IB ECONOMICS

SECTION 3.3 THE BALANCE OF PAYMENTS

1. Outline the role of the balance of payments.

The balance of payments (BOP) records financial transactions

made between consumers, businesses and the government in one
country with others.
The BOP figures tell us about how much is being spent by consumers
and firms on imported goods and services, and how successful firms
have been in exporting to other countries.
The balance of payments accounts record all flows of money in
and out of a country.
These flows might result from the sale of exports (an inflow or
credit) or from the domestic country purchasing imports from
overseas (an outflow or debit).
They might also arise from other countries investing in the domestic
country (inward investment - a credit), or from domestic country
companies investing abroad (a debit).
 1. Outline the role of the balance of payments.

Theoretically, the BOP should be zero, meaning that assets

(credits) and liabilities (debits) should balance. But in practice
this is rarely the case and, thus, the BOP can tell the observer
if a country has a deficit or a surplus and from which part of
the economy the discrepancies are stemming.
 All trades conducted by both the private and public sectors
are accounted for in the BOP in order to determine how
much money is going in and out of a country
 Usually, the Balance of Payments is calculated every
quarter and every calendar year.
2. Distinguish between debit items and credit items
in the balance of payments.

Debit and credit are the two fundamental aspects of

every financial transaction in the double-entry
bookkeeping system in which every debit transaction
must have a corresponding credit transaction(s) and
vice versa.
 Debit: an expense, or money paid out from an

account. (-)
 Credit: is used to mean positive cash entries in an
account. (+)
3. Explain the four components of the current account,
specifically the balance of trade in goods, the balance of trade in
services, income and current transfers.

The current account includes four components:

• Trade in goods: visible account consists of physical items.

• Trade in services: invisible account consists of transport, tourism

and insurance etc.

• Net Income flows: Income flows consist of wages, interest and
profits flowing into and out of the country.
• Current transfers of money: Government contributions to and
receipts from international organizations and international
transfers of money by private individuals and firms.
 4.Distinguish between a current account deficit
and a current account surplus.

A deficit in the current account shows the country is spending

more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than it
receives through sales of exports, and it supplies more of its own
currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.
 4.Distinguish between a current account deficit
and a current account surplus.

A current account surplus occurs when the country’s exports are

more than its imports. This is a desirable condition, however it has its
own problem associated with it.
A surplus in the long run will lead to the appreciation of the
country’s currency which will reduce its export competitiveness.
Relatively stronger currency will induce people to go in for
imported goods, thus harming the domestic consumption and
investment.
In the long run, it will harm the domestic industry and increase
unemployment.
 5. Explain the two components of the capital account, specifically
capital transfers and transaction in non-produced, non-financial
assets.

Capital transfers are transactions, either in cash or in kind, in which the ownership
of an asset (other than cash and inventories) is transferred from one institutional
unit to another, or in which cash is transferred to enable the recipient to acquire
another asset, or in which the funds realized by the disposal of another asset are
transferred.
Non-financial assets are entities, over which ownership rights are enforced by
institutional units, individually or collectively, and from which economic benefits
may be derived by their owners by holding them, or using them over a period of
time, that consist of tangible assets, both produced and non-produced, and most
intangible assets for which no corresponding liabilities are recorded.
Non-produced assets are non-financial assets that come into existence other
than through processes of production; they include both tangible assets and
intangible assets and also include costs of ownership transfer on and major
improvements to these assets.
6. Explain the three main components of the financial account,
specifically, direct investment, portfolio investment and reserve
assets.

Direct investment is a category of international investment

made by a resident entity in one economy (direct investor) with
the objective of establishing a lasting interest in an enterprise
resident in an economy other than that of the investor (direct
investment enterprise).
Portfolio investment is the category of international
investment that covers investment in equity and debt securities,
excluding any such instruments that are classified as direct
investment or reserve assets.
Reserve assets - capital held back from investment in order to
meet probable or possible demands
 7. Calculate elements of the balance of payments
from a set of data.

Calculate the following balances:

I. Current account
II. Financial account
III. Capital account
IV. Reserve assets
V. Balance of payments
Does the country have a trade deficit or surplus?
Determine the amount needed for the reserve assets if any and
explain why its either positive or negative.
7. Calculate elements of the balance of payments
from a set of data.

Category Balance / billions of $

Imports of goods 550
Import of services 400
Export of goods 380
Export of services 550
Income -130
Current transfers 70
Direct investment 40
Portfolio investment -80
Capital transfer 90
Transaction in non-produces, non-financial -25
assets
Reserve assets ?
Balance of payments ?
7. Calculate elements of the balance of payments
from a set of data.

Calculate the Current account:

Current account balance =

Export of goods 380

Export of services 550
Import of goods 550
Import of services 400
Income balance -130
Current transfer 70
Current account balance = -$80 billion
7. Calculate elements of the balance of payments
from a set of data.

Calculate the Financial account:

Financial account balance =

Direct investment 40

Portfolio investment -80

Financial account balance = -$40 billion

7. Calculate elements of the balance of payments
from a set of data.

Calculate the Capital account:

Capital account balance =

Capital transfers 90
Transaction in non-produces, non- -25
financial assets

Capital account balance = $65 billion

7. Calculate elements of the balance of
payments from a set of data.

Current account + financial account + capital

account + change in reserve assets = 0, therefore:
-80 + -40 + 65 + reserve assets = 55
Change in reserve assets is $55 billion.
Balance of payments = current account + financial
account + capital account + change in reserve
assets
BOP = -80 + -40 + 65 + +55 = 0
7. Calculate elements of the balance of payments
from a set of data.

The country has a trade deficit. It purchased more

goods and services from the rest of the world than the
rest of the world bought of its goods and services.
The country’s reserve assets must have changed by
$55 billion. This number is positive because the
country overall had a net deficit in its current, capital
and financial accounts of $55 billion, meaning that
more money left the country for all its international
transactions than came into the country.
8. Explain that the current account balance is equal to the
sum of the capital account and financial account balances.

Current account
• Balance of trade in goods
• Balance of trade in services
• Income
• Current transfers
Capital account
• Capital transfers
• Transactions in non-produced, non-financial assets
Financial account
• Direct investment
• Portfolio investment
• Reserve assets
8. Explain that the current account balance is equal to the
sum of the capital account and financial account balances.

Current account + financial account + capital

account + change in reserve assets = ZERO
Another way to look at this is to notice that a nation’s
current balance equal the inverse of the capital,
financial and reserve account balance.
Current account = -(capital account + financial
account + change in reserve assets)
9. Examine how the current account and the financial
account are interdependent.

The current, capital, and financial accounts

are interdependent
 Current account measures flow of goods and

services
 Capital and financial accounts measure flow
of financing
 Therefore, sum of capital account and

financial accounts equal to current account

with opposite sign
10. Explain why a deficit in the current account of the balance of
payments may result in downward pressure on the exchange rate of the
currency.

A deficit in the current account shows the country is spending

more on foreign trade than it is earning, and that it is borrowing
capital from foreign sources to make up the deficit.
In other words, the country requires more foreign currency than
it receives through sales of exports, and it supplies more of its
own currency than foreigners demand for its products.
The excess demand for foreign currency lowers the country's
exchange rate until domestic goods and services are cheap
enough for foreigners, and foreign assets are too expensive to
generate sales for domestic interests.
 What are the main causes of a current account
deficit?

 High income elasticity of demand for imports – when consumer

spending is strong, the volume of imports grows quickly
 Long-term decline in the capacity of manufacturing industry
because of de-industrialization. There has been a shift of
manufacturing to lower-cost emerging market countries who then
export products back into the developed country. Many businesses
have out-sourced assembly of goods to other countries whilst
retaining other aspects of the supply chain such as marketing and
research within the home country.
 The trade balance is vulnerable to shifts in world commodity
prices and exchange rates.
11. Discuss the implications of a persistent current account deficit, referring to factors
including foreign ownership of domestic assets, exchange rates, interest rates,
indebtedness, international credit ratings and demand management.

The effect of a current account deficit on the exchange rate:

Under a floating exchange rate system, deficits in the current account
should be automatically corrected due to adjustments in exchange rates.
When households and firms in one nation demand more of other countries’
output than the rest of the world demands of theirs, there is upward
pressure on the value of trading partners’ currencies and downward
pressure on the importing nation’s currency. In this way, a movement
towards a current account deficit should cause the deficit country’s
currency to weaken.
The downward pressure on exchange rates resulting from an increase in a
nation’s current account deficit should have a self-correcting effect on the
trade imbalance. In this way, a flexible exchange rate system should, in
the long-run, eliminate surpluses and deficits between nations in the
current account.
 11. Discuss the implications of a persistent current account deficit, referring to factors
including foreign ownership of domestic assets, exchange rates, interest rates,
indebtedness, international credit ratings and demand management.

The effect on interest rates: A persistent deficit in the current account can
have adverse effects on the interest rates and investment in the deficit
country. As explained before, a current account deficit can put downward
pressure on a nation’s exchange rate, which causes inflation in the deficit
country as imported goods, services and raw materials become more
expensive. In order to prevent massive currency depreciation, the country’s
central bank may be forced to tighten the money supply and raise
domestic interest rates to attract foreign investors and keep demand for
the currency and the exchange rate stable.
Additionally, since a current account deficit must be offset by a financial
account surplus, the deficit country’s government may need to offer higher
interest rates on government bonds to attract foreign investors. Higher
borrowing rates for the government and the private sector can slow
domestic investment and economic growth in the deficit nation.
 11. Discuss the implications of a persistent current account deficit, referring to factors
including foreign ownership of domestic assets, exchange rates, interest rates,
indebtedness, international credit ratings and demand management.

Foreign ownership of domestic assets: By definition, the balance of

payments must always equal zero. For this reason, a deficit in the current
account must be offset by a surplus in the capital and financial accounts. If
the money spent by a deficit country on goods from abroad does not end up
returning to the deficit country for the purchase of goods and services, it will
be re-invested into the county through foreign acquisition of domestic real
and financial assets, or held in reserve by surplus nations’ central banks.
Essentially, a country with a large current account deficit, since it cannot
export enough goods and services to make up for its spending on imports,
instead ends up “exporting ownership” of its financial and real assets. This
could take the form of foreign direct investment in domestic firms, increased
portfolio investment by foreigners in the domestic economy, and foreign
ownership of domestic government debt, or the build up of foreign reserves
of the deficit nation’s currency.
 11. Discuss the implications of a persistent current account deficit, referring to factors
including foreign ownership of domestic assets, exchange rates, interest rates,
indebtedness, international credit ratings and demand management.

The effect on indebtedness: A large current account deficit is synonymous

with a large financial account surplus. One source of credits in the financial
account is foreign ownership of domestic government bonds (i.e. debt). When
a central bank from another nation buys government bonds from a nation
with which it has a large current account surplus, the deficit nation is
essentially going into debt to the surplus nation.
On the one hand, foreign lending to a deficit nation is beneficial because it
keeps demand for government bonds high and interest rates low, which allows
the deficit country’s government to finance its budget without raising taxes on
domestic households and firms.
On the other hand, every dollar borrowed from a foreigner has to be repaid
with interest. Interest payments on the national debt cost US taxpayers over
$400 billion in 2010, making up around 10% of the federal budget. Nearly
half of this went to foreign holders of US debt, meaning almost $200 billion
of US taxpayer money was handed over to foreign interests, without adding
a single dollar to aggregate demand in the US.
 11. Discuss the implications of a persistent current account deficit, referring to factors
including foreign ownership of domestic assets, exchange rates, interest rates,
indebtedness, international credit ratings and demand management.

The effect on international credit ratings and demand

management:
Over time, budget deficits financed through foreign borrowing
reduce the attractiveness of the deficit country’s government bonds
to foreign investors, harming its international credit rating, forcing
the government to offer ever increased interest rates to foreign
lenders.
Higher interest rates that must be offered reduce the government’s
ability to manage the level of aggregate demand in that nation
through fiscal policy to promote its macroeconomic objectives.
 11. Discuss the implications of a persistent current account deficit, referring to factors including
foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international
credit ratings and demand management.

What does a current account deficit mean?

Running a deficit on the current account means that an economy is not paying its way in the global
economy. There is a net outflow of demand and income from the circular flow of income and
spending. Spending on imported goods and services exceeds the income from exports.
Balance of payments and the standard of living
• In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on
foreign direct investment or borrow money to make up the difference
• In the short term, if a country is importing a high volume of goods and services this is a boost to
living standards because it allows consumers to buy more consumer durables.
Balance of Payments and Aggregate Demand
• When there is a current account deficit – this means that there is a net outflow of demand and
income from a country’s circular flow. In other words, trade in goods and services and net flows
from transfers and investment income are taking more money out of the economy than is flowing in.
Aggregate demand will fall.
• When there is a current account surplus there is a net inflow of money into the circular flow and
aggregate demand will rise.
 Reasons why a country’s balance of payments on current account
may at times be in deficit and at other times be in surplus

changes in exchange rates which alter the relative prices of

imports and exports
 the impact of the level of economic activity in overseas
markets on exports
 the impact of the level of domestic economic activity on
imports
 relative domestic and foreign rates of inflation
 changes in the pattern of comparative advantage and
overseas competition
 the impact of changes in barriers to trade
 changes in investment income and transfers
 changes in the terms of trade
 the impact of fiscal and monetary policies
 Does the existence of a current account deficit represent
an economic problem?

not a problem if:

 deficit is small and/or temporary
 it is counterbalanced by capital inflows

 other countries are continuously willing to finance

the deficit
 it reflects a growing economy and higher living
standards
 automatic correction of a deficit under a floating
exchange rate system
 Does the existence of a current account deficit represent
an economic problem?

reasons why it may be a problem:

 need to finance deficit may lead to depletion of
foreign exchange reserves/overseas
borrowing/greater indebtedness
 a reflection of trading uncompetitiveness / overvalued
exchange rate
 overseas creditors decide to “turn off the taps”
 the impact on the exchange rate and inflation
 the need for domestic deflation and the conflict with
the goals of full employment and economic growth
 12. Explain the methods that a government can use to correct a persistent current
account deficit, including expenditure switching policies, expenditure reducing
policies and supply-side policies, to increase competitiveness.

Expenditure switching policies

These are policies implemented by the government that attempt to
switch the expenditure of domestic consumers away from imports
towards domestically produced goods & services.
 devaluating currency: Fixing the domestic currency value at a
lower price and thus making exports more attractive. Moreover,
imports will become more expensive, thus diverting consumption to
domestic goods.
However, expensive imports will lead to imported inflation
 Protectionist measures: Reducing imports by levying tariffs and
setting up quotas.
 12. Explain the methods that a government can use to correct a persistent current account
deficit, including expenditure switching policies, expenditure reducing policies and supply-side
policies, to increase competitiveness.

Expenditure reducing policies

These are policies implemented by the government that attempt to
reduce overall expenditure in the economy, so shifting the AD to the
left.
• deflationary fiscal policies: Increasing taxes and reducing

government spending.
• deflationary monetary policies: Increasing Interest rates.

However, contractionary fiscal and monetary policies will lead to

fall in Aggregate Demand, which is not desirable. This will result in
compromising economic growth and higher unemployment.
 12. Explain the methods that a government can use to correct a persistent current
account deficit, including expenditure switching policies, expenditure reducing
policies and supply-side policies, to increase competitiveness.

Supply Side policies

The main objective of the supply side policies is to improve the quantity and quality of
factors of production. By achieving efficiency in the production of goods and services, the
economy can improve its international competitiveness and increase its exports. This would
include
 Improvement in technology

 Improving the education and skill level of its workforce

 Providing better infrastructure

 Privatization

 deregulation

All of the above measures will also attract foreign investment in the economy, which will
lead to inflow of foreign currency and improve balance of payment.
Supply-side policy can provide a highly effective policy framework for long term
improvement in competitiveness and current account performance. The main problem is
that supply-side policy may take decades to work and is not a quick-fix.
12. Explain the methods that a government can use to correct a persistent current
account deficit, including expenditure switching policies, expenditure reducing
policies and supply-side policies, to increase competitiveness.
 13. Evaluate the effectiveness of the policies to correct a
persistent current account deficit.

Evaluation of Expenditure reducing policies:

The main criticism of deflationary policy is that, as spending-power must fall,
personal incomes and standards of living will also fall, and this can trigger
demand deficient unemployment. However, different deflationary policies may
result in different effects. For example, raising interest rates may work more
quickly than raising tax rates.

For the above reasons, deflation is a politically unpopular policy option. Voters
are much more likely to be concerned with recession and unemployment than with
a balance of payments deficit, hence politicians are unlikely to priorities the
reduction of a deficit.

It is also difficult to predict the precise effect of a fall in spending on imports,

which requires an accurate calculation of the marginal propensity to import.
13. Evaluate the effectiveness of the policies to correct
a persistent current account deficit.

Evaluation of Expenditure switching policies:

Devaluation relies on the assumption that the sum of price elasticity
of demand for imports and exports is elastic (>1), the so-called
Marshall-Lerner condition. However, this may not be satisfied in the
short run, or even the longer run.

Devaluation may also trigger cost-push inflation, where a fall in

the value of a currency will increase the price of imported goods, in
terms of the domestic currency.

Devaluation could be interpreted as a hostile move against other

countries and may lead to retaliation by competitors, so that no
long term benefit is derived by the devaluing country.
13. Evaluate the effectiveness of the policies to correct
a persistent current account deficit.

Evaluation of Expenditure switching policies:

In the short run, trade barriers may help to reduce

imports and help improve the current account.
However, retaliation is a likely response, and any
short-term gains will be eroded away. Therefore,
direct controls are not generally considered an
effective long-term solution to a current account
deficit.
13. Evaluate the effectiveness of the policies to correct
a persistent current account deficit.

Evaluation of Supply-side policies:

Supply-side policy can provide a highly effective

policy framework for long term improvement in
competitiveness and current account performance. The
main problem is that supply-side policy may take
decades to work and is not a quick-fix.
14. State the Marshall-Lerner condition.

The Marshall–Lerner condition has been cited as a technical reason

why a reduction in value of a nation's currency need not immediately
improve its balance of payments.
The condition seeks to answer the following question: When does a
real devaluation (in fixed exchange rates) or a real depreciation (in
floating exchange rates) of the currency improve the current-account
balance of a country?
The Marshall-Lerner condition states that a real devaluation (or a real
depreciation) of the currency will improve the trade balance if the
sum of the elasticity's (in absolute values) of the demand for imports
and exports with respect to the real exchange rate is greater than
one,
Exportsped+Importsped > 1
15. Apply the Marshall-Lerner condition to the effect
of depreciation/devaluation on the current account.

Immediately following the depreciation or devaluation

of the currency, the volume of imports and exports
may remain largely unchanged due in part to pre-
existing trade contracts that have to be honored.
Moreover, in the short run, demand for the more
expensive imports (and demand for exports, which
are cheaper to foreign buyers using foreign
currencies) remain price inelastic. This is due to time
lags in the consumer's search for acceptable, cheaper
alternatives (which might not exist).
15. Apply the Marshall-Lerner condition to the effect
of depreciation/devaluation on the current account.

Over the longer term a depreciation in the exchange rate

can have the desired effect of improving the current
account balance. Domestic consumers might switch their
expenditure to domestic products and away from expensive
imported goods and services, assuming equivalent domestic
alternatives exist.
Equally, many foreign consumers may switch to purchasing
the products being exported into their country, which are
now cheaper in the foreign currency, instead of their own
domestically produced goods and services.
16. Explain the J-curve effect, with reference to the Marshall-
Lerner condition.

A country's trade balance experiences the J-curve

effect if its currency becomes devalued.
At first, the country's total value of imports (goods
purchased from abroad) exceeds its total value of
exports (goods sold abroad), resulting in a trade
deficit.
But eventually, the currency devaluation reduces the
price of its exports. Consequently, the country's level
of exports gradually recovers, and the country moves
back to a trade surplus.
16. Explain the J-curve effect, with reference to the
Marshall- Lerner condition.

Following the depreciation or devaluation of the

currency, the volume of imports and exports will
remain level due in part to pre-existing contracts for
imported goods that have to be honored. However,
the depreciation will cause the price of imports to rise
and the price of exports to fall. Therefore, total
spending on imports will subsequently increase and
total spending on exports will decrease. It is this that
causes the worsening of the current account.
16. Explain the J-curve effect, with reference to the
Marshall- Lerner condition.

Moreover, in the short run, demand for the more expensive imports
remain price inelastic. This is due to time lags in the consumer's search
for acceptable, cheaper alternatives. As a result, the quantity
demanded for imports remain the same, although consumers are now
paying a higher price for it. Ceteris paribus, a worsening of the current
account, and hence the balance of payments, is to be expected in the
short run.
Over the longer term a depreciation in the exchange rate can have
the desired effect of improving the current account balance. Demand
for exports picks up and domestic consumers will switch their
expenditure to domestic products and away from expensive imported
goods and services. Equally, many foreign consumers may switch to
purchasing cheaper imported products instead of their own
domestically produced goods and services.
16. Explain the J-curve effect, with reference to the
Marshall- Lerner condition.
17. Explain why a surplus in the current account of the balance of payments
may result in upward pressure on the exchange rate of the currency.

If a nation consistently sell more of its output to

foreigners than it demands of foreign output, demand
for the exporting nations currency will eventually rise
and appreciate. In addition, since the surplus nation
demands relatively little of foreign goods, the supply
of its currency in foreign exchange markets will fall,
contributing to the currency’s appreciation.
18. Discuss the possible consequences of a rising current account surplus, including
lower domestic consumption and investment, as well as the appreciation of the
domestic currency and reduced export competitiveness.

Over time, an appreciation currency will reduce the

export industry’s competitiveness with the rest of the
world and force domestic producers to become more
efficient or shut down as foreign demand for their
goods eventually falls.
Under a floating exchange rate, current account
surpluses should be kept in check by the appreciation
of the surplus nation’s currency and the corresponding
decrease in demand for its exports and the increasing
appeal of imports among domestic consumers.
 18. Discuss the possible consequences of a rising current account surplus, including
lower domestic consumption and investment, as well as the appreciation of the
domestic currency and reduced export competitiveness.

Many countries operate with a trade and current account surplus – good examples are
China, Germany, Norway and emerging market countries with strong export sectors. There
are several causes and each country will have a unique set of circumstances:
Export-oriented growth: Some countries have set out to increase the capacity of their
export industries as a growth strategy. Investment in new capital provides the means by
which economies of scale can be exploited, unit costs driven down and comparative
advantage can be developed.
Foreign direct investment: Strong export growth can be the result of a high level of
foreign direct investment where foreign affiliates establish production plants and or
exporting.
Undervalued exchange rate: A trade surplus might result from a country attempting to
depreciate its exchange rate to boost competitiveness. Keeping the exchange rate down
might be achieved by currency intervention by a nation’s central bank, i.e. selling their own
currency and accumulating reserves of foreign currency. One of the persistent disputes
between the USA and China has revolved around allegations that the Chinese have
manipulated the Yuan so that export industries can continue to sell huge volumes into North
American markets.
 18. Discuss the possible consequences of a rising current account surplus, including
lower domestic consumption and investment, as well as the appreciation of the
domestic currency and reduced export competitiveness.

High domestic savings rates: Some economists attribute current account

surpluses to high levels of domestic savings and low domestic consumption of
goods and services. China has a high household saving ratio and a huge
trade surplus; in contrast the savings ratio in the United States has collapsed
and their trade deficit has got bigger. Critics of countries with persistent trade
surpluses argue they should do more to expand domestic demand to boost
world trade.
Closed economy – some countries have a low share of national income taken
up by imports – perhaps because of a range of tariff and non-tariff barriers.
Strong investment income from overseas investments: A part of the
current account that is often overlooked is the return that investors get from
purchasing assets overseas – it might be the profits coming home from the
foreign subsidiaries of multinational businesses, or the interest from money
held on overseas bank accounts, or the dividends from taking equity stakes in
foreign companies.
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS
Balance of payments
balance of payments - principally because the
total of outflows must be equivalent to the total
of inflows.
The BOP is made up of the Current account,
Capital account and the Official Reserve
account. (Financial account)
The Balance of Payments
Current account
Current account: It is the account where all of one
country's international transactions in goods and services
are recorded.
A record of a country's earnings from the sale of visible and
invisible items minus its expenditure on visible and invisible items
from abroad.
 The balance of trade in goods (Visible)
 The balance of trade in services (Invisible)
 Net income flows
- Net investment income (profits, interest and dividends)
- Net transfers of money (foreign aid, grants, remittance,
pensions)

CHAPTER 9 APPLICATION: INTERNATIONAL TRADE

Explain the four components of the current account,

Specifically:
 the balance of trade in goods,

 the balance of trade in services,

 income and

 current transfers.

 Current account deficit: A deficit on the trade

account means that imports are larger than exports.
 Current account surplus: A surplus on the trade
account means that imports are less than exports.
The current account is made up of the following payments:

Trade in goods:
These items include the import and export of finished goods, such as cars, and
computers; semi-finished goods, such as parts and components for assembly, and
commodities, such as oil, tea and coffee.
Trade in services:
Trade services include financial services, tourism, and consultancy.
Investment income:
Investment income, which includes overseas profits, such as those from business
activities of subsidiaries located abroad; interest received from UK financial
investment and loans abroad and; dividends from owning shares in overseas firms.
Transfers:
Transfers in items such as gifts, donations to charity, remittance and overseas aid
Capital Account

 The capital account (financial account) is a

measure of the buying and selling of assets
between countries.
 Foreign direct investment
 Portfolio investments (stocks & bonds)
 Other investments (currency transactions and
bank and savings account deposits)
The Capital and Financial Account records the flows of capital and finance between the
UK and the rest of the world. Types of flow include the following:

1. Real foreign direct investment (FDI), such as a UK firm setting up a

manufacturing plant in South Africa.
2. Portfolio investment, such as UK citizens buying shares in an overseas firm in
anticipation of a long term return.
3. Short-term speculative flows, called hot money, where speculators invest
abroad in order to obtain the highest return in the short run. For example, a UK
fund manager working for a major UK investment bank may buy shares in a
US hi-tech firm in the hope of making a fast return. Speculators may quickly
sell shares and other financial assets if a short-term profit has been made.
4. Official financing, which occurs when governments, or their agents, buy or
sell currencies, securities and other assets to create an inflow or outflow in the
balance of payments accounts. For example, when a deficit occurs it may be
financed through the Bank of England acting for the government. In an
accounting sense the Bank of England must ensure that the account balances –
the bottom line of the account must always equal zero.
Capital Account

 The Capital Servicing account:

Includes the interest, profits and dividends paid to and
by foreigners.
For developing countries, this section is usually
negative. More is paid out to foreign investors than is
received as interest and dividends.
 For industrialized countries like the US and Japan, this
account is typically positive because of the large amount
earned on foreign investments.
4.5 Balance of payments
 Capital account: if the Japanese invest in US treasury bills, it is the US that
gets the money, and the Japanese that get the TB's.
 It counts as negative on the Japanese balance of payments (and their
GDP).
 This is how the balance of payments is always balanced: if there are
negatives on the current account, they must be balanced by a plus on the
capital account.
 Short term capital is held mainly in money market instruments such as
treasury bills or bank accounts (portfolio as opposed to direct investment).
 Long term capital movements:
 Portfolio: generally involve the purchase of stocks or bonds.
 Direct: investments in capital in the country or joint venture agreements.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS

Capital account
 Capital account: That part of the balance of
payments accounts that measures the flows of
capital in and out of the country.
 Capital inflows: The movement of money into the
domestic country in the form of e.g. the purchase of
shares, the purchase of companies and loans by
overseas companies.
 Capital flight (outflows): The movement of
financial assets out of a country in response to an
unfavorable domestic circumstances.
Official Reserve Account
 Central Bank controls to balance the BOP
accounts with foreign currencies, gold and
SDR’s.
 Depends on the level of flexibility of the
currency.
Official Reserve account
 Reserves: monetary assets held by central
banks to intervene in foreign exchange
markets and to settle international debts.
 Reserve currency: A currency held by central
banks to intervene in foreign exchange
markets and to settle international debts.
balance of trade
 The balance of trade (or net exports, sometimes
symbolized as NX) is the difference between the
monetary value of exports and imports of output in
an economy over a certain period. It is the
relationship between a nation's imports and exports.
 A positive balance is known as a trade surplus if it
consists of exporting more than is imported;
 a negative balance is referred to as a trade deficit
or, informally, a trade gap.
 Factors influencing the balance of payments include:

 Income: as national income rises the demand for imports rise shifting the current
account toward a deficit.
 Changes in relative prices: as domestic prices rise relative to foreign prices,
imports appear cheaper and exports more expensive and the current account
will move toward a deficit.
 Changes in relative investment prospects: as return on
investment rises, foreign capital will be attracted into the country and
the capital account will move toward a surplus.
 Changes in relative interest rates: as domestic interest rates rise,
short term capital is attracted moving the capital account toward a
surplus.
 If the foreign exchange rate is rising (domestic currency appreciating),
the central bank may intervene by selling more domestic
currency.
 If the foreign exchange rate is falling (domestic currency is
depreciating), the central bank may intervene by buying domestic
currency with the reserve of foreign currency.
Factors influencing the balance of payments

 Changes in exchange rates which alter the relative

prices of imports and exports
 The impact of the level of economic activity in
overseas markets on exports
 The impact of the level of domestic economic
activity on imports
 Relative domestic and foreign rates of inflation
 Changes in the pattern of comparative advantage
and overseas competition
Factors influencing the balance of payments

 The impact of changes in barriers to

trade
 Changes in investment income and
transfers
 Changes in the terms of trade

 The impact of fiscal and monetary

policies
Causes of a current account deficit

 Excessive growth
If the economy grows too quickly and rises above its own trend rate, which in the
UK is around 2.5%, then domestic output (AS) may not be able to cope with
domestic aggregate demand. When national income rises above its trend rate it is
likely that income elasticity of demand for luxury imports such as motor cars is
relatively high, so that imports rise relative to exports.
 De-industrialization
An increasing trade deficit may be a symptom of long-term de-industrialization.
The UK started to lose its manufacturing base in the 1970s, and this process has
continued over the last 30 years.
 High export prices
High export prices will occur if a country's inflation is higher than its competitors, or
if its currency is over-valued which will reduce its price competitiveness.
Causes of a current account deficit

 Non-price competitiveness
Non-price factors can discourage exports, such as poorly designed
products, poor marketing or a worsening reputation for reliability.
 Low levels of investment in human capital

This involves a lack of investment in education and training, which

reduces skill levels relative to competitor countries and forces countries to
produce low value exports.
 Poor productivity

An economy might not be producing enough from its scarce factors of

production. Labor productivity, which is defined as output per worker,
plays an important role in a country’s competitiveness and trade
performance, and the UK has suffered from poor productivity. The
productivity gap is the gap between the UK’s relatively poor productivity
performance and that of the UK’s leading competitors.
Causes of a current account deficit

 Low levels of investment in real capital

This could be caused by excessive long-term interest rates, or low levels of
research and development.
 Low levels of investment in human capital
This involves a lack of investment in education and training, which reduce skill levels
relative to competitor countries and force countries to produce low value exports.
 The rise of alternative global suppliers
While the UK has slowly deindustrialized, emerging economies like China and India
have increased their share of world trade, with their firms benefitting from access
to new technology and from economies of scale. This has reduced the likelihood of
smaller UK manufacturers selling abroad, while at the same time increased the
likelihood of UK households and firms importing from these economies.
Is a current account deficit a problem?

A deficit can be a problem under certain

circumstances, including the following:
1. It is a persistent deficit that does not self-correct
over time.
2. The deficit forms a large share of GDP.

3. There are no compensating inflows of investment

income or inward capital account flows.
4. The central bank has low reserves.

5. The economy has a poor record of repaying debt.

Reasons why a country’s balance of payments on current account
may at times be in deficit and at other times be in surplus

 changes in exchange rates which alter the relative prices of

imports and exports
 the impact of the level of economic activity in overseas markets
on exports
 the impact of the level of domestic economic activity on imports
 relative domestic and foreign rates of inflation
 changes in the pattern of comparative advantage and overseas
competition
 the impact of changes in barriers to trade
 changes in investment income and transfers
 changes in the terms of trade
 the impact of fiscal and monetary policies
Does the existence of a current account deficit represent
an economic problem?

not a problem if:

 deficit is small and/or temporary

 it is counterbalanced by capital inflows

 other countries are continuously willing to

finance the deficit
 it reflects a growing economy and higher living
standards
 automatic correction of a deficit under a floating
exchange rate system
Does the existence of a current account deficit represent
an economic problem?

reasons why it may be a problem:

 need to finance deficit may lead to depletion of foreign
exchange reserves/overseas borrowing/greater
indebtedness
 a reflection of trading un-competitiveness /overvalued
exchange rate
 overseas creditors decide to “turn off the taps”

 the impact on the exchange rate and inflation

 the need for domestic deflation and the conflict with the
goals of full employment and economic growth
Methods of correcting a persistent current account deficit

Expenditure-switching policies, are policies

implemented by the govt. that attempts to switch the
expenditure of domestic consumers away from imports
toward domestically produced goods and services.
 Devaluation/ depreciation of the currency
 Protectionist measures

 Policies to reduce inflation below that of competitors

 Policies that reduce cost of domestic firms.

(Ex. Subsidies & increases in productivity)

Methods of correcting a persistent current account deficit

Expenditure-reducing policies, are policies

implemented by the govt. that attempt to reduce
overall expenditure in the economy, so shifting
AD inward.

 Contractionary Fiscal policy

 Contractionary Monetary policy
Methods of correcting a persistent current account deficit

Supply-side policies to increase competitiveness.

 Lower input prices
 Increase productivity
 LIE policies:
 Taxes
 Govt Spending
 Govt Regulations
Policies to reduce a deficit

Deflating demand
 Deflating demand means deliberately reducing consumer
spending, or reducing its rate of growth, through fiscal
contraction, such as raising direct taxes, or by monetary
contraction, such as raising interest rates or reducing the
availability of credit.
 As a by-product of this, imports are also likely to fall, hence

deflating demand is said to work by a process called

expenditure reduction. This policy targets general household
spending, and given that imports are dependent on spending,
then imports will fall as spending falls.
Devaluation
The second policy option to improve the current account is devaluation, which
involves the deliberate reduction in the value of a country’s currency. It works
by expenditure switching, which means that the policy encourages consumers to
alter the distribution of their spending, rather than the total level of spending.

An ‘equilibrium’ exchange rate is the specific rate where export revenue and
import spending are equal.

A fall in the exchange rate will, ceteris paribus, reduce export prices
encouraging overseas consumers to switch to lower price products. This is likely
to lead to a rise in export demand. Devaluation will also lead to an increase
in import prices, encouraging domestic consumers to switch away from
imports to domestically produced products. This will lead to a fall in import
demand.
Direct controls

A third option to help reduce a current account

deficit is to impose direct controls on imports by
erecting barriers against imports or by providing
assistance to exporters.
Specific measures include:
 Tariffs

 Non-tariff barriers, such as quotas, subsidies to

domestic firms and discrimination against

imports and in favor of domestic firms.
Supply-side policy
Finally, supply-side policy could be used to help
improve an economy’s ability to produce. There are
several actions that a government can take to improve
supply-side performance. These measures include
improving labor productivity and labor market
flexibility.
Current account surpluses

A surplus on the current account component of the

Balance of payments indicates that the country is
exporting more goods and services than importing. This
means they are gaining foreign currency they can use to
buy foreign assets such as government bonds and invest in
foreign factories.
It is not clear that a surplus on the current account is a bad
thing. It has certain advantages such as being able to
invest in foreign countries and build up foreign exchange
reserves. It may also indicate that the country is quite
competitive relative to other countries.
Current account surpluses

However, a large current account surplus may indicate an

unbalanced economy. For example, it may indicate the country is
relying too heavily on exports and consumer spending is
relatively too low.
In the case of China, one reason for large current account surplus
is their decision to keep their currency undervalued. This makes
their exports more competitive and imports more expensive,
increasing domestic demand. However, this undervaluation of the
currency is arguably contributing to inflation. China is at risk of
allowing their economy to grow too quickly and cause a boom
and bust.