Balance of Payments

Ch24 IB Economics
Balance of Payments
The balance of payment is a record of
the value of all the transactions between
the residents of one country and the
residents of all other countries in the
world over a given period of time
There are 2 main parts
Current account and capital
account
The current account measures flow of
trade in goods and services plus other
income
It can be divided into 4 parts
1.The balance of trade in goods
Also known as visible trade
Exports minus imports of tangible
goods
When export revenue is higher
than import expenditure there is a
surplus
When export revenue is lower than
import expenditure there is a deficit
Balance of Payments
2.The balance of trade in services
Also known as the invisible balance
Measure of revenue received from export of
services minus expenditure on imports of
services
Services such as banking, insurance and
tourism
An Italian tourist spending money in London
would be an invisible export to the UK economy
3.Income
Also known as net investment income
Net movement of profit, interest and dividends
moving into and out of the country as a result of
financial investment abroad
Residents in the UK may put money in banks in
other countries – the interest they gain would be
a positive item
Residents in the UK might buy shares in
companies in other countries – the dividends
they receive would be a positive item
Balance of Payments
4.Current Transfers
These are payments made
between countries but no goods
or services change hands
Foreign aid or grants at
government level
Expat workers sending money
home at individual level

Current account balance = Balance of

trade in goods + Balance of trade in
services + Net income flows + Net
transfers
The Capital Account
Relatively small part of the
BoP
Has 2 components
Capital Transfers – transfers of
goods and financial assets by
migrants leaving or entering;
debt forgiveness; sales of fixed
assets; gift taxes; inheritance
taxes; death duties
Transactions in non-produced,
non financial assets – consists of
sales and purchases of things
like land or rights to natural
resources and intangible assets
like patents, copyrights, brand
names, franchises etc.
The Financial Account
Measures the net change in foreign ownership of domestic financial assets
If foreign ownership of domestic financial assets increases more quickly
than domestic ownership of foreign financial assets there is more money
coming into the country than going out and there is a surplus
There are 3 parts
 Direct investment – purchase of long term assets like property,
buying a company, buying shares in a company
 Needs to be a lasting/long term interest
 Portfolio investment – stock and bond purchases that don’t fit in the
above section (not a long lasting interest)
 Reserve Assets – the reserves of gold and foreign currencies held by
a country
 Movements into and out of this account ensure that the balance
of payments will always balance to zero
 In reality it is never zero because there are too many individual
interactions to be exact. This is covered by the net errors and
omissions

Current Account = Capital Account + financial

account + net errors and omissions
The relationship between the current
account and the exchange rate
A deficit in the current account means
more imports than exports
This means buying of external currency
This means supplying of domestic currency
to buy foreign currency
This reduces the price of the currency
If the currency becomes weaker imports
become more expensive and exports become
cheaper
In theory more exports should be
demanded by foreign countries
In theory less imports should be demanded
by the domestic country
This should help fix the balance of
payments
This is only the case with a floating
exchange rate
The relationship between the current
account and the exchange rate
When there is a fixed exchange rate a
deficit on the current account means the
exchange rate has been set too high
The deficit could be covered by increases in
capital and financial accounts or by the
government using reserve assets to balance
the accounts
This can only happen in the short run
In the long run the exchange rate will need
to be depreciated
HL Balance of Payments

Ch24 IB Economics
The consequences of a current account deficit
If the current account is in deficit then the capital account
will have to be in surplus to balance out the deficit
This means one of three things will have to happen
1.Foreign exchange reserves may be used to increase the
capital account
However, no country is able to fund long term current
account deficits with reserves – eventually they will run
out
2.It may be that a high level of foreign buying of assets for
ownership is financing the deficit
Foreign investors may be buying property, businesses,
or stocks and shares
If it is based on foreign confidence in the domestic
economy then this is not a problem
This is sometimes viewed as a threat to sovereignty
If there is a drop in confidence they move these assets
to other countries
They could sell their assets resulting in an increase in
the supply of the currency and a fall in its value
3.It may be that it is financed by high levels of lending abroad
High rates of interest will have to be paid
If governments lending the money decided to withdraw
it this would lead to a massive selling of currency and a
sharp fall in the exchange rate
The consequences of a current account
surplus
If the current account is in surplus there
will be other consequences
1.Allows a country to have a deficit on its
capital account by building up its official
reserve account or by purchasing assets
abroad
However, one country’s surplus is
another’s deficit and this may lead to
protectionism by other countries
2.It will usually lead to an appreciation of
the currency on the foreign exchange
market as it implies an increase in demand
for the currency
This will make imports cheaper so
reducing inflationary pressures
It will also make exports more
expensive harming exporters
How big is a ‘big’ current account deficit or
surplus?
There are two ways to interpret the size of a
country’s deficit or surplus
Total value
Or as a proportion of GDP
This is like having an overdraft on your bank
account
If you earn $100,000 and you have a $10,000
overdraft this is manageable
If you earn $30,000 and have a $10,000 overdraft
you may be in trouble
Big is only bad if you can’t pay it back
Methods of correcting a persistent current Expenditure
account deficit switching policies
There are two types of policy used to correct – attempt to reduce
a persistent current account deficit spending on
Expenditure-switching policies imports towards
domestic goods
If successful imports will fall and the current
and services
account deficit should improve
Examples
Depreciating or devaluing the currency – exports
will become cheaper and imports more expensive
It depends how responsive domestic and foreign
buyers are to the price change but the deficit should
improve
Protectionist measures – restricting foreign
imports will make domestic consumers switch
spending from imports to domestic goods
Evaluation
Governments are often reluctant to use such
measures because it may lead to retaliation and
could be against WTO measures
Protecting domestic industries may also may them
inefficient in the long run
Methods of correcting a persistent current Expenditure
account deficit reducing policies
Expenditure-reducing policies – attempt to reduce
Deflating the economy may reduce the current account but overall spending in
it is likely to lead to a fall in domestic employment and a fall in the economy
the rate of economic growth
(shifting AD to the
Examples
left)
Deflationary fiscal policy
increasing taxes and/or reducing government spending
which will be politically unpopular
Deflationary monetary policies
increasing the rate of interest and/reducing money
supply
Hot money would flow into the country’s capital
account helping offset the deficit in the current account
Politically unpopular because payments on mortgages,
loans and credit cards will increase
Investment may decrease
Overall
The economic costs of reducing a large current account
deficit suggest why it is important to prevent it from
happening
Governments will actively pursue export promotion
policies – trade missions, govt advertising campaigns
The Marshall Lerner Condition Marshall-Lerner condition –
reducing the value of the
In theory when a country’s currency
exchange rate will only be
depreciates its exports will be cheaper successful if the total value of
and there will be an increase leading to
the PED for exports and the
an increase in the current account
PED for imports is greater than
This is not necessarily the case one
How much the price change has an PEDexports + PEDimports > 1
effect on the demand depends on the
PED of imports and exports
The Marshall-Lerner condition is a rule
that tells us how successful a
depreciation or devaluation of a currenc
y’s exchange rate will be
If the demand for exports was inelastic
and the price fell there proportionate
increase in demand would be less than
the proportionate decrease in price
The same for imports
Complete student workpoint 24.3 (P
The Marshall Lerner Condition Marshall-Lerner
The table below shows a study of trade elasticities condition –
in 2000 reducing the value
In almost all cases the short run values were lower of the exchange
rate will only be
than the long run values
successful if the
This is to be expected because PED become more total value of the
elastic over time (ability to look for alternatives) PED for exports
Only the US would meet the Marshall Lerner and the PED for
condition in the short run but all meet the condition imports is greater
in the long run than one
PEDexports +
PEDimports > 1
The J-Curve effect
 In the short term a depreciation of the exchange rate may not
improve the current account deficit of the balance of payments
 This is due to the low price elasticity of demand for imports and
exports in the immediate aftermath of an exchange rate change
 Initially the volume of imports will remain steady partly because
contracts for imported goods will have been signed
 However, depreciation raises the sterling price of imports (that will
also remain steady due to contracts with suppliers) causing total
spending on imports to rise
 Export demand will also be inelastic in response to the exchange
rate change in the short term
 Therefore the earnings from exports may be insufficient to
compensate for higher spending on imports
 The balance of trade may worsen (X to Y) in the immediate
aftermath of a fall in the external value of the currency
 This is widely known as the J-Curve effect as seen in the diagram
 The PED for exports and imports increases with time until it meets
the Marshall-Lerner condition and satisfied leading to a movement
from Y to Z
Time for you to do some work!!
HL Data response P307
SL – Q1 & 2
Examples
Iceland
• Export value - 421,907,186.32 USD
• Main exports –
40% Fish + Fish products
40% Aluminum and alloys
Animal Products

• GDP represented by exports

$421,907,186.32 / $14.06 Billion = 3%
Iceland
• Import Value - 319,283,771.32 USD
• Imports –
Machines and equipment
Petroleum products
Foodstuff and textiles

• GDP represented by Imports

$319,283,771.32 / $14.06 Billion = 2.27%

Balance of Payments Surplus

India
• India exports were worth 22330 Million USD. Spices, textiles,
tea, coffee, coal
• Mainly agricultural goods, which are land, labor, and capital
intensive.
• Imports petroleum goods, machinery, chemicals. 
• 1.21%
• India’s imports are worth 37953 Million USD Imports are of a
higher value, which means it is a leakage in the circular flow
diagram.
• 2.15%
Spain