BALANCE OF PAYMENTS

Learning Objectives:
1.
Describe the components of the balance of payments;
2.
Identify the different types of imbalance within the balance of payments;
3.
Explain the causes of imbalances within the balance of payments;
4.
Identify the policy measures for correcting imbalance within the balance of
payments.
During a given year, Jamaicans like nationals of other countries, engage in a vast number
and variety of transactions with residents of other countries. They import, export, engage
in service transactions, receive or send gifts abroad, obtain net income from overseas,
receive loans or make payments on loans received and undertake or receive foreign
investment.
All these transactions together comprise the international trade and payments of
Jamaica. However, to analyze and evaluate these transactions they must be classified and
aggregated to make a Balance of Payments (BOP) statement.
The Balance of Payments is a summary of all economic
transactions between domestic and foreign residents during
a given period of time, usually one year.
The main purpose of keeping these records is to inform government authorities of the
overall international economic position of the country in order to assist them in arriving
at decisions on monetary and fiscal policy, on the one hand, and trade and payments
policy on the other. -Balance of payments statistics are therefore helpful to government
authorities charged with maintaining macroeconomic stability.
Principles and Concepts
Balance of payments accounting is governed by a set of principles and conventions that
ensures the systematic and coherent recording of transactions, which are consistent
across countries and over time. These principles and concepts will be discussed and
where necessary practical examples will be used to explain the concepts. They are:
1.
2.
3.
4.
1.

Double Entry System

Concept of Economic territory and Residence
Valuations and Time of Recording
Concept of Economic Transactions

Double Entry System

The balance of payments is constructed according to the principles of double-entry

bookkeeping. Under this system a transaction is represented in the balance of payment by
two entries with equal values. One of these entries is designated a credit and the other a
debit.
There are some basic rules governing how entries are recorded in the balance of
payments. A credit entry is recorded when the transaction gives rise to a receipt by a
domestic resident from a foreign resident. The receipt itself may take the form of an
increase in the resident's foreign assets or balances of foreign currencies. Whatever its
form, the receipt is recorded as a debit entry. Conversely, any transaction that gives rise
to a payment by a resident to a foreign resident is recorded as a debit entry. The payment
that results from this transaction is recorded as a credit entry.
The double entry approach can be demonstrated with some hypothetical examples.
Example 1
Let us assume Alcoa, a mining company in Jamaica exports US$2.0m worth of bauxite to
Jimpex a company in the USA and Jimpex pays for the bauxite by depositing US$2.0m to
Alcoa's bank account. Table 1 shows the entries that would be made in Jamaica's
balance of payments:

Exports will appear as a credit entry because they give rise to receipts from abroad and
the receipt, which represents a claim on non-residents, appears as a debit entry in the
financial account.
Conversely, imports of foreign goods and services will appear as debits in the balance of
payments as these transactions give rise to payments to the rest of the world. The
corresponding payments, which resulted from the increase in liabilities to foreigners, are
recorded as credit entries.
To illustrate, let us assume Jamaica imports US$150 million worth of oil. In the balance
of payments of Jamaica (see table 2) the oil import is recorded as a debit entry, as it gives
rise to a payment by a resident to a non-resident. The corresponding payment, which
resulted from the increase in Jamaica's liabilities to foreigners, is recorded as a credit
entry.

Example 2
Let us now assume that Jamaica borrows US$100 million dollars from the World Bank
and the proceeds of the loans are deposited at the Bank of Jamaica (BOJ). Table 3 shows
the entries that would be made in Jamaica's balance of payments:
Table 3

The loan, which gives rise to a receipt is recorded in the balance of payments of Jamaica
as a credit entry and the actual proceeds from the loans - the foreign currency receipt- is
recorded as a debit entry.
If all the principles of the BOP manual are adhered to then the sum of all the credit
entries should be identical to the sum of all the debit entries and the net balance of all
entries in the BOP statement, including changes in the reserves of the Central Bank,
should be zero. In practice, however, when all the actual entries are summed the resulting
balance will invariably show a net credit or a net debit. That balance is the result of
incomplete coverage of transactions, use of non-uniform prices and inconsistent times of
recording and conversion practices.
The custom in BOP accounting is to show the net balance of all the actual transactions as
"net errors and omissions". This entry is equal to the difference in the credit and debit
entries, but with the sign reversed. Thus if the balance of the recorded components is a
credit, the item for net errors and omissions would be shown as a debit of equal value and
vice versa.

The custom in BOP accounting is to show the net balance of all the actual transactions as
"net errors and omissions". This entry is equal to the difference in the credit and debit
entries, but with the sign reversed. Thus if the balance of the recorded components is a
credit, the item for net errors and omissions would be shown as a debit of equal value and
vice versa.
Relatively large and persistent net errors and omissions are cause for concern as they are
indicative of statistical error, major discrepancies or improperly recorded information.
2.

Concept of Economic Territory and Residence

The identification of transactions between residents and nonresidents underpins the

balance of payment compilation process. For balance of payments purposes, the concept
of residence is not based on nationality or legal criteria but rather on the transactor's
centre of economic interest. Of importance too is the necessity to identify the economic
territory of the country to which the concept of residence is to be applied. This is so as
the boundaries recognized for political purposes may not necessarily coincide with those
for economic purposes.
A country's economic territory consists of a geographic area, administered by a
government. In addition to including the air space, and territorial waters over which the
country has jurisdiction, the economic territory of a country also includes territorial
enclaves in the rest of the world. These enclaves are clearly identified areas located in
other countries that are owned or rented by governments for diplomatic, military,
scientific or other purposes, with the agreement of the country where the land area is
located. So for example, the Jamaican embassy in Washington DC is regarded as a part of
the economic territory of Jamaica. Similarly Guantanomo Bay in Cuba is a part of the
economic territory of the USA as is the US Embassy in Jamaica.
The concept of residence is defined broadly to include two main types of institutional
units:
(1)
(2)

households and individuals that comprise a household and

the legal and social entities of that economy such as the government, and
enterprises (profit and nonprofit) operating in the economy, whether foreign owned
or not.

As far as individuals are concerned, the concept of residence is based mainly on the
principle of "centre of interest". It is generally accepted that if a person resides for more
than a year in a given economy, he or she is considered to be a resident of that economy.
So if a Jamaican resident leaves Jamaica and returns to his/her household within a year,
the individual continues to be a resident even if he or she makes frequent trips outside
Jamaica. The individual's centre of economic interest remains in the economy in which

the household is resident. In the same vein, tourists are residents of the country from
which they come rather than the country they are visiting.
However, there are exceptional circumstances whereby individuals are regarded as
residents, for BOP purposes, even though they reside outside of their country for more
than a year.
a.

Students should be treated as residents of their countries of origin however long

they study abroad, as long as they remain members of households in their home
countries.

b.

Military personnel and civil servants, including diplomats employed abroad in

government enclaves are all regarded as residents of the country from which they
originate as those enclaves form part of the economy of the employing government.
The government employees working in these enclaves continue to have centres of
economic interest in their countries of origin for however long they work in the
enclaves. Therefore if a Jamaican diplomat/civil servant is posted to the Jamaican
Embassy in Washington for three years that employee continues to be a Jamaican
resident while he works in the enclave.

3.
a)

Valuations and Time of Recording

Valuation
A consistent method of valuing transactions is required for the compilation of the
balance of payments statement. All transactions are valued at market prices. This
is the price that willing buyers pay to acquire a good or service from willing sellers
and the exchanges are made between independent parties and on the basis of
commercial considerations only. Inconsistent valuations lead to different debit and
credit entries being made for the same transaction thus resulting in "net errors and
omissions" in the BOP.

b)

Time of Recording
In the double entry system of the balance of payment it is important that both
entries relating to a transaction are recorded at the same time. However, while this
is the ideal data recording methodology, it is not always possible, thus resulting in
errors and omissions" in the BOP. An entry is recorded in the balance of payments
when a transaction involves a change of ownership or where a change of ownership
is not obvious the transaction is recorded when the parties enter it in their
accounts.

4.

Concept of Economic Transactions

The primary concern of the BOP is not confined to payments, as the name would
suggest, but rather with transactions. A transaction involves the change of
ownership of goods and/or financial assets, the provision of services, labour and
capital.

The most numerous and important transactions in the balance of payments are
classified as exchanges. This refers to transactions in which economic values are
provided or received in exchange for other economic values. These values consist of
real resources (goods, services and income) and financial items.
a)

b)

Transactions classified as exchanges

This form of transaction requires a transactor to provide an economic value
to another transactor and receives in return an equal value. Listed below
are some examples of this type of transaction:
Purchases and sales of goods and services against financial items - e.g. the
sale of bauxite for foreign exchange.
Barter - e.g. the exchange of bauxite for motor vehicles.
The interchange of financial items for other financial items - e.g. the sale of
securities for money.
Transactions classified as transfers
There are also transactions in which a transactor provide an economic value
to another transactor and does not require an economic value in return. The
required offsetting entries, in the BOP, for these transactions are recorded as
transfers. Listed below are some examples of this type of transaction:
The provision or acquisition of goods and services without a quid pro quo e.g. donation of medical supplies by USA government to government of
Jamaica.
The provision or acquisition of financial items without a quid pro quo - e.g.
debt forgiveness.
MAJOR CATEGORIES IN THE BALANCE OF PAYMENTS

The BOP is divided into two main categories according to the broad nature of the
transactions. These categories are:
1. The Current Account
2. The Capital and Financial Account
1. CURRENT ACCOUNT:The current account includes all transactions (excluding those
recorded in the capital & financial account) between resident and non-resident entities
that that involve economic value.
This account is sub-divided into:
a. Goods
b. Services
c. Net Property Income
Abroad)

(also called Merchandise Trade Balance)

(also called Net Factor Income from

d. Current transfers
a.

Goods:

This accounts for the import and export of goods or tangible

commodities. The difference between exports and imports of tangible
goods is the trade balance, sometimes called the visible trade balance.

b.

Services:

This accounts for the import and export of services. Services

are often called invisibles because they are not tangible. It covers
travel, transportation and other services.

i.

Travel covers goods and services acquired from an economy by non-resident

travelers for business and personal purposes during their visits (of less than
one year). Expenditures made by seasonal workers (e.g. Jamaican farm
workers) and those for educational and health-related purposes made by
students and medical patients are recorded in this sub-account.

ii.

Transportation covers all transportation services (sea, air and land), bought
and sold, that involve the carriage of passengers, movement of goods
(freight), charter of carriers with crew and other supporting services.

iii.

Other Services are accorded great prominence in the balance of payments

and reflect the growing importance of international services in world trade.
Other Services consist of the purchase and sale of:

c.

Communication services
Construction services
Insurance services
Financial services

Income:

Computer and information services

Royalties and licences fees
Personal, cultural and recreational services
Government services

This reflects the net income related to the compensation or

reward to factors of production used and rendered between one
country and the rest of the world.
For instance, production may take place in a country, but the factors
of production may be owned by foreigners. In this scenario, the factor
rewards would go the foreign owners. The reverse is also true where
nationals of a country have stakes in foreign investments.
The difference between all inflows of income and outflow of income
gives the income balance, which is the equivalent to the Net Factor
Income from Abroad adjustment required to convert GDP into GNP.

d.

Current

Current transfers are unilateral transfers with

Transfers:

nothing received in return. It tracks the "one-way" transfer of funds

from one country to another that are made without any exchange or
goods and services in return. These payments are merely gifts from
one country to another. The gift might come from a person, business,
or government. Foreign aid payments from one government to another
are an important part of unilateral transfers.
These include remittances, donations, aids and grants, official
assistance and pensions.

Now that we have covered the four basic components, we need to look at the mathematical
equation that allows us to determine whether the current account is in deficit or surplus
(whether it has more credit or debit). This will help us understand where any
discrepancies may stem from, and how resources may be restructured in order to allow for
a better functioning economy. The formula is:
Current Account Balance = X M + NY + NCT.
where:

X = Exports of goods and services

M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers

What Does the Current Account Balance Tell Us?

Theoretically, the balance should be zero, but in the real world this is improbable, so if
the current account has a deficit or a surplus, this tells us something about the state of
the economy in question, both on its own and in comparison to other world markets.
A surplus is indicative of an economy that is a net creditor to the rest of the world. It
shows how much a country is saving as opposed to investing. What this means is that the
country is providing an abundance of resources to other economies, and is owed money in
return. By providing these resources abroad, a country with a CAB surplus gives
receiving economies the chance to increase their productivity while running a deficit. This
is referred to as financing a deficit.
A deficit reflects an economy that is a net debtor to the rest of the world. It is investing
more than it is saving and is using resources from other economies to meet its domestic
consumption and investment requirements. For example, let us say an economy decides
that it needs to invest for the future (to receive investment income in the long run), so
instead of saving, it sends the money abroad into an investment project. This would be
marked as a debit in the financial account of the balance of payments at that period of
time, but when future returns are made, they would be entered as investment income (a
credit) in the current account under the income section.

A current account deficit is usually accompanied by depletion in foreign-exchange assets

because those reserves would be used for investment abroad. The deficit could also signify
increased foreign investment in the local market, in which case the local economy is liable
to pay the foreign economy investment income in the future.
It is important to understand from where a deficit or a surplus is stemming because
sometimes looking at the current account as a whole could be misleading.

2.

CAPITAL AND FINANCIAL ACCOUNT:

The Capital and Financial Account records transactions that directly affect the
wealth and debt of the country. This account tracks the flow of currency and other
monetary assets used to purchase financial and physical assets. This part of
balance of payments tracks domestic investment in the foreign sector and foreign
investment in the domestic sector.
The account is sub-divided into two main categories:
a. The Capital Account, and
b. The Financial Account

A deficit or surplus in the capital account is matched by an opposite surplus or deficit in

the current account.
a.

The Capital Account

The capital account is equal to capital transfers, and the sale of natural and
intangible assets to foreigners minus the capital transfers, and the purchase of
foreign natural and intangible assets by a countrys residents.
The Capital Account covers
(i)
capital transfers and
(ii)
the acquisition/disposal of non-produced, non-financial assets.
Capital transfers include debt forgiveness and migrants transfers (goods and
financial assets accompanying migrants as they leave or enter the country). In
addition, capital transfers include the transfer of title to fixed assets and the
transfer of funds linked to the sale or acquisition of fixed assets, gift and
inheritance taxes, death duties, uninsured damage to fixed assets, and legacies.
Capital transfers include the transfer of ownership of fixed assets, the transfer of
funds linked to disposal/acquisition of fixed assets and the cancellation of debt by
creditors.

Acquisition and disposal of non-productive, non-financial assets represent

the sales and purchases of non-productive assets, such as the rights to natural
resources, and the sales and purchases of intangible assets, such as patents,
copyrights, trademarks, franchises, and leases. It also includes purchases and
sales of land by foreign embassies.
b.

The Financial Account

The financial account, a subdivision of the capital account, lists trade in assets
such as business firms, bonds, stocks, and real estate.
The Financial Account covers
(i)
direct investment,
(ii)
portfolio investment,
(iii)
other investments (trade credits, loans, currencies and deposits)
(iv)
changes in reserves.

(i)

Direct investment is the category of international investment in which a resident

entity in one economy acquires or disposes of 10 per cent or more of the ordinary
shares or voting power of an enterprise located in another economy and has an
effective voice in management. The resident entity is referred to as the direct
investor and the enterprise is the direct investment enterprise. The components of
direct investment are: equity capital, reinvested earnings and inter-company debt
transactions.

(ii)

Portfolio Investment covers transactions in equity securities and debt securities.

With respect to equity a portfolio investment would imply less than 10 per cent
ownership of the voting power of an enterprise located in another country. Debt
securities include bonds and notes, money market instruments and financial
derivatives. The essential characteristic of these instruments is that they are
tradable. This means these instruments offer investors the flexibility to shift
invested capital from one instrument to another.

(iii)

Other investment is a residual category that includes all financial transactions

not covered in direct investment, portfolio investment or reserve assets. It includes
trade credits, (the direct extension of credit by suppliers to buyers of goods and
services), loans to finance trade, other loans and advances and financial leases.

(iv)

The Reserves represent the foreign exchange which the country has available for
financing an imbalance of payments with the rest of the world. An increase in the
reserves of a country (a debit) indicates that there was a surplus from the
remanding non-reserve transactions, indicating an overall surplus for the balance
of payments and vice versa.

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A distinction is made between gross foreign reserves and net foreign reserves. In
the case of Jamaica, gross foreign reserves represent the official holdings of foreign
assets, by the Central Bank and the Central Government, while gross foreign
liabilities are principally liabilities of the Central Bank to the International
Monetary Fund (IMF). The difference between the gross foreign assets and
liabilities gives the net international reserve position of the country. This can be
disaggregated into the net international reserves of the Central Bank and the
external assets of the Central Government.
A country's monetary authority normally should not permit reserve holdings to
decrease below the level considered minimally appropriate or adequate for the
country. A common measure of the adequacy of reserve holdings is the ratio
of reserve assets to import of goods and services. This ratio is sometimes
expressed as the number of weeks worth of imports of goods and services that
could be paid for from the of gross reserve assets. The international benchmark for
reserve adequacy is 12 weeks of imports of goods and services.

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MAIN SOURCES OF DATA

There are three main sources of data for compiling the balance of payments of Jamaica.
1. Surveys
2. Foreign exchange records
3. Administrative and other documentary sources
1.

Balance of payments surveys of business enterprises and other organizations are

conducted at least once per year. Information is requested regarding a company's

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transactions with the rest of the world. Like all statistical surveys, there are
problems such as nonresponse and incomplete coverage for which estimates have
to be done. Since the repeal of the Exchange Control Act, the annual survey has
been one of the main sources of data.
2.

Foreign exchange records are also a useful source of balance of payments

statistics. However, such records do require adjustments with regard to
classification and timing before they satisfy the needs of the balance of payments
compiler. Many of the items in the services and financial accounts are prepared
from consolidated foreign exchange reports received from the authorized foreign
exchange dealers.

3.

Administrative records, particularly those kept by government institutions

provide data on items such as merchandise trade, foreign loans and official
transfers. External trade data is compiled by The Statistical Institute of Jamaica
(STATIN) from records maintained by Customs. Estimates of receipts from foreign
travel are derived from the number of visitors in various categories compiled by the
Jamaica Tourist Board together with the average expenditure of each category. The
Bank of Jamaica generates information on the country's foreign exchange reserves
in keeping with the Bank's role as custodian of such reserves.
OVERALL SURPLUS AND DEFICIT OF THE BALANCE OF PAYMENTS

In instances where there is an overall balance of payments deficit, the amount of foreign
exchange held by the country is depleted. The reverse is also true, as where there is a
balance of payments surplus, the foreign exchange held by the country increases.
The Central Bank or monetary authority of a country keeps amounts of foreign exchange
in its vaults for official purposes. As such, these foreign currency holdings are called
official foreign exchange reserves. For instance, if global disturbances due to natural
disasters or other circumstances cause exports to be significantly curtailed, then the
Central Bank would be able to use its foreign exchange reserves to cover imports and
other essential foreign payments such as foreign debt servicing.
As indicator of how long the country could sustain its current level of imports using its
foreign exchange reserves, the import cover ratio is calculated. This simply divides the
official foreign exchange reserves balance by the level of monthly imports.
In addition to this role, foreign exchange reserves can also be used to manipulate the
exchange rate. This will be discussed in the next topic: Exchange Rates.
CURRENT ACCOUNT DEFICITS

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The Balance of Payments account tells an important story of the overall level of
participation of a country in the international environment. In the complex world of
international trade and capital movements, there is a systematic relationship where
countries are intertwined by their dependence on each other for supplies, markets for the
various goods and services produced and international finance. The health of this
relationship needs to be maintained in order for it to successfully continue into the long
term. This is because, if a country would like to continue to import foreign goods on a
long term basis, then it needs to keep earning sufficient foreign exchange to finance such
imports. If not, the current account would be in deficit and imports would have to be
financed by borrowing foreign exchange. Many developing countries face the dilemma of
large current account deficits over extended periods of time. This typically leads them to
depend on international lending institutions such as the International Monetary Fund for
assistance to finance such deficits. Such borrowing, however, is usually accompanied by
severe economic conditionality or strict measures such as major cut-backs on government
spending which aggravate poverty.
CAUSES OF A CURRENT ACCOUNT DEFICIT
The current account deficit occurs when imports of goods and services, investment
income outflows and outward transfers exceed the exports of goods, services, investment
income inflows and inward transfers. Some of the causes of a current account deficit are:
1.

Low Competiveness. If a countrys manufacturing and service industries lack

competitiveness, then it would experience difficulty in selling its products in foreign
markets. As such, its level of exports would be low. In addition, the lack of
competiveness on the part of domestic industries would encourage consumers to
purchase products from more efficient foreign producers. This would lead to a high
level of imports, which combined with low exports would result in a current
account deficit.
Domestic industries may lack competiveness if needed resources are simply
unavailable. It may also arise if small scale production is employed which prevents
the attainment of economies of scale. Even if there is large scale production, the
employment of obsolete technology may also result in high costs and hence low
competitiveness. Finally, high domestic inflation could also lead to an erosion of
domestic competitiveness.

2.

An overvalued exchange rate. If the exchange rate is set at a level which makes
imports cheap relative to domestically produced goods and services, then imports
would rise. Furthermore, an overvalued exchange rate would also make exportable
goods seem expensive to foreigners which would lead to a decline in exports. Both
of these combined would result in a current account deficit.

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3.

Rapid growth in income. As income increases, consumption rises and as such

the level of imports increases. If exports remain unchanged, then a rise in income
would result in a rise in imports and hence a deficit in the current account.

4.

Huge capital inflows. If a country benefits from large capital inflows which result
in a surplus in the capital account, it is likely that the current account in future
years would be negatively impacted. This is because foreign investments generate
investment income to the foreign investors which are outflows in the current
account.
PROBLEMS WITH A CURRENT ACCOUNT DEFICIT

A deficit represents a net withdrawal from the circular flow of income by the foreign trade
sector. As such, aggregate expenditure within the domestic economy falls, leading to a
decline in income via the multiplier process. This may also result in the creation of a
deflationary gap where cyclical unemployment exists. In addition, a current account
deficit caused by huge importation is usually financed by borrowing from overseas. This
gives rise to significant interest payments which leads to an exacerbating if the deficit.
Such interest payments may also be a burden on GNP since it is an outflow of net
property income from abroad.
MEASURES USED TO ELIMINATE A CURRENT ACCOUNT DEFICIT
There are a host of different measures which a government can use to eliminate a current
account deficit. These include:
1. Expenditure Reducing Measures
2. Expenditure Switching Measures
3. Export Subsidies
4. Enhanced Competitiveness
1. Expenditure Reducing Measures:
These are deflationary or contractionary measures that decrease national income.
This is because imports are said to be induced, i.e., rise as income increases and
likewise fall as income decreases. Exports on the other hand are said to be
autonomous to the level of national income. Hence, as income decreases, imports
fall while exports remain unchanged causing the deficit to be eliminated. This is
shown by a movement along the import function in the diagram (Figure 1) from
point A to point B. As a result of the decrease in the level of imports, the current
account improves, possibly resulting in an overall balance.

15

Figure 1: Contractionary Policy and the Current Account Balance

2. Expenditure Switching Measures:
This includes all measures designed to switch expenditure away from imports and
towards domestically produced goods, such as:

Devaluation or depreciation of the exchange rate. This will be discussed in

more detail in the topic: Exchange Rate. A devaluation applies if there is a fixed
exchange rate, while a depreciation occurs if there is a floating exchange rate
regime. Both measures result in an increase in the price of foreign currencies
and by extension, imports become more expensive and domestic exports
become cheaper in foreign markets. Assuming that the demand for imports is
elastic, then overall, as imports become more expensive, expenditure on imports
would fall, leading to a decline in outflows in the current account. If the
demand for exports is elastic, as it becomes cheap, export revenues would rise,
leading to an increase in inflows in the current account.
Both of these effects reinforce each other as a means of eliminating the deficit
in the current account. The requirement that the demand for imports and
exports are elastic is known as the Marshall-Lerner condition. If this condition
does not hold, then the devaluation or depreciation would not help to eliminate
the current account deficit.

Introduction of protectionist policies. This option eliminates a current

account deficit by curtailing the amount of imports via the implementation of
policy measures which seek to protect the home market from imported
products.

Subsidizing import substitutes. This option requires allocations of subsidies

directed at local production, with the objective of lowering cost of production
import substitutes. This is seen to be necessary, as the lowered cost of

16

domestic output would encourage consumers to purchase such products as

opposed to foreign manufactured goods.

3.

Export Subsidies:
An export subsidy is a payment to a domestic producer who exports a good abroad.
This can also be used independently or in conjunction with other policies for the
purpose of eliminating a current account deficit. Because of the subsidizing of
domestic exports, producers are able to reduce production cost which improves the
competitiveness of their output in the international markets. This should therefore
serve to boost export earnings and thereby eliminate the current account deficit.

The first two measures, expenditure reducing and expenditure switching, may be regarded
as complements rather than competing measures. This is because the government might
initially undertake expenditure reducing policies in order to create spare capacity in the
economy. Afterwards, it would implement expenditure switching policies which would
divert demand away from imports to domestic output. Since there is spare capacity in the
economy, domestic firms would be able to increase output and meet the increase in
domestic demand.
CURRENT ACCOUNT SURPLUSES
If one country has a current account surplus, then its trading partner would inevitably
have a current deficit. China currently has the largest current account surplus in the
world and its main trading partner, the USA, has the largest deficit in the world. As a
result, current account surpluses can result in retaliation where the deficit country cuts
back on importation possibly leading to a deficit in the surplus country. If both countries
had neither deficits nor surpluses then no such feedback effects would occur.
METHODS OF ELIMINATING A CURRENT ACCOUNT SURPLUS
1.

Revaluation or appreciation of the exchange rate. This refers to an increase in

the exchange rate under the fixed exchange rate and floating exchange rate
respectively. This policy action makes imports appear cheaper to domestic
consumers and exports more expensive to foreigners as the external value of the
countrys currency increases. As a consequence, the value of imports rises while
the value of exports declines thus eliminating the surplus.

2.

Remove protectionist measures. The removal of protectionist policy would

encourage increased importation and thus eliminate the surplus by allowing
imports to increase.

3.

Expansionary policy. Any increase in domestic income brought about by

expansionary policy would lead to a rise in imports with no change in the level of

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exports. As a consequence, outflows in the current account rise, with inflows held
constant. Eventually this leads to an elimination of the surplus. This is shown in
Figure 2 where the level of export is constant at $40 million. If income is at Y R
imports are $10 million and there is a surplus of $30 million. As income increases
from YR to YS there is an expansion in imports as shown by the movement along the
import schedule from R to S. As a result imports rise to $40 million and the
current account surplus is eliminated.

Expansionary Policy and the Current Account Balance

GLOSSARY OF FREQUENTLY USED TERMS

Balance of Payments Manual: This is the standard issued by the International

Monetary Fund (IMF), which provides guidance to member countries in the compilation of
balance of payments statistics.
Transaction: A transaction is an economic flow between residents and non-residents.
Transactions involve changes in ownership of goods and financial assets/liabilities, the
provision of services, labour and capital and transfers in cash and kind.
Compensation of Employees: This is income received as remuneration for work. It
includes wages and salaries paid to employees, commissions, bonuses, payments in kind
and incentive payments in a given time period.
Direct Investor: The direct investor may be an individual; an incorporated or
unincorporated private or public enterprise or any other organization that owns direct
investment enterprises in an economy other than the one in which the direct investor
resides.

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Direct Investment Enterprise: A Direct Investment Enterprise is an incorporated or

unincorporated company in which a direct investor acquires 10 per cent or more of its
ordinary shares or voting power. Most Direct investment enterprises are either branches
or subsidiaries.
Foreign Assets: Foreign assets refer to a country's claim on foreigners.
Foreign Liabilities: Foreign liabilities refer to a country's indebtedness to foreigners.
Trade Credits: This is credit that one non-financial firm extends to another for goods and
services transactions.
Equity: The value of the ordinary shares issued by a company.
Monetary Policy: Monetary policy describes the use of variations in the quantity of
money which may raise or lower interest rates, and hence either directly or indirectly
lower or raise aggregate demand.
Fiscal Policy: Fiscal policy describes the use of taxation and expenditure by the
government to influence the level of business activity.

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