GN.AEC, Economics, Gr.

11 Page 1

Unit24.TheBalanceof
Payments
A country engaged in foreign trade will be making payments to
foreign countries and receiving payments. Each nation keeps an
account of its transactions with the rest of the world, which it
presents in the form of a balance sheet called the balance of
payments.

The balance of payments is an account of a countrys payments to

and receipts from the rest of the world during a period of time. Or
the balance of payments is a record of a countrys financial
transactionswiththerestoftheworldduringaperiodoftime.

Thestructureofthebalanceofpayments
The balance of payments account is classified into two main
sectionscurrentaccountandthecapitalandfinancialaccount.

Currentaccount
Thecurrentaccountofthebalanceofpaymentsismainlyconcerned
withtheearningsandspendingofacountry.Ithasfourcomponents:
Tradeingoods,Tradeinservices,IncomesandCurrenttransfers.

1. Trade in goods (Visible trade): This refers to trade (exports and

imports) in physical goods (e.g. cars). The difference between the
value of exports and imports of physical goods is known as the
balanceoftradeingoods(Balanceoftradeorvisiblebalance).

2. Trade in services: This refers to trade (export and import) in

intangibleservicessuchasbanking,insurance,transport,education,
health service, tourism and entertainment. The difference between
the value of exports and imports of services is known as balance of
tradeinservices.

When the trade in goods balance is added to the trade in service

balance the result is known as the balance of trade in goods and
services. When the total value of exports is greater than the total
value of imports, it will have a surplus balance and if the value of
importsisgreaterthanthevalueofexports,thebalanceoftradein
goodsandserviceswillbeindeficit.

3. Incomes: The incomes account includes the flow of money

between one country and the rest of the world in the form of rent,
wages or salaries, interests and profits or dividends. The difference
between income credits (inflows) and income debits (outflows) is
knownasbalanceonincomesaccountornetincomes.

4. Current transfers: This includes the flow of money between one

countryandtherestoftheworldintheformofgiftsandgrants.The
difference between transfers credits (gifts and grants received) and
transfers debits (gifts and grants paid) is known as balance on
currenttransfersornettransfers.

Current account balance: The current account balance is equal to

the balance of trade in goods plus balance of trade in services plus
netincomesplusnettransfers.

Deficitsandsurpluses
The nations earnings from the exports of goods and services and
receipts of incomes and current transfers are credit items and are
entered with a plus sign. Its spending on imports of goods and
services and payments of income and current transfers are debit
itemsandareenteredwithaminussign.Whenthesumofallthese
debit () items exceeds the sum of all these credit (+) items, the
nation has a deficit on the current account of its balance of
payments(equaltothedifference).
Ifthetotalvalueofthecredititemsisgreaterthanthetotalvalueof
thedebititemsthecurrentaccountwillhaveasurplus.

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CapitalandFinancialaccount
The capital account includes capital transfers such as aid given to
foreign countries for capital projects and the purchase and sale of
nonproduced and nonfinancial assets such as land, copyrights,
trademarksandpatents.Itisarelativelysmallsection.

The financial account is mainly concerned with investment flows. It

isdividedintofourcategories.
Direct investment: This includes flows of foreign direct
investment made mainly by MNCs (e.g. Nissan builds a new
carplantintheUK).
Portfolio investment: This includes the purchase and sale of
sharesandgovernmentsecurities.
Other investment flows: These include the flow of deposits
andloansbetweentheresidentsofthenationandtherestof
theworld.
Reserve assets: This includes changes in the countrys gold
andforeigncurrencyreserves.

Capital and financial transactions bring about changes in the

countrysexternalassetsandliabilities.Forexample,borrowingfrom
overseas increases our stock of foreign currency, but increases our
external liabilities. Buying property overseas increases our external
assetsbutreducesourstockofforeigncurrency.

Balancingitem
Thebalanceofpaymentsisabalancesheetandlikeallotherbalance
sheets it must balance. Since the account balances, the total of the
credititemsmustbeequaltothetotalofthedebititems.However,
inpracticebecauseofmistakesandfailuretorecordallitems,there
is always a discrepancy. The net errors and omissions (or balancing
item)istheamount,whichisrequiredtobringtherecordedbalance
of payments into balance. A positive balancing item means that
therehasbeenanunrecordednetinflowofforeigncurrency.

Causes of deficits on goods and services balance (or

currentaccountorbalanceofpayments)
Currentaccountdeficitsaremainlycausedbylossofpriceandnon
pricecompetitivenessofhomeproductsorchangesintheratesof
economicgrowth.Thefollowingaresomeofthereasonsfora
currentaccountdeficit.

High level of income (high rate of economic growth) in the home

country:Thisincreasesthedemandforimportedfinishedgoodsand
rawmaterialsandreducesexports.

Low level of income (recession) abroad: This reduces exports and

mayincreaseimports.

Highrateofexchange:Thiswillmakeexportsexpensiveintermsof
foreigncurrencyandimportscheaperintermsofdomesticcurrency.
Thiswillleadtoafallinexportsandanincreaseinimports.

Highrateofinflation:Iftherateofinflationinthehomecountryis
higherthanthatinothercountries,ourexportswillfallandimports
willrise.Thiswillresultinacurrentaccountdeficit.

Loss of price competitiveness: This may be caused by a rise in

labour cost, fall in productivity, high rate of inflation and a high
exchangerate.

Loss of nonprice competitiveness: These include quality, design,

reliabilityandaftersaleserviceofhomeproductsinrelationtothose
of foreign products. Other things being equal a fall in nonprice
competitiveness worsens the current account of the balance of
payments.

Decliningcomparativeadvantage:Thecomparativeadvantage(the
ability of a country to produce a commodity at a lower opportunity
cost than other countries) is subject to change with changes in
technology and the finding of new resources. The UK lost its
GN.AEC, Economics, Gr.11 Page 3

comparative advantage in many manufactured products because of
thelowcostproductioninnewlyindustrializedcountries.

Fall in the prices of important mineral: Some countries rely heavily

on the export of certain primary products whose demands are
inelastic.Afallinthepricesoftheseproductscancauseasharpfall
in total export revenue and deterioration in the countrys current
account.

Effectsofacurrentaccentdeficit
Intheshortrunadeficitwillincreaselivingstandards.Thisis
because the country will be consuming more goods and
servicesthanitproduces.
Adeficitwillalsoreduceinflationarypressureasitinvolvesa
netleakageofincome.
However, in the long term a current account deficit would
weaken the domestic economy. If the value of imports is
greaterthanthevalueofexports,itwillreducetheaggregate
demand.Thiswillraiseunemploymentandreduceeconomic
growth.Thestandardoflivingwillfallinthelongterm.
Another problem is that the country may need to borrow or
attract foreign investment in order to finance the current
account deficit. This will later lead to an outflow of foreign
currency in the form of interest, dividends and profits
therebyworseningthecurrentaccountinthefuture.
A current account deficit may also lead to a fall in the
exchangerateofthecountryscurrency.

However, the effects of current account deficits depend on the

following.
ThesizeofthedeficitThesizeofthedeficitasapercentage
of the GDP or as a percentage of the countrysexports value
isimportant.Arelativelysmalldeficitonthecurrentaccount
maynotbeaproblem.
Whether the deficit is persistent or periodical: A persistent
deficit on the current account is likely to have more harmful
effectsthanadeficitintheshortterm.
The cause of the deficit: For example, a deficit which is
caused by the import of capital equipments is likely to have
less harmful effects than a deficit caused by import of
consumergoods.Thisisbecause,theimportofcapitalgoods
willincreaseoutputandleadtomoreexportsinthelongrun.
Policiestoreduceabalanceofpaymentsdeficit

Expenditurereducingpolicies
Expenditure reducing policies are those which aim to reduce
aggregatedemand.Theyincludefiscalpolicyandmonetarypolicy.

Deflationaryorcontractionaryfiscalpolicy:Thisinvolvesincreasing
taxation and reducing government spending. These measures will
reduce aggregate demand and lead to a fall in imports and an
increase in exports as domestic firms find it more difficult to sell in
thehomemarketandmakegreatereffortstosellinforeignmarkets.
Afallinaggregatedemandmayalsoreducepricelevelandincrease
thepricecompetitivenessofthehomeproducts.

Deflationary or contractionary monetary policy: This involves

increasing the rate of interest or reducing the supply of money. A
rise in the rate of interest encourages saving and discourages
borrowing. As a result the demand for both consumer goods and
capitalgoodswillfall.Afallinaggregatedemandwillreduceimports
and increase exports and improve the current account of the
balance of payments. A high rate of interest is also likely to attract
short term capital inflow which in turn improves the capital and
financialaccountofthebalanceofpayments.

Deflationary policies are likely to reduce demand pull inflation. On

the other hand, they also reduce economic growth and increase
unemployment.

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Expenditureswitchingpolicies
Expenditureswitchingpolicyisonewhichseekstoredirectspending
from foreign goods and services towards domestically produced
goodsandservices.E.g.devaluationandimportcontrols.

Protectionism (import controls): Protectionism refers to the

governmentpoliciestoreduceimportsbytheuseoftariffsandnon
tariffbarriers.Tariffs,quotas,exchangecontrolandothermeasures
canbeusedtoreduceabalanceofpaymentsofdeficitsbyreducing
imports. They also increase the demand for home products and
increasedomesticemploymentandgrowth.Ontheotherhand,they
raise inflation and invite retaliation. Another problem is that a
countrys freedom to employ import restrictions is limited by the
membershipofWTOoratradeblocsuchastheEU.

Devaluation:Thegovernmentmayreducetheexchangerateofthe
home currency in order to reduce the deficit on its balance of
payments. Devaluation will change the relative prices of imports
and exports. Exports will become cheaper in terms of foreign
currencyandimportswillbecomedearer(moreexpensive)interms
ofhomecurrency.Thiswillleadtoanincreaseinexportsandafallin
importsandreducecurrentaccountdeficits.
Devaluation will also increase the demand for domestic goods and
services and increase domestic employment and economic growth.
Themaindisadvantageofdevaluationisthatitmayraiseinflation.

However, devaluation can only be successful in reducing a current

accountdeficitif:
Majortradingrivalsdonotdevaluetheirowncurrencies.
The combined price elasticities of demand for exports and
imports (PED
X
+ PED
M
) are greater than one (Marshall
Learner condition). In the short run, the price elasticities of
demand for exports and imports are very low (inelastic).
Therefore, in the short term devaluation is likely to lead to
deterioration in the current account position before it starts
toimprove.ThisiscalledJcurveeffect.

Supply side policies: Supply side policies tend to be longterm

policies. They cannot cure a current account deficit within a short
period.Theyincludethefollowing.
Measures to reduce labour cost e.g. increasing investment
andlabourproductivity
Measures to improve the quality and design of the products
e.g.grantstoencourageresearchanddevelopment
Measures to develop modern and sunrise industries e.g. by
givingfinancialassistance
Measurestoimprovemarketinge.g.promotingtradefairs
Measurestoreducetherateofinflation

Financingacurrentaccountdeficit
A current account deficit can be covered in one or more of the
followingmethods:
Borrowingfromoverseascentralbanks
Borrowing from international organizations such as the
InternationalMonetaryFund(IMF)
Takingmoneyfromtheofficialreservesofforeigncurrency
Sellingthecountriesassetsabroad

Distributingacurrentaccountsurplus
A current account surplus may be used in one or more of the
followingways:
Tomakeloanstooverseasresidentsortorepayoverseas
Toincreasethenationsforeigncurrencyreserves
To buy assets abroad (e.g. to buy land and building in other
countriesortobuysharesinforeigncompanies)