Balance of payments

CONTENTS
The balance of payments
The current account
Financial and capital account
Current account deficit
Causes of a current account deficit
Consequences of a current account deficit
Causes of a current account surplus
Impact of a current account surplus
Terms of trade
Causes of changes in the terms of trade
 The balance of payments

A country’s balance of payments is a record of all the economic transactions between

residents of that country and residents in other countries.

Money coming into the country creates credit items, which have a positive sign.

Money going out of the country gives rise to debit items which have a negative sign.

The components of the balance of payments are

The current account

The capital account

The financial account

Equilibrium in the balance of payments

A balance of payments is in equilibrium if, over a period of years, the exchange rate
remains stable and autonomous credits and debits are equal in value (the annual
trade in goods and services is in overall balance).

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 The current account
The current account balance is the overall balance of the trade in goods, trade in services,
income and current transfers.

Current account transactions are subdivided into four parts:

Trade in goods:

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.

Examples
raw materials
semi-manufactured products
manufactured goods.

Trade in services:

The invisible trade balance is a record of the export and import of services (intangible products).

Examples
shipping
tourism
banking
insurance.

Income:

Income is divided into two parts:

Income from employment of residents by overseas firms
Income from capital investment overseas

Current transfers:

Examples
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.

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 Financial and capital account

Capital account

The capital account includes, for instance, government debt forgiveness,

money brought into and taken out of the country by migrants, the sales and
purchases of copyrights, patents and trademarks

Financial account

The financial account records large movements of funds into and out of the
country.

The balance on the financial account is made up of flows of capital to and from
the non-government sector, such as

direct investment in overseas facilities

portfolio investment (in shares, bonds, and so on)
speculative flows of currency

Movements on government foreign currency reserves are also included under

this heading.

Balancing item

The balance of payments as a whole must always balance. This is because any
credit item has to be matched by a corresponding debit item.

In practice, however, with so many transactions involved, it is difficult to keep

an accurate record. Some mistakes are likely to be made and some
transactions may not be included. To compensate for this, a net errors and
omissions figure (also sometimes called the balancing item) is included.

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 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 .

Causes of a current account deficit

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 competitiveness.
an economic recession in foreign markets
a higher exchange rate

Increased demand for imports

This can be caused by

domestic inflation
cheaper or better quality imports
a growing domestic economy

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Causes of a current account deficit
Lower demand for exports can be caused by

A decline in competitiveness.

There are a number of causes of a lack of international competitiveness. These include an overvalued
exchange rate, a relatively high inflation rate, low labour and capital productivity.

A structural deficit is a cause of concern as it will not be self-correcting.

Declining incomes in foreign markets

This can be perhaps due to an economic recession. This means households and firms have less money
available to spend on another country's exports.

A current account deficit that arises from either change in the economic cycle of the domestic economy or
the economies of trading partners is sometimes referred to as a cyclical deficit.

It is not usually considered to be a problem as it will be relatively short-term and is likely to be self-correcting.

A higher exchange rate

A higher exchange rate makes exports more expensive for foreign buyers, so it reduces the volume and value
of exports.

Increased demand for imports can be caused by

Cheaper and better quality imports

Domestic buyers tend to buy more imports if they are cheaper or of better quality. For example, a higher
exchange rate means the domestic currency can buy more foreign currency, so this makes it cheaper to buy
imports.

Domestic inflation

Domestic inflation means that imports are relatively cheaper, so more domestic residents and firms will tend
to buy foreign goods and services.

A growing domestic economy

When firms are increasing their output, they may buy more raw materials and capital goods from abroad. As
well as import expenditure increasing, export revenue may decline as a result of exports being diverted from
the foreign to the domestic market.

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Consequences of a current account deficit

A country living beyond its means

A current account deficit allows the residents of a country to consume more

products than the country produces. This is sometimes referred to as a country
living beyond its means.

Slows down economic growth

A trade deficit means the economy is spending more money on imports than it
receives from the export of goods and services. This can cause aggregate
demand in the economy to fall, which may slow down economic growth. As the
demand for labour is a derived demand, a fall in aggregate demand is likely to
cause unemployment in the economy.

Indication of an uncompetitive economy

In general, large and persistent current account deficits are a sign that the
country is internationally uncompetitive, which has more severe consequences
for the domestic economy.

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Causes of a current account surplus

If inflows of money (from the sale of exports, etc.) exceed outflows of money (from the
purchase of imports, etc.) there is a current account surplus. This means the country will
have a positive balance on its current account.

Causes of a current account surplus

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 competitiveness
higher incomes in overseas markets- foreign buyers have more money to spend on
the country's exports
a lower exchange rate which makes exports less expensive for foreign buyers

Reduced demand for imports

This could be caused by a lower exchange rate which makes it more expensive to buy
imports inflation in overseas countries causes imports to be more expensive

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Impact of a current account surplus

Employment

A sustained current account surplus can be desirable, as higher export sales help
to create jobs.

Standards of living

It might be thought that a current account surplus is always beneficial as it

involves a country saving more than it is spending. It does, however, mean that
the country’s residents are not enjoying as high a standard of living as possible.
The high level of demand, combined with additions to the money supply, may
generate inflationary pressure.

Policies

Those countries experiencing current account deficits may also put pressure on
the country to change its policies in order to reduce its surplus.

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MAKE A MINDMAP

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The
balance
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Deficit Causes
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 The terms of trade
What price will our exports fetch abroad? What will we have to pay for
imports? The answer to these questions is given by the terms of trade.

The terms of trade is simply the ratio of export prices to import prices.

Example

Canada exports a lot of oil, so when the price of oil goes up, its terms of
trade improve. It earns more foreign currency on its exports. Meanwhile,
foreign investors rush to buy shares in Canadian oil companies. Both those
things create extra demand for Canadian dollars.

Ratio

The ratio is calculated from the average prices of many goods and services
that are traded internationally. The prices are weighted by the relative
importance of each product traded.

Improvement in the terms of trade

If the index increases, this is described as a favourable movement or an

improvement in the terms of trade. Fewer exports now have to be sold to
purchase any given quantity of imports.

Deterioration in the terms of trade

An unfavourable movement or deterioration in the terms of trade means

that the index number has fallen. Now more exports will have to be
exchanged to gain the same quantity of imports.

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Causes of changes in the terms of trade

Changes in the terms of trade are caused by changes in the demand

for and supply of imports and exports, and by changes in the
exchange rate.

Favourable movement

Essentially what causes a favourable movement in the terms of

trade is a rise in export prices relative to import prices.

Increase in the demand for exports

An increase in the demand for exports would increase their price

and so cause a favourable movement in the terms of trade.

A rise in relative inflation rate

A rise in a country’s relative inflation rate would also make its export
prices higher relative to its import prices.

Unfavourable movement

An unfavourable movement occurs when there is a fall in export

prices relative to import prices.

Devaluation

A devaluation is sometimes referred to as a deliberate deterioration

of its terms of trade. This is because it is a deliberate attempt to
reduce export prices and raise import prices in order to make the
country’s products more internationally competitive.

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Terms
of
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