The structure of the balance of payments

The meaning of the balance of payments

The role

The role of the balance of payments is to be a statement of all transactions made between entities in a country in a year. It is called balance of payments because for every entry of a transaction there is an equal and opposite entry in a different section which balances out the transaction.

Credit and debit items

Debit items: Transaction which causes currency to leave country, these have a negative sign.

Credit items: Transaction which causes money to enter country, these have a positive sign.

Components of balance of payments

There are three accounts that make up the balance of payments: Current, capital and financial.

Current account

This is the account for frequent payments made outside of the government. (reflecting net income)

• Balance of trade in goods and services.
• Net income flows (dividends, interests)
• Current transfers (remittances)

Capital account

This is the account for changes in ownership of national assets

• Capital transfers
  • Provision of resources for capital purposes that are receivable and payable)
• Transfers in non-produced, non-financial goods such as the purchase or sale of intangible assets
  • E.g rights to land or patents

Financial account

This is the account for international ownership assets.

• Foreign Direct Investment
  • A country acquiring control or influence over firms in another countries economy)
• Portfolio investment
  • Acquiring stocks and bonds as well as exchanging loans and deposits
• Reserve assets
  • Currency held by the central bank to finance balance of payments and affect the exchange rate through interventions in foreign exchange market.

Current account deficits

Effect on exchange rate

Can cause depreciation as there will be more imports than exports and thus supply shifted right, creating a downwards pressure on the exchange rate.

Effects of balancing the current account deficit

The deficit in the current account can be balanced in the capital or financial, by selling currency, in other ways than goods and services:

• Inward investment being greater than outward investment (Done by increasing interest rates)
• Sell reserve assets
• Sell bonds

However this causes the following problems:

• Run out of foreign reserves.
• Too much inward investment
  • Giving away too much ownership of domestic assets loses sovereignty
  • Create reliance on investing country to have stable investing conditions. 
  • To get foreign investment, interest rates go up which decreases consumption and domestic investment. 

Correcting the deficit

1. Expenditure switching policies - Reduce trade so internal spending is higher than external
   • Causes higher domestic prices, loss of welfare and retaliations.
   • Whether this policy works or not depends on marshall-lerner condition.
2. Expenditure reduction policy - Force people in country to spend less so that overall they spend less externally 
   • Reduces economic growth and standards of living
3. Supply-side policies - supply more goods to increase competitiveness of exports 
   • Market based or interventionist.
   • Has opportunity cost and time lag.

Marshall-lerner condition and J-curve

Marshall-lerner condition: Currency devaluation will only reduce current account deficit if sum  of PED for imports and exports are greater than 

Effect of depreciation of exchange rate

1. Causes price of exports to lower and and price of imports to rise
2. Causes quantity of exports to increase and quantity of imports to decrease.
3. Whether this has a positive effect on current account depends on whether the increase in revenue of exports becomes greater than the fall in revenue in imports. This is determined by PED imports + exports, and whether this is greater than 1.

Note: Exports revenue can only increase because only external price changes, internally we still earn same price. Same price but higher quantity = loads of revenue!

Current account surpluses

Negative Consequences

• Low domestic spending
• Accumulation of foreign assets
• appreciation of currency
• Risk of protectionism.

 

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