O E2 4.2

4.2 BALANCE OF PAYMENTS

This video is relevant for this section despite it saying that it is for AQA.

The balance of Payments measures the financial transactions made between consumers, businesses and government in one country with others. With the balance of payments the key is to follow where the money is going. Inflows of foreign currency are a positive entry and these include exports. Outflows of foreign currency are a negative entry and these include imports.

The balance of payment is composed of 3 separate parts.

The current account
The capital account
Official financing account

Current Account
For AS, you are only expected to know about the current account. The current account is made up of:

Trade-in goods – the imports and exports of goods either finished or semi -finished or commodities.
Trade-in services – any traded service such as financial services, consultancy and tourism.
Primary income – income from investment and employment. Investment income is any income made abroad. It includes profits from business activities of subsidiaries located abroad, interest from UK financial investment and loans abroad, and dividends from owning shares overseas. Payments to workers who are resident of a country but employed in another, are also included in the current account.
Secondary income – transfers. These are gifts between countries, such as donation to charities abroad and overseas aid.

We then come up with a value for the balance of payments. A positive figure is a surplus and this is when exports are larger than imports. A deficit is a negative figure for the balance of payments and this indicates that a country is importing more than they are exporting. How are a deficit and surplus financed?

With a deficit more money is leaving a country than is coming in. This results in the country having to sell gold or its holdings of foreign exchange. Alternatively, they could borrow from other central banks, such as the European Central Bank, or the IMF.
A surplus will be where more money is coming into a country than is leaving. This results in gold and other currency stock increasing. The country can then use this excess money to pay off existing debts it may have to financial institutions in other countries.

Are surpluses or deficits bad? Both are bad if they are persistent and they form a large part of GDP. If a deficit forms a large part of GDP then it means you are susceptible to price increases. If a surplus is a large part of GDP, then a country’s economy will be unbalanced, and if there was to be a fall in demand for their exports then their economy could be in serious trouble. Also, it depends how much the central bank has in its reserves. China is a country that has massive surplus, meaning that they are building huge reserves of American Dollars, which may not be sustainable in the long run. A country that has a deficit may run out of reserves if a deficit is consistent. Governments and central banks should monitor the balance of payments, but slightly positive or negative figures should not be too much of a concern providing that these are not persistent.

Factors Influencing the BoP?
Here are some factors that influences the BoP:

Inflation – if inflation in a country is high then it makes goods and services in real terms more expensive. Therefore demand for domestic firms’ goods would fall. Relatively high levels of inflation push the BoP into a deficit or reduce the surplus in the BoP.
Exchange rate – If a currency appreciates (goes up in value) then it makes the real purchasing power of that currency increase. This makes imports relatively cheap, in comparison to foreign goods, so imports increase. Also, foreign countries now have to pay more for your goods (they are more expensive), so they demand less and the value of exports falls. Depreciation in the currency has the opposite effect.
Economic activity in other countries – if other countries’ economies are booming, then they have a high level of demand. This means that they are likely to suck in imports. This increases the exports for the countries whose BoP we are focusing on. Also, the country experiencing good economic activity, may now consume goods made in their own country rather than exporting them. This will then decrease the level imports for our country. High levels of economic activity in other countries have the potential to turn the BoP into a surplus/ reduce the deficit/ increase the surplus.
Productivity – if a country has a high level of productivity growth, with wage increases rising by less than the productivity increases, then a country can make goods relatively cheaper than it did before. This results in the country becoming more competitive globally, on price and (potentially) quality, meaning that exports increase and imports fall.

However, it needs to be noted that all of these effects depend on how the economy is structured. If an economy exports a lot of goods and this makes a large percentage of GDP they will be more susceptible to a downturn in global conditions. A change in global conditions would affect this country more compared with one who barely imports and exports. Also, it depends on the responsiveness of demand to a change in price of both foreign and domestic goods; price elasticity of demand to import and price elasticity of demand to export.