Balance of Payments

Question 1

Balance of Payments Definition

Answer 1

a record of a country’s economic transactions with the rest of the world over a year.

Question 2

Balance of Payments consists of:

Answer 2

1) The current account
2) The capital account
3) The financial account
4) Net errors and omissions (the balancing item)

Question 3

The current account consists of:

Answer 3

1) Trade in goods
2) Trade in services
3) Income
4) Current transfers

Question 4

Trade in goods

Answer 4

Covers the export and import of goods (visibles) e.g. cars, laptops, clothing.
- Trade in goods balance = Revenue from exported goods - Revenue from imported goods

Question 5

Trade in services

Answer 5

Covers the export and import of services (invisibles) e.g. tourism, shipping, banking.
- Trade in services balance = Revenue from exported services - Revenue from imported services

Question 6

Income

Answer 6

Covers income (dividend, interest and profit) earned from domestic investments abroad and foreign investments domestically.

Question 7

Credit (export) of income

Answer 7

• Dividends received by domestic residents from their shares in foreign firms
• Interest received by domestic residents from their savings in foreign bank accounts
• Profit received by domestic firms from their investments made abroad

Question 8

Debit (import) of income

Answer 8

• Dividends received by foreigners from their shares in domestic firms
• Interest received by foreigners from their savings in domestic bank accounts
• Profit received by foreign firms from their investments made domestically

Question 9

Current Transfers

Answer 9

Covers payments made and received for which there is no corresponding exchange of goods and services.

Question 10

Credit (export) of Current Transfers

Answer 10

• Payments received from international institutions (e.g. IMF or World Bank)
• Receipt of foreign aid
• Domestic workers in foreign economies sending money home (worker remittances)

Question 11

Debit (import) of Current Transfers

Answer 11

• Payments made to international institutions (e.g. IMF or World Bank)
• Payment of foreign aid
• Foreign workers in the domestic economy sending money home (worker remittances)

Question 12

Current Account Balance

Answer 12

• Current account balance = (X - M)
• Current account surplus = (X > M)
• Current account deficit = (X < M)

Question 13

The Capital Account

Answer 13

A relatively small part of the BoP, it records capital transfers and the acquisition and disposal of non-produced, non-financial assets.

Question 14

Examples of Capital Account

Answer 14

• Government debt forgiveness.
• Money brought in / out by migrants.
• Purchase and sale of copyrights, patents and trademarks.

Question 15

The Financial Account

Answer 15

A record of the transfer of financial assets between the country and the rest of the world.

Question 16

The Financial Account consists of:

Answer 16

1) Direct investment
2) Portfolio investment
3) Other investments
4) Reserve assets

Question 17

Net errors and omissions

Answer 17

Also known as the balancing item, this is a figure included to ensure the BoP balances.

Question 18

BoP equilibrium

Answer 18

The overall balance of the current account, capital account and financial account should equal zero.

Question 19

BoP disequilibrium

Answer 19

when there is a large imbalance in one of the accounts

• etc. Large current account surplus or deficit
• etc. Large financial account surplus or deficit

Question 20

Causes of Current Account Deficit

Answer 20

1) Strong exchange rate: price of exports rise in foreign economies and the price of imports fall in the domestic economy (EV: J-Curve, Marshall-Lerner).
2) Strong domestic growth: rising incomes results in more spending (including on imports), especially if domestic firms cannot meet the demand (EV: marginal propensity to import).
3) Declining competitiveness: low levels of investment in capital and labour cause domestic firms to struggle with imports and exporters to struggle abroad (EV: comparative advantage changes over time)
4) Higher inflation: affects competitiveness of domestic products at home and exports abroad (EV: underlying cause of inflation).
5) Recession in other economies: less spending on everything, including foreign imports (our exports) (EV: marginal propensity to import)
6) Decline in the export sector: structural change of the economy resulting in less manufacturing of goods (easier to trade) and more services (more difficult to trade) (EV: protectionism)

Question 21

Consequences of Current Account Deficit

Answer 21

Positive
- Domestic consumers can purchase more products than the country produces (higher standard of living).
Negative
- Lower AD: when X < M, this reduces AD, which leads to lower GDP.
- Rising unemployment: jobs will be lost due to: lower AD, the uncompetitive export sector, and the domestic industries replaced by imports.
- Fall in foreign currency reserves: imports will need to be purchased using foreign currency.
- Fall in confidence: current account deficit can be seen as a sign of economic weakness.

Question 22

Financial Account Deficit consequences

Answer 22

Not a concern because:
- It will lead to an inflow of profits, interest and dividends in the future.
- It is the short term result of hot money flowing out of the economy in search of higher interest rates elsewhere.
A concern if:
- It results from a long-term lack of confidence in the economy’s prospects, possibly leading to capital flight.
- The movement out of foreign firms reduces tax revenues and employment, which might cause a recession.

Question 23

Policies to correct balance of payments disequilibrium

Answer 23

1) Expenditure switching policies (protectionism / trade barriers)
2) Expenditure reducing policies (contractionary fiscal and monetary policies)

Question 24

Expenditure switching policies definition

Answer 24

policies that attempt to bring about a change in the pattern of demand in an economy by reducing demand for imports and increasing demand for domestic products and exports.

Question 25

Methods of Expenditure switching policies

Answer 25

protectionism (trade barriers

Question 26

Problems of Expenditure switching policies

Answer 26

• Disrupts free trade and specialisation according to comparative advantage.
• Higher prices and less choice for consumers
• Living standards fall.
• Retaliation.
• Opposed by the World Trade Organisation (WTO).

Question 27

Expenditure reducing policies definition

Answer 27

policies that attempt to bring about a reduction in the level of aggregate demand.

Question 28

Methods of Expenditure reducing policies

Answer 28

1) Contractionary (deflationary) monetary policy: increase in interest rates and/or decrease in money supply → decrease in C of all goods (including M) → negative multiplier effect → decrease in AD.
2) Contractionary (deflationary) fiscal policy: increase in taxation and/or decrease in government spending → decrease in C of all goods (including M) → negative multiplier effect → decrease in AD.

Question 29

Impacts of Expenditure reducing policies

Answer 29

• Contractionary fiscal and monetary policies result in less consumption of all goods, including imports, therefore less demand for M.
• Also, due to falling domestic consumption, domestic firms will be encouraged to export more.

Question 30

Problems of Expenditure reducing policies

Answer 30

• People are poorer.
• Living standards fall.
• Unemployment rises.
• Economic growth slows.