3.

4: Balance of Payments
Definitions

1. Balance of payments account is a record of the value of all the transactions between the
residents of one country with residents of all other countries over a given period of time,
usually a year.
2. Current account is measure of the flow of funds from trade in goods and services, plus
other income flows. It is usually divided into four parts, namely the balance of trade in
goods, balance of trade in services, income and current transfers.
3. Balance of trade in goods is a measure of the revenue received from the exports of
tangible goods minus the expenditure of the imports of tangible goods over a given
period of time.
4. Balance of trade in services is a measure of the revenue received from the exports of
tangible services minus the expenditure of the imports of tangible services over a given
period of time.
5. Net incomes is a measure of the net monetary movement of profit, interest and dividends
moving into and out of the country over a given period of time, as a result of financial
investment abroad.
6. Current transfers is a measurement of the net transfers of money, which are payments
made between countries when no goods or services change hands.
7. Foreign direct investment (FDI) is a measure of the purchase of the long-term assets by
multinational corporations in another country, where the purchaser aims to gain a lasting
interest in a company in another country.
8. Portfolio investment is a measure of stock and bond purchases, which are not direct
investment since they do not lead to a lasting interest in a company.
9. Expenditure-switching policies are policies implemented by the government that attempt
to switch the expenditure of domestic consumers away from imports towards
domestically produced goods and services. If successful, expenditure of imports will fall
and so the current account deficit will improve.
10. Expenditure-reducing policies are policies implemented by the government that attempt
to reduce overall expenditure of the economy, so shifting AD to the left. Expenditure on
all goods and services should fall, including expenditure of imports, thus improving the
current account deficit.
11. Marshall-Lerner condition states that a depreciation, or a devaluation, of a currency will
only lead to an improvement in the current account balance if the elasticity of demand for
imports plus the elasticity of demand for exports are greater than one.
 12. J-curve effect suggests that in the short term, even if the Marshall-Lerner condition is
fulfilled, a fall in the value of the currency will lead to worsening of the current account
deficit, before things improve in the long term.

The Balance of Payments Account

● Record of value of transactions between residents of one country → residents of all
other countries in the world in a given time period.
● Three main parts: Current Account, Capital Account and Financial Account.
● Transactions entering the country from abroad → Credit → Positive value.
● Transactions leaving the country to go abroad → Debit → Negative value.

Current account
● Measure of flow of funds from trade in goods and services + other income flows.
● Divided into four components:
1. Balance of trade in goods
● Revenue received from exported goods - Expenditure on imported goods.
● Exports = Inflows.
● Imports = Outflows.
● Export revenue > Import expenditure → Surplus.
● Export revenue < Import expenditure → Deficit.
2.Balance of trade in services
● Revenue received from exported services - Expenditure on imported services.
3.Income flows
● Measure of net monetary movement of profit, interest and dividends moving into and out
of the country over a given time period, as a result of financial investment abroad.
● Domestic firms setting up branches in other countries → Positive item.
● Profits sent out of the country by foreign firms → Negative item.
● Payment of interest to foreign investors leaving the country → Negative item.
● Residents and firms receiving dividends from foreign firms → Positive item.
● Any dividends paid by domestic firms to foreign stakeholders → Negative item.
4. Current transfers.
● Net transfers of money.
● No goods or services change hands between countries.
● Examples include subsidies and grants.

CURRENT ACCOUNT BALANCE = BALANCE OF TRADE IN GOODS + BALANCE

OF TRADE IN SERVICES + NET INCOME FLOWS + NET TRANSFERS
Capital Account
● Doesn’t have a significant effect on the balance of payments account.
● Consists of two components:
1. Capital transfers
● Measure of net monetary movements gained or lost.
● Done through actions such as transfer of goods and financial assets by migrants entering
or leaving the country, debt forgiveness, gift taxes, inheritance taxes, death duties.
2. Transactions in non-produced, non-financial assets
● Consists of net international sales and purchases of non-produced assets.
● Examples include purchasing brand names, franchises, copyrights, patents, land, natural
resources, international sales and purchases of intangible assets.

Financial Account
● Measures the net change in foreign ownership of domestic financial assets.
● Increase in foreign ownership of domestic assets → Financial account surplus.
● Increase in domestic ownership of foreign assets → Financial account deficit.
● Consists of three components:
1.Direct investment
● Measure of purchase of long term assets.
● Purchaser is aiming to gain a lasting interest in a company in another economy.
● Examples include buying properties, purchasing firms or buying stocks/shares of a firm.
● Investment doesn’t have to be paid back. Buyer of the asset has all the risk.
● Mostly in form of Foreign Direct Investment (FDI).
2.Portfolio investment
● Measure of stock and bond purchases, which aren’t direct investment.
● Doesn’t leave lasting interest in a company in another economy.
● Buying and selling things such as treasury bills and government bonds.
● Expected to go through the process of borrowing and lending in an international market.
3.Reserve assets
● Movements into and out of this component determines the balance of payments account
reaches zero.
● Surplus in current and financial account → Increase in official reserve account.
● Deficit in current and financial account → Decrease in official reserve account.

IMPORTANT!! There is always transactions that aren’t recorded due to too much
transactions going on at the same time. So in order to balance out the balance of payments
account, “NET ERRORS AND OMISSIONS” is added to the accounts to make sure the
account does balance.
Relationship between Current Account and Exchange Rate
● Deficit in the BOP account → Downward pressure on the exchange rate of the
currency.
❖ In fixed exchange rate regime, implication is that the value of the currency is too high.
★ In the short run, deficit is covered by increases in capital and financial accounts +
government using reserve assets to balance the accounts.
★ This can’t go on since reserve assets will run out, so exchange rate → depreciated.
❖ In floating exchange rate regime, implication is that there’s an excess supply of the
currency in the foreign exchange markets.
★ Cause might be fall in demand for exports → fall in demand for currencies → increase
in demand for imports → increase in demand for foreign currencies → greater supply
of domestic currency on the foreign exchange market.
● Surplus in the BOP account → Upward pressure on the exchange rate of the
currency.
❖ In fixed exchange rate regime, implication is that the value of the currency is too low.
★ In the short run, this may offset by deficits on the capital and financial account or
increases in the reserve assets.
★ Other countries will be unhappy with artificially low exchange rate → demand
higher rates or threaten protectionist measures against the country’s exports.
❖ In floating exchange rate regime, implication is that there’s an excess demand of the
currency in the foreign exchange markets.
★ Cause might be rise in demand for exports → rise in demand for currencies →
decrease in demand for imports → decrease in demand for foreign currencies → lower
supply of domestic currency on the foreign exchange market.

Consequences of current account deficit

1. Foreign exchange reserves may be used to increase capital account and so to regain
balance with a deficit in the current account.
● Reserves taken out of the official reserves account → positive item in capital account.
● Eventually all reserves run out, no matter how rich or poor a country is.
2. High level of purchasing assets for ownership for financing the current account deficit.
● Inflows in the capital account are funding the current account deficit.
● Might lead to economic sovereignty due to foreign countries believing their ownership of
domestic assets was too great.
● Fall in confidence → foreign investors shifting assets to other countries.
● Selling assets → increases supply → fall in its value.
3. High level of lending from abroad for financing the current account deficit.
 ● High interest rates → Short-term drain → Increase current account deficit.
● Lead to massive selling of currencies and sharp fall in the exchange rate.

Consequences of current account surplus

1. Allows a country to have a deficit on its capital account by building up its official reserve
account or by purchasing assets abroad.
● One country’s deficit = Another country’s surplus.
● Might lead to protectionism by other countries to reduce their own deficits.
2. Leads to appreciation of the currency on the foreign exchange market due to increase in
demand for the currency.
● Results in cheaper imports → Reducing inflationary pressures.
● Costlier exports → Harms exporting industries.

Methods of correcting a persistent current account deficit

1. Expenditure-switching policies
● Policies implemented by the government that attempt to switch expenditure of
domestic goods away from imports → domestically produced goods and services.
● If successful, expenditure on imports falls → Improves current account deficit.
● Examples include:
❖ Government policies to depreciate/devaluate the value of the currency
★ Exports → Less expensive.
★ Imports → More expensive.
❖ Protectionist measures
★ Reducing availability of imports by quotas, embargoes, export restraints, administrative,
health and safety, environment barriers.
★ Increase prices using tariffs.
★ This leads to domestic consumers switching their spending from imports → domestic
goods.
● Governments are reluctant to use these policies as it leads to retaliation and often are
against World Trade Organization’s agreements.
● Protecting domestic industries → reduces competition → encourage inefficiency.
 2. Expenditure-reducing policies
● Policies implemented by the government that attempt to reduce overall expenditure in the
economy.
● Decreasing aggregate demand in an economy → shifting AD curve to the left.
● Expenditure on all goods and services, including imports falls → improvement in the
current account deficit.
● Size of fall in imports depends on level of marginal propensity to import.
● Reducing current account deficit → Fall in domestic employment → Fall in rate of
economic growth.
● Examples include:
❖ Deflationary fiscal policies
★ Increasing direct tax rates and reducing government expenditure.
★ Unpopular decision for the government to make.
❖ Deflationary monetary policies
★ Increasing interest rates or reducing money supply.
★ High interest rates → Increase capital flows from abroad as foreigners put money into
financial institutions attracted by higher rates → Surplus on the capital account →
Improve the current account deficit.
★ High unpopular decision as well.

Marshall-Lerner Condition
● A rule that tells how successful a depreciation or devaluation of a country’s exchange rate
will be as a means to improve a current account deficit in the balance of payments.
● Reducing the value of the exchange rate will only be successful if the total value of PED
for exports and PED for imports is greater than one.
● PEDimports + PEDexports > 1
● If PED for exports was inelastic and price fell as a result of a fall in the exchange rate
→ Proportionate increase in the quantity of exports demanded < proportionate
decrease in the price of exports → export revenue would fall.
● If PED for exports was inelastic and price rose as a result of a fall in the exchange rate
→ Proportionate fall in the quantity of imports demanded < proportionate increase in
the price of imports → import expenditure would increase.
J-curve effect
Paper 3 Question

Complete the balance of payments account for Country X.

Line Balance of Payment Figures in millions of US$ 2011 Notes

1 Current Account

2 Export of goods 387,800

3 Import of goods -661,200

4 Balance of trade in goods -273,400 1+2

5 Export of services 162,800

6 Import of services -122,400

7 Balance of trade in services 40,400 5+6

8 Income receipts 276,500

9 Income payments -243,400

10 Net income receipts 33,100 8+9

11 Current transfers, net -38,500

12 Net income flows -5,400 10 + 11

13 Current account balance -238,400 4 + 7 + 12

14 Capital account

15 Capital account transactions, net 130

16 Financial account

17 Direct investment, net 105,885

18 Portfolio investment, net 84,700

19 Reserve assets funding 21,315

20 Errors and omissions 26,500

21 Capital and financial account balance 238,400 13 = 21