5 - Balance of Payments

Question 1

Balance of Payments (BOP)

Answer 1

• Measures all financial and economic transactions between the residents of home country and the residents of other countries over a specified period of time
• Largely followed by bankers, businessmen, economists, investors etc

Question 2

Three principle BOP categories

Answer 2

1. Current account: records exports and imports of goods and services
2. Capital account: records transfers of goods and financial assets by migrants
3. Financial account: records public and private investment and lending activities

Question 3

BOP and double-entry book keeping

Answer 3

• Every economic transaction recorded as a credit brings about an equal offsetting debit entry
• Credit = decrease in assets or increase in liabilities
• Debit = increase in assets or decrease in liabilities
• Current account balance + Capital account balance + Financial account balance = Balance of Payments = 0

Question 4

National Spending and National Income

Answer 4

• National Income (NI) = Consumption + Saving
• National Spending (NS) = Consumption + Investment
• Therefore NI - NS = S - I

Question 5

If National Income is greater than National Spending

Answer 5

• If a national produced more than it spends, it invests overseas
• With positive NFI, there will be a net capital outflow which will appear in a financial account-deficit

Question 6

Consumption and Spending’s relationship with Exports/Imports

Answer 6

-When CONSUMPTION of domestic goods and services are deducted from national income, the remaining goods and services must be equal to exports (X)
-When SPENDING on domestic goods and services are subtracted from total national spending, the remaining spending must be equal to imports (M)
SO: NI - NS = X - M
-CA surplus arises when national output exceeds domestic expenditures, and a CA deficit arises when domestic expenditures exceed domestic output

Question 7

Current account deficits and surpluses

Answer 7

• A nation with CAS is a net exporter of capital (+ve NFI)
• A nation with a CAD is a net importer of capital (-ve NFI)
• A CAS is not always a sign of health; a CAD is not always a sign of weakness

Question 8

Two ways to deal with a CAD

Answer 8

1. Currency depreciation

2. Protectionism

Question 9

Currency Depreciation

Answer 9

• Overvalued currency makes exports expensive and imports cheap which means overvalued currency is a “tax on export and subsidy on imports”
• By devaluing a currency, export can be increased and import reduced which corrects CAD in the long run

Question 10

Protectionism

Answer 10

• Tariff: tax on imported products to raise prices to discourage purchase and to encourage buying of domestic product (flat increase in price of imported goods)
• Quota: specifies the quantity of particular imported product, that is reducing import from its current level. It restricts supply of products, which contribute to increased price inflation