3.3 The Balance Of Payments

Question 1

What is the balance of payments?

Answer 1

A financial record of a country’s transactions with the rest of the world for a given time period, usually over one year.

Question 2

What is the role of the balance of payments?

Answer 2

To record credit items (payments received from other countries) and debit items (payments made to other nations).

Question 3

What are some examples of credit items?

Answer 3

Revenues earned from the export of goods and services, FDI and capital transfers.

Question 4

What are some examples of debit items?

Answer 4

Purchase of imports of foreign goods and services, income transfers overseas and the repatriation of profits from multinational companies in the economy, These transactions have a corresponding outflow of money from the domestic economy.

Question 5

What are the components of the balance of payments?

Answer 5

The current account, the capital account and the financial account.

Question 6

What is the formula for the current account?

Answer 6

Current account = capital account + financial account + errors and omissions

Question 7

What is the current account?

Answer 7

A record of al exports and imports of goods and services plus its net investment income from overseas assets and the net balance of transfers made between countries by individuals and governments, the account is usually reported per year.

Question 8

What are the four components of the current account?

Answer 8

Balance of trade in goods
Balance of trade in services
Income
Current transfers

Question 9

What is the balance of trade in goods?

Answer 9

This records all exports and imports of physical goods between a country and the rest of the world.

Question 10

What is the balance of trade in services?

Answer 10

The records all exports and imports of services between a country and the rest of the world.

Question 11

What is included in income?

Answer 11

This records the income receipts earned from foreign investments minus the income payments of factor incomes paid to foreign investors. Investment income consists of the inflows and outflows of wages, rent, interest and profit.

Question 12

What is included in current transfers?

Answer 12

This records the inflows and outflows of payments that are not made in exchange for anything between a country and the rest of the world.

Question 13

What is the balance of trade?

Answer 13

The difference between a country total export earnings and its total import expenditure on both goods and services. The balance of trade is typically the largest components of the current account.

Question 14

What is a current account deficit?

Answer 14

When a country spends more money than it ears, ie. the sum of money flowing out of a country exceeds the money flowing into the country.

Question 15

What is a current account surplus?

Answer 15

If a country has a positive net balance on its current account.

Question 16

How can a current account deficit occur?

Answer 16

Lower demand for exports - mainly caused by exports being relatively more expensive to foreign buyers. It can be caused by high labour costs in the domestic economy, falling incomes or a higher exchange rate making exports dearer.
Increased demand for imports - Domestic buyers tend to buy more imports if they are relatively cheaper or of better quality.

Question 17

What is the capital account?

Answer 17

The smallest components of the balance of payments it records the different forms of capital inflows and outflows of a country during a given time period.

Question 18

What are the two components of the capital account?

Answer 18

Capital transfers

Transactions in non produced non financial assets

Question 19

What is included in capital transfers?

Answer 19

The net monetary movements of capital goods used in the production process and financial assets.

Question 20

What is included in transactions in non produced non financial assets?

Answer 20

The exchange of money in non produced assets ie/ natural resources and intangible assets eg. copyrights.

Question 21

What are financial assets?

Answer 21

Such as money or bonds, are of little physical value. Instead their value is based on what the asset represents.

Question 22

What are non financial assets?

Answer 22

Assets with physical value,

Question 23

Why to less economically developed countries tend to have a capital account deficit?

Answer 23

There is financial instability and mounting government debt and loans.

Question 24

What is the financial account?

Answer 24

Records a country’s net transaction in external financial assets and liabilities. Records the difference between sales of domestic assets to foreign buyers and purchases of foreign assets by domestic buyers.

Question 25

Whe does a financial capital inflow occur?

Answer 25

When foreigners loan money to domestic citizens by acquiring domestic assets.

Question 26

What are the three components of the financial account?

Answer 26

Direct investment
Portfolio invesemnt
Reserve assets

Question 27

What is direct investment?

Answer 27

Refers to inflows and outflows of long term investments in physical capital. Direct investments are mainly undertaken by multinational cooperations.

Question 28

What is portfolio investment?

Answer 28

The buying and selling of stocks, shares and government bonds, pension funds and other financial investments in foreign companies is collectively known as portfolio investment, Essential y these assets represent international borrowing and lending.

Question 29

What are reserve assets?

Answer 29

Refers to official reserves the are readily viable to a government for direct financing of international payments imbalances and to affect its exchange rate.

Question 30

Why in theory must the balance of payments always balance?

Answer 30

Because in the long term a country can only spend what it ears ie. th sum of all credit items equals the sum of debit items. However it is possible to run deficit in one component of the balance of payments so long as it can balance this by having a surplus on another account.

Question 31

Why are the current and financial account interdependent?

Answer 31

A country with a current account deficit consumers more than it produces so has to pay for this extra output through a surplus on the financial account and vice verse.

Question 32

Why in reality will the balance of payments no balance?

Answer 32

As there are too many transactions to account for. To resolve this errors and omissions are used to represent statistical discrepancies when compiling the accounts.

Question 33

When does a current account deficit occur?

Answer 33

When the sum of the outflows from the current account excess the inflows into the account.

Question 34

What does a current account deficit show?

Answer 34

The country is sending more than it is earning so it must require foreign exchange whilst it faces lower demand for its own currency as exports decline.

Question 35

How is the deficit automatically resolved?

Answer 35

Under a freely floating exchange rate system because it makes exports relatively cheaper and imports relatively more expensive. Export earnings should rise and import expenditure should fall restoring equilibrium .

Question 36

How can a more problematic deficit be made better in a fixed exchange rate system?

Answer 36

By a devaluation of the currency, this should improve the current account in the same way as with a depreciation of the currency.

Question 37

How can deficit be restored in a maintained exchange system?

Answer 37

By combining market forces and central bank intervention by buying and selling of foreign currencies to reduce the value of the domestic currency in overseas markets.

Question 38

When does a current account surplus exist?

Answer 38

When the sum of inflows from the current account exceeds the outflows into the account.

Question 39

How can a current account surplus occur?

Answer 39

Higher demand for exports - this could be caused by improved domestic manufacturing competitiveness, higher labour productivity or higher incomes in overseas markets (foreign households and firms have more disposable income to spend on the country’s exports)
Reduced demand for imports - domestic buyers will tend to buy fewer imports if they are more expensive or of lower quality than those provided by domestic firms, choosing instead to buy more home produced goods and services.

Question 40

What does current account surplus mean for a country?

Answer 40

The country is earning more than it is spending, so there is a greater demand for its currency as exports increase hence there is greater upwards pressure on its exchange rate. In general a current account surplus means that the country is a net lender to the rest of the world whereas it would be a net borrower from the rest of the world if it ran a current account deficit.

Question 41

How can a current account surplus be seen as negative?

Answer 41

It could signify that the country is spending less on imports than its trading partners because of relative lower incomes. Thus households have a relatively lower standard of living as they are unable to access a wider range of goods and services. Countries with a persistent or rising current account surplus are heavily dependent on export earnings and a high savings rate but with weak domestic AD.

Question 42

How can a current account surplus be removed in a freely floating exchange rate system?

Answer 42

In a freely floating exchange rate system the currency appreciation caused by a persistent current account surplus results in a fall in the demand for exports and a rise in the demand for imports. Thus the fall in the exchange rate automatically eliminates the current account surplus.