Balance of Payments
Economics: Edexcel A A Level, topic 7.2.5
Balance of Payments
The balance of payments shows a record of all transactions that a country does with the rest of the world. It's made up of three accounts: current, capital and financial.
Current account
- The current account is comprised of:
- Trade in goods and services (X-M).
- Net primary income - net factor income from abroad (e.g. remittances, profits, interest on dividends).
- Net secondary income - net unilateral transfers (e.g. foreign aid).
Capital account
- The capital account is comprised of:
- Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts, and goodwill.
- Transfers of ownership of fixed assets.
Financial account
- The financial account is comprised of:
- Net foreign ownership of domestic assets.
- Hot money flows.
Balancing items
- The balance of payments has to add up to 0.
- But in reality, there are errors and omissions in calculating what comes in and what goes out of an economy.
- So we add a “balancing item” or “net errors and omissions” to make it balance.
Current Account and Flows
The current account in the balance of payments is made up of several different categories of money flows.
Merchandise trade balance
- The merchandise trade balance is made up of the exports and imports of goods.
- The sale of Aston Martins made in the UK would count as an export of goods in this section of the balance of payments.
Services trade balance
- This is made up of the exports and imports of services.
- Barclays selling financial services (e.g investment bank consultancy fees) to a company based in Saudi Arabia would count as the export of services.
Income receipts and payments
- Income receipts and payments includes money received from foreign investments.
- Investment income can come from investments abroad.
- When someone invests in the US and makes a return, this is then transferred to the person in the UK who owns the asset.
Unilateral transfers
- Unilateral transfers are payments by governments or individuals in which money is sent abroad without any direct good or service being received.
- The UK sending humanitarian aid to African countries, India or North Korea would count as a unilateral transfer.
Current Account Deficit
Many developed countries, including the UK and US, have significant current account deficits. This isn't a cause for concern in of itself, but could indicate wider problems with the economy.
Causes of a deficit
- The following could cause a deficit:
- Low productivity, meaning the final price of the goods are likely to be higher.
- Inflation being higher domestically than abroad, reducing the international competitiveness of domestic goods.
- A strong exchange rate, reducing the price of imports and increasing the price of exports.
- Non-price factors, such as poor quality of goods and services.
- Supply-side constraints, which could cause a lot of goods being imported from abroad.
Is a current account deficit a concern?
- If a deficit is because of capital goods imports, then it is likely to be good for future productivity and future growth.
- If a deficit is because of the purchase of current goods, it will be good for the short-term standard of living.
- If a deficit is because of a lot of FDI in the past, profits are being repatriated today. This means the investments were profitable.
- If the deficit is a high % of GDP and is getting worse, this may be worrying.
- If nobody wants to buy a country's exports, then this may be concerning.
Effects of a deficit
- A current account deficit needs to be financed by a financial account surplus - so it will become a problem if foreign investors stop wanting to purchase assets in that country.
- If a country has a free floating currency, the currency will depreciate. This may partially offset the uncompetitiveness of exports.
- This will also cause the price of imports to rise though, leading to higher prices for consumers and potentially cost-push inflation.
Test yourself on Balance of Payments
Which of these is NOT an account of the balance of payments?
What is the calculation for the current account?
Which of the following is a component of the current account?
Which of the following can cause a current account deficit?
Which of the following is a potential effect of a current account deficit?