The balance of payments

The balance of payments shows all the payments and receipts between one country(the reporting country) and all the other countries it trades with. The balance of payments has three main parts: the current account, the capital account and the financial account. This topic is focused on EdExcel Unit 2(Managing the Economy), therefore we will look at the current account of BOP in detail.

The current account

The main purpose of balance of payments on current account is to show how well a country is doing in the international trade in goods and services. It measures all the money that is paid by the reporting country for imports of goods and services, and all the money that is received by the reporting country for its exports of goods and services. This is called the balance of trade.

The current account also includes wages received by people from the country working overseas and it also includes the wages paid out to workers from foreign countries working in the country. It also records flows of money in and out of the country for interest payments, profits and dividends on loans, investments and shares. This section of the current account is known as the income balance.

There is also a section of the current account known as ‘current transfers‘. Current transfers are unilateral transfers with nothing received in return. These include workers’ remittances, donations, aids and grants, official assistance and pensions. Due to their nature, current transfers are not considered real resources that affect economic production.

Balance of payment deficit on the current account

Balance of payment deficit on the current account means there is a net outflow of money from the country with regards to the items mentioned above; that is, balance of trade, income balance and current transfers.

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.

Factors which cause a current account deficit in the balance of payments

A current account deficit occurs when the value of imports (of goods, services and investment incomes) is greater than the value of exports.

There are various factors which could cause a current account deficit:

1. Fixed Exchange Rate

If the currency is overvalued, imports will be cheaper and therefore there will be a higher Q of imports. Exports will become uncompetitive and therefore there will be a fall in the quantity of exports.

2. Economic Growth

If there is an increase in national income, people will tend to have more disposable income to consume goods. If domestic producers can not meet the domestic demand, consumers will have to import goods from abroad. In the UK there is a high Marginal propensity to imports mpm because they do not have a comparative advantage in the production of manufactured goods. Therefore if there is fast economic growth there tends to be a significant increase in the quantity of imports. In this aspect, having deficit is good because it leads to higher economic growth and higher standard of living.

3. Decline in Competitiveness.

In the UK there has been a decline in the exporting manufacturing sector, because it has struggled to compete with developing countries in the far east. This has led to a persistent deficit in the balance of trade.

– Higher inflation
This makes exports less competitive and imports more competitive. However this factor may be offset by a decline in the value of the Sterling Pound.

– Recession in other countries.
If the UK’s main trading partners experience negative economic growth then they will buy less of UK’s exports, worsening the current account.

– Borrowing money
If other countries borrow money from UK to invest, then it could lead to balance of payment deficit on the current account.

Measures to correct balance of payment deficit

1. Deflation
A government can use contractionary monetary policy and contractionary fiscal policy to reduce the aggregate demand in the economy. This means there is less money being pumped around the circular flow of income in the economy. When the aggregate demand is reduced, people will have less to spend on imports. Deflation also means controlling inflation, when this happens, the prices in the UK is more attractive compared to the other countries, therefore people will buy domestic goods rather than imported goods.

2. Protectionism
Countries can use measures of protectionism such as tariffs, quotas and embargoes to try to limit imports, thereby leading to a favourable change in the balance of payment.

3. Devaluation
This refers to lowering the value of a country against the foreign currencies. When a country’s currency is devalued, it makes exports cheaper for the foreign countries to buy, and imports more expensive.

4. Supply-side improvements:

Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. The time-lags for supply-side policies to have an impact are long.
Policies to encourage business start-ups – successful small businesses with export potential
Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance, medicine
Investment in modern critical infrastructure to support businesses and industries involved in international markets

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