Chapter 39

Current account of balance of payments

 Learning objectives
By the end of this chapter you will be able to:
desaibe the components of the current account of the
balance of payments calculate deficits and surpluses on
the current account of the balance of payments analyse
the causes of current account deficits and surpluses
analyse the consequences of current account deficits
and surpluses
discuss the effectiveness of policy measures to achieve
balance of payments stability
39.1 Structure of the current account
The meaning of the balance of payments
The balance of payments Is a record of all economic
transactions between the residents of a country and the
rest of the world in a particular period (over a quarter of a
year or more commonly over a year). These transactions
are made by individuals, firms and the government Money
coming into the country is recorded as credit items and
money leaving the country as debit items, The first section
of the balance of payments, and the best known, is the
current account
The components of the current account

The current account shows the income

received by the country and the expenditure
made by it in its dealings with other countries
It is usually divided into four components
 Trade in goods
• This covers exports and imports of goods including
cars, food and machinery. Such goods are sometimes
referred to as merchandise exports and imports and
visible exports and imports. If revenue from the
export of goods exceeds the expenditure from import
of goods, the country is said to have a trade in goods
Surplus. This can also be referred to as a visible trade
surplus. In contrast, a trade in goods deficit occurs
when export revenue decreases import expenditure
 Trade In services
• As its name suggests, this part records payments for services
sold abroad and expenditure on services bought from foreign
countries Services are also sometimes called invisibles with
saies of services abroad called invisible exports and the
purchase of sales from abroad known as invisible imports
Among the items included are banking, construction services,
financial services, travel and transportation of goods and
passengers between countries. A trade in service surplus would
mean That service receipts exceed payments for services.
Together the first two components give the balance on trade in
goods and services
 • Primary Income (previously called
income)
• This covers income earned by individuals and firms. It records two
categories of income flow. which are compensation of employees and
investment income. Compensation of employees includes wages,
salaries and other benefits earned by residents working abroad minus
that earned by foreigners working in the home economy. Investment
income covers profit, dividends and interest receipts from abroad
minus profit, dividends and interest paid abroad. Investment Income is
earned on foreign direct investment and financial investment including
shares government bonds and loans It, for example. a multinational
company sends profits out of the country back to its home country. it
wdl appear as a debit item in this section. The receipt of dividends on
shares in foreign companies and rnterest on loans made to foreign
firms will be credit items
 Secondary Income (previously called
current transfers
• This is transfers of money. goods or services which are
sent out of the country or come into the country, not in
return for anything else It essentially covers gifts. Items
include charitable donations. workers remittances
(money sent by migrant workers to relatives abroad and
money received by relatives from migrant workers in
other countries) and aid from one government to other
governments Workers remittances are a large item in
some countries’ secondary income
Calculation of deficits and surpluses on the
current account of the balance of payments
•
The balances of the four components are summed
up to give the current account balance (also
sometimes just called the current balance) A
current account surplus arises when the value of
credit items exceeds the value of debit items. If the
value of debit items is greater than the value of
credit items, there is a current account deficit.
 Answer
1 a Balance of trade in goods: $19 618 m − $24
900 m = −$5 282 m, Balance of trade in
services = $2 121 m − $4 074 m = −$1 953 m.
Balance of trade on goods and services = −$5
282 m + −$1 953 m = −$7 235 m.
Answer
 Answer
A A current surplus means that the country has
received more from its exports of goods and
services, primary income and secondary
income than it has spent on imports and the
income and transfers it has sent abroad.
B Primary income.
 Answer
C It will do so in the short run. The workers’
remittances make a major positive contribution
to the country’s current account balance. The
reason they are working abroad is likely to be
because of a lack of good opportunities at home.
If in the future, however, economic growth
increases in the country, the workers may be able
to work in the Philippines and exports of goods
may be able to replace workers’ remittances.
 Changes in exports and imports
• There are a number of factors that influence the value
of a country’s exports and imports. These include:
The country’s inflation rate. If the country has a
relatively high rate of inflation, domestic households
and firms are likely to buy a significant number of
imports. The country’s firms are also likely to
experience some difficulty in exporting. A fall in
inflation, however, would increase the country’s
international competitiveness and would be likely to
increase exports and reduce imports.
 The country’s exchange rate
A fall in a country’s exchange rate will lower
export prices and raise import prices. This will
be likely to increase the value of its exports
and lower the amount spent on imports
 Productivity
• The more productive a country’s workers are.
the lower the labour costs per unit and the
cheaper its products. A rise in productivity is
likely to lead to a greater number of
households and firms buying more of the
country’s products — so exports should rise
and imports fall.
 Quality
• A fall in the quality of a country’s products,
relative to other countries’ products, would
have an adverse effect on the country’s
balance of trade in goods and services.
 Marketing
• The amount of exports sold is influenced not
only by their quality and price but also by the
effectiveness of domestic firms in marketing
their products Similarly, the quantity of
imports purchased is affected by the
effectiveness of the marketing undertaken by
foreign firms.
 Domestic GDP
If incomes rise at home, more imports may be
bought Firms are likely to buy more raw materials
and capital goods, and some of these will come
from abroad Households will buy more products,
and some of these will be imported The rise in
domestic demand may also encourage some
domestic firms to switch from the foreign to the
domestic market, If this does occur, exports will
fall
 Foreign GDP
• If incomes abroad rise, foreigners will buy
more products. This may enable the country
to export more.
 Trade restrictions
• A relaxation in trade restrictions abroad will
make it easier for domestic firms to sell their
products to other countries.
 Answer
A An export of services is the sale of intangible products,
such as banking and insurance, to another country.
B Demand for construction services in China is likely to
increase in the future. This is because China is expected
to continue to grow. More businesses are likely to set up
and housing and places of entertainment are to be built.
C The UK may be particularly good at producing financial
services because it has a history of providing such
services, a range of financial institutions, skilled labour
and advanced capital equipment.
 39.2 The causes of a current account
deficit
The factors influencing changes in exports and
imports give an indication as to what can
cause a current account deficit One is incomes
at home and abroad .A deficit arising from low
incomes abroad and/or high incomes at home
can be referred to as a cyclical deficit
 Answer
• a i Profits, interest and dividends.
• ii Factories, shares and loans.
 Answer
B It is possible that the fall in investment income
may have been the result of UK banks lending
less to foreigners or lending the same amount
but receiving a lower rate of interest on its loans.
Either way, the interest earned by the UK may
have fallen. Of course, the decline in investment
income might also have been the result of the
dividends earned on foreign shares or the profits
earned by UK firms producing abroad declining.
 39.3 The consequences of a current
account deficit
A current account deficit may mean that a
country is consuming more goods and services
than what it is producing. This is sometimes
referred to as a country living beyond its
means. A current account deficit can also
mean a reduction in inflationary pressure, as
there will be a fall in aggregate demand.
 Answer
• a i A rise in the exchange rate and a rise in
inflation.
• ii Trade in goods.
B It may be concerned that the products it is
manufacturing are not in high world demand.
If this is the case, it may continue to have a
deficit.
 39.4 The causes of a current account
surplus
A current account surplus may arise for a
number of reasons including
• A low exchange rate. This will make export
prices cheap and import prices expensive,
 • High quality of domestically produced
products.
• This will encourage foreign and clomesbc
citizens to purchase the country’s output.
 High incomes abroad
• This will enable foreigners to buy a high
volume of me country’s exports.
 Low costs of production
• This may make an economy’s products
internationally competitive.
 High investment income earned abroad

• The economy’s banks, firms and individuals

may be earning more profits, interest and
dividends in other economies than is earned
by foreigners assets in this economy.
 The receipt of high workers’ remittances

• The economy's workers working abroad may

be sending more money home to relatives
than foreign migrant workers are sending to
their relatives
 39.5 The consequences of a current
account surplus
An increase in a current account surplus will increase an
economys aggregate demand and so may lead to a rise in real
GOP and higher employment More money will enter the
economy than will leave it and the higher aggregate demand may
cause demand-pull inflation if the economy is operating close to
full capacity It also means that the country is consuning fewer
products than it is producing
If an economy Is operating a floating exchange rate, an Increase
in a current account surplus may result In an appeclatlon in the
exchange rate This Is because demand for the economys currency
will exceed its supply
 Answer
• a 75%. UAE, USA and China are all important
destinations of Indian exports and sources of
its imports.
• b Countries may buy spices from India
because of their higher quality and lower price
offered by India, with respect to other
countries.
 39.6 Policies to achieve balance of
payments stability
Over time, a government is likely to want to achieve balance
of payments stability It will not want to see large and
persistent current account deficits or large and persistent
current account surpluses As mentioned above, a current
account deficit reduces total demand, A current account
surplus means that the people of the country are not
consuming as many products as they could afford To avoid
large and persistent current account deficits or surpluses
there are a number of policy measures a government can
use
 Measures to correct a current account
deficit
A government will seek to reduce a current account deficit by
using policy measures designed to reduce imports and/or
increase exports. It may try to do this directly by imposing import
restrictions, subsidising exports and reducing the country’s
foreign exchange rate It may also try to reduce imports and
increase exports by introducing measures that will lower
spending by the countrys consumers. Such measures may include
increasing income tax, raising the rate of interest and pushing up
rates of indirect taxes These measures may reduce imports and
may give domestic firms a greater incentive to export as they may
find it harder to sell at home.
 Measures to correct a current account
surplus
If a government wants to reduce a current account surplus.
there are a number of measures it could use These are.
essentially, the reverse of measures to reduce a current
account deficit. It could revalue a fixed exchange rate or
encourage an appreciation of a floating exchange rate. It could
also enable households and firms to purchase more imports by
making use of expansionary fiscal policy and monetary policy
For example. a cut in income tax would raise the disposable
income of households. This would enable them to buy more
goods and services. induding imported goods and services.
 Multiple choice questions
I Which of the following is an import of a
service into Indonesia?
A French firms selling insurance to Indonesian
firms
B Indonesian citizens buying cars from the USA
C Indonesian firms buying land in Germany
D Tourists visiting Indonesia
Multiple choice questions
 Multiple choice questions
• 3 Whit of the following Urns is included In the
current account of the balance of payments?
A The payment of interest on foreign loans
B The purchase of shares in foreign companies
C The saie of government bonds to foreign
residents
D The setting up of a branch of a bank ln a
foreign country
 Multiple choice questions
• 4 Which of the following S most Iikely to
reduce a deficit on the current account of the
balance of payments?
A A fall in government expenditure on benefits

B A fall in income tax

C A rise in consumer confidence
D A rise in the value of the currency
 Answer
• 1A
• Insurance is a service and it is being bought by
Indonesia. B is an import of a good, C would
not appear in the current account and D is an
export of a service.
• 2B
• Mexico is selling an export of a good and
buying an import of a service.
 Answer
• 3A
• A is investment income. B, C and D would not
appear in the current account.
• 4A
• Cutting government expenditure on benefits
will reduce demand for all products including
imports. B and C would raise demand and D
would increase the price of exports while
lowering the price of imports.
 Four part question
A Define primary income. (2)
B Explain how a county could have a deficit on Its
primary income but a current account surplus. (4)
C Analyse how a rise in a country’s Inflation rate could
move a current account surplus into a current
account deficit (6)
D Discuss whether or not an increase In a current
account surplus will benefit an economy. (8)
 Answer
A Primary income is a component of the current
account of the balance of payments. It covers
income earned by people working in different
countries and investment income.
 Answer
B A country could have a deficit on its primary
income but a current account surplus if there is a
larger surplus on one or more of the other
components of the current account. For instance, a
country could have a deficit of $10 bn on its
primary income and a deficit of $30 bn on its trade
in goods balance. If it has a surplus of $25 bn on its
trade in services balance and a surplus of $35 bn
on its secondary income, it will have a current
account surplus of $10 bn.
 Answer
C A rise in a country’s inflation rate would make the
country’s goods and services less price
competitive if it rises by more than rival
countries. The price of exports would rise relative
to imports. Demand for the country’s exports of
goods and services is likely to fall, while demand
for imports of goods and services is likely to rise.
If demand for exports and imports is price elastic,
export revenue would decrease and import
expenditure would rise
 Answer
The trade in goods and services balance may
move into a deficit or a smaller surplus. This
change will move the current account deficit
in two circumstances. One is that a trade in
goods deficit: is not offset by a surplus on
primary and secondary income. The other is
that a reduction in a trade in goods and
services surplus leaves the surplus at less than
a deficit on primary and secondary income.
 Answer
D Whether an increase in a current account s
urplus will benefit an economy will depend, in
part, on the cause of the increase and on the
state of the economy. If the increase is due to
a rise in international competitiveness, caused
by higher productivity, the economy’s output
will increase. This should also result in a fall in
unemployment as more workers are likely to
be employed to produce the extra output.
 Answer
• There is, however, the possibility that the increase
in the surplus may be the result of a recession
• in the country. In this case, the increase may be
the result of a fall in imports rather than exports.
• Domestic firms may be importing less raw
materials and capital goods because their output is
• falling. Domestic households may be buying fewer
consumer goods because their incomes are
• declining.
 Answer
An increase in a surplus may be the consequence of a rise
in incomes in other economies. With higher incomes
abroad, demand for the economy’s exports may rise. An
economy can benefit from other economies becoming
stronger but the surplus may be threatened if these
economiesexperience a slowdown in economic growth or
a recession. The surplus may also come under pressure if
the economy has exported more raw materials and capital
goods. In the longer term, these exports may enable the
importing economies to produce more efficiently and so
may become more effective competitors.
 Answer
A rise in a surplus on the trade in goods and services balance is not the
only reason for an increase in a current account surplus. It is possible
that the increase in the current account surplus is the result of a rise in
primary income or secondary income. If a positive balance on net
primary income has arisen because, for instance, higher profit is being
received from the economy’s existing branches of MNCs producing
abroad, this would be beneficial. If, however, the higher profit received
is due to more branches producing abroad, it may be debatable whether
the economy would have benefited more from the production occurring
at home. Similarly, if the economy’s workers abroad are sending more of
their earnings home, it can be useful as it can raise the living standards
of their relatives. If, however, secondary income has arisen because
more the economy’s skilled workers are working abroad, the economy
may suffer from a shortage of skilled workers.
 Answer
A current account surplus, not offset by a fall in consumer
expenditure, government spending or investment, will increase
total demand. This higher demand may not benefit an economy if
it is operating close to its full capacity. In this case, demand-pull
inflation may occur. Of course, there is the possibility that a current
account surplus will raise the economy’s exchange rate. Foreign
banks, firms and individuals will be buying more of the economy’s
currency than domestic banks, firms and individuals will be selling.
A higher exchange rate will reduce the price of imports. The cost of
production could fall due to lower-priced imported raw materials
and capital goods. There would also be more pressure on domestic
firms to keep their prices low in order to continue to compete with
relatively cheaper imported consumer goods.