups and industries, such as government subsidies and tax incentives
Protectionist measures – These measures reduce the competitiveness of imports,
thereby making domestic consumption more attractive.
Current account surpluses
Causes of current account surpluses
A surplus on the current account can occur due to a combination of two factors:
• Higher demand for exports – This could be caused by an improvement in manufacturing competitiveness, perhaps due to higher labor productivity in the domestic economy. Another factor is higher incomes in overseas markets, meaning that foreign households and firms have more money to spend on the country’s exports. A third cause of higher demand for exports is a lower exchange rate
• Reduced demand for imports – Domestic buyers rend to buy fewer imports if they are more expensive or of lower quality than those provided by domestic firms. For example, a lower exchange rare means the domestic currency can buy less foreign currency, so this makes it more expensive to buy imports.
Consequences of current account surpluses
The consequences of a country having a current account surplus include the following:
• Employment – A sustained current account surplus can be desirable, as higher export sales help to create jobs.
• Standards of living – A favorable current account balance means the country reaches a higher income because domestic firms have a competitive advantage in the products they export.
• Inflationary – Higher demand for exports can lead to demand-pull inflation
• Higher exchange rate – The higher demand for exports can cause the currency to appreciate in value