2.5 Balance of Payments Flashcards
What is the Balance of Payments (BoP)?
It records all economic transactions between residents of an economy and the rest of the world
What are the components of the Balance of Payments?
Current account, financial account, capital account, net errors
What is the current account (CA)?
Covers all transactions related to international trade in goods and services, as well as primary and secondary income flows from abroad
What is the financial account (FA)?
Covers all transactions that result in a change in ownership of financial assets and liabilities between UK residents and foreign residents
What are the components of the current account (CA)?
- Trade balance
- Primary income (investment income) Balance
- Secondary income (transfers) Balance
What is the trade balance?
- A measure of net international trade in goods and services
- Records the total value of exports minus the total value of imports
What are exports and imports as items on the current account?
Exports = credit item
Imports = debit item
What is the primary income (investment income) balance?
The difference between total earnings received by domestic residents from assets located outside the domestic economy, and the total income paid out to foreign owners of assets located in the domestic economy
- eg. rent on foreign property, interest payments from foreign bank accounts, dividends payments from foreign financial assets
What is the secondary income (transfers) balance?
The net balance on one-way transfers into and out the domestic economy
- eg. foreign aid, membership dues to international organisations, remittances sent to relatives overseas
When is there a current account (CA) surplus?
Trade balance + net primary and secondary income balance > 0
When is there a current account (CA) deficit?
Trade balance + net primary and secondary income balance < 0
What are the factors influencing the current account?
- Economic activity in the domestic and foreign economies
- Inflation rate in domestic economy relative to foreign economies
- Productivity growth in domestic economy relative to foreign economies
- Exchange rate
What is a persistent CA deficit/surplus
A sustained short-fall/excess of foreign exchange income from trade, primary income and secondary income
What are the possible consequences of a CA deficit?
- Downward pressure on the exchange rate and depreciation of domestic currency - caused by a fall in the demand for domestic currency by foreigners alongside (less exports) an increase in demand for foreign currency by domestic residents for imports
- Reduced foreign exchange reserves - due to always paying more for imports than income for exports, is an issue
- Increased foreign ownership of domestic assets - a CA deficit needs to be offset by a FA surplus, may lead to further future outflows of income (primary income)
- Loss of domestic sovereignty
- Possible increase in foreign indebtedness
- Possible increase in domestic borrowing costs - central bank rate may increase to prevent currency depreciating
- Possible lack of funds to influence AD - restricts use of fiscal policy
- Negative impact on international credit ratings
What does the significance of a current account imbalance depend on?
- Size of the CA deficit/surplus - larger deficit = larger outflow of income, more international borrowing = more debt repayments
- Duration - shorter deficit can mean rising living standards, longer deficit can be a sign of a weak economy, longer deficit = greater loss of ownership of assets
- Cause - structural weakness and lack of international price-competitiveness likely to be more damaging to an economy, however, high imports of capital goods can increase productive capacity and long run growth -> can increase international competitiveness and correct CA deficit over time
What are factors that influence if an economy can afford a CA imbalance?
- If a country continues to attract financial and direct investment from abroad it will be able to finance a CA deficit
- If a country has a large existing stock of domestic-resident-owned assets, it is far more likely to afford to sustain a CA deficit over time
- If a CA deficit is caused by a commitment to fix the domestic currency, the currency may be fundamentally overvalued - may be harmful in long run
- If a CA surplus is an indication that a currency is fundamentally undervalued, due to manipulation by monetary authorities, may lead to trade disputes and retaliation
What are policies to correct a persistent CA imbalance?
Deficit:
- Deflationary/expenditure reducing policies (reducing AD)
- Devaluation (applies to fixed exchange rates) - expenditure switching
- Direct controls (protectionism) - expenditure switching
- Supply-side policies (to address structural weaknesses)
Opposite policies for a surplus
