Balance of Payments
A Macroeconomic objective
We previously looked at how the Balance of Payments are measured. If you haven't read that page yet, please click here.
We should know by now that the Balance of Payments are comprised of sub-accounts: the current account and capital account and financial account.
(You need to be aware of the capital account and financial account, but don't need to know too much about them at this level. However, you will definitely need to know about the current account, which we will examine on this page)
The Current Account
The current account is made up of a number of different transactions:
Trade in goods
Trade in services
Income flows
Net transfers
Trade in goods - measures the value of goods imported and exported (also known as visible trade)
Trade in services - measures the value of services imported and exported (also known as invisible trade)
[Trade in Goods + Trade in Services = Trade Balance]
Income flows - this measures income coming in to a country and income leaving the country. In this case, income would be defined as income from employment (salaries) or income from investments abroad e.g. deposits in foreign banks generate interest. Profits received from abroad would also be treated as income. These are also known as dividend payments.
Net transfers - this would include transfers made to family members abroad or payments made from governments to foreign countries
If we add up all of these sections, we form the current account balance. The current account balance can be in deficit (negative) or surplus (+).
If the current account is in deficit, then it means that more money is flowing out of the current account than is coming in.
If the current account is in surplus, then it means that more money is flowing into the current account than is coming in.
Causes of BOP Surplus and Deficit
Level of spending saving: if saving levels in a country are low, it will mean spending is high. This will contribute to more short-run economic growth, boosting national income. In turn, this means that people are spending more and will be buying more imports. [Remember, this is if income elasticity of demand is positive]
Therefore, if a country spends a lot and doesn't save enough, a current account deficit is likely.
However, if there has been an economic recession, then the country is more likely to lean towards surplus. This is because consumers have less income available to spend on imported goods. Furthermore, local producers may start trying to sell to foreign customers, because customers at home are broke!
International competitiveness: if a country is not very competitive internationally, then it will likely not be able to sell to enough foreign customers and generate export income.
What affects competitiveness?
Cost of production: a country will be more competitive is costs are low
Level of technology: a country can be more competitive if the level of technology is more advanced
Productivity levels: a country can be more competitive if labour productivity is higher
Level of inflation: a country can be more price competitive with lower rates of inflation, as prices are rising at slower rates compared to other countries
Exchange rate: a country can be more competitive if its currency is cheap to purchase. If the exchange rate is lower, then the country can be more price competitive
Therefore, if costs of production are high, productivity low, inflation high, exchange rate high and the rate of technological advancement is low -> this can all lead to a current account deficit.
External shocks
Raw material prices
Large changes in the availability and price of commonly demanded raw materials can have an effect on the balance of payments. For example when oil prices rise, then the value of imports is likely to rise for a net importer of oil (like the UK). This is because oil is price inelastic - we need oil to continue living the way we do. So if oil prices rise, we are still likely to purchase similar quantities of oil as it is considered a necessity.
Therefore, if you are dependent on raw materials from abroad, then shocks to raw material prices can leave your country in a current account deficit.
State of the world economy
If there is a global recession, then it is likely that your country will see a reduction in exports. This is because income abroad is falling, and people are demanding less.
On the other hand, if there is an economic boom abroad, then it is likely your country will export more, as your customers now effectively have more money in their pockets.
Trade barriers
Trade barriers between countries can have an effect on the BOP. If trade barriers are set up in other countries, then it can reduce the number of exports you are selling. If trade barriers have been set up in your country, then this can reduce the number of imports from abroad.
In summary, we have learned:
The BOP sub-accounts
Causes of Surplus and Deficit
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