4.6 Balance of Payments
BOP
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The BOP is a systematic record of all financial transactions between the citizens of a country and other countries.
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BOP consists of Current account, Capital account ad Financial account
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Current account is the balance of trade of goods and services, net primary incomes from abroad and net current transfers[secondary incomes].
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Primary incomes consist of Profits, dividends and Interests from investments in other countries. Current transfers consist of unilateral payments of payments made with no return, like donations, remittances.
Capital account and Financial account
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Capital account covers transactions of nonfinancial assets, like capital transfers and some small financial transactions. Financial account covers change of ownership of assets internationally and claims or liabilities to non residents regarding financial assets.
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A inflow of money into a account is marked as credit(+)
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A outflow of money from a account is marked as debit(-)
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If there is more inflow than outflow in an account then there is a surplus in the account. If the opposite occurs, then there is a deficit
Importance of Current account
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The current account is closely linked to a country's exchange rate. The current account records a countrys transactions, exports/imports with other countries. This directly affects a countrys exchange rate as it is based on demand and supply principles. An exchange rate shows the price of a country's currency in terms of another country's currency.
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So if a country’s currency exchange rate is strong, its exports become internationally uncompetitive as they become relatively more expensive, at the same time imports become internationally competitive. So, if imports are more and exports are less, this means the current account may go into deficit if primary and secondary incomes are overshadowed by this trade deficit.
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The opposite will occur if the exchange rates are weaker. It is important to note that neither a surplus or deficit in current account making up the BOP is good, ideally we want it to be 0.
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The exchange rate helps to correct a deficit or surplus by the prior mentioned events;
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Current account surplus; more exports>strong exchange rate>Expensive exports>export reduces, import expenditure increases>current account stabilizes/corrected
Diagram
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This is a representation of the possible events that will occur if currency depreciation; less demand or too much supply.
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SRAS or short run aggregate supply is upward sloping as it shows the basic relationship of price and supply and can extend to meet demand, LRAS [long run] is vertically straight as in the long run output/Real GDP isn’t based on the price/It shows the full employment level of output so no more supply can be produced
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Financial account and its importance
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Like current account, financial account also affects the exchange rate. When there is an inflow of foreign investments[investments from non residents into the economy] the demand for the currency increases. This may cause currency to appreciate.
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Conversely if there is a outflow of domestic investments[Investments from residents in other countries] hence the supply will increase and this may cause currency to depreciate.
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This again depends on the strength of the currency, if its strong, its more expensive to invest into the country for non residents rather than residents investing outside of the country hence its likely there will be more outflow. Vice versa.
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*Note* Currency only appreciates and depreciates if its a floating exchange rate; not influenced by the country’s foreign exchange reserves, and instead is dependent on the demand and supply principles.
How the accounts are related
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In an ideal scenario, the accounts balance each other out; If current account is in surplus at least one of the financial or capital accounts would be in deficit, for example the country may be investing globally offsetting the current account surplus.
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A balance of these accounts brings about a balance in the BOP which is important as it brings general economic stability.
The exchange rate
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In the real world there isn’t a 1:1 relationship between BOP and Exchange rates as other policies affect the rates, however generally speaking if a country’s BOP is in surplus they will tend to have a stronger currency. There are exceptions though like russia; although as of 2024 their BOP is in surplus their currency keeps weakening due to ongoing sanctions against them.
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Exchange rates will determine price of a country’s currency against another currency.
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A strong exchange rate means it is cheaper for citizens to import and more expensive for global consumers to consume exports from the country. Thus can lead to an increase in import expenditure and potential deficit in current account. It also makes investments more expensive which could cause a deficit in the financial account.
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Likewise a weaker exchange rate would mean exports are cheap for global consumers and importing is more expensive, thus would lead to increased export revenue and potential current account surplus. Investing also becomes cheaper so more investments would flow into the country improving the financial account.
Diagram
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A diagram showing a exchange rate is identical to a demand and supply diagram and works on the same principles, Y axis is named [Price of (currency A) in terms of (Currency B)]
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X axis still represents supply however you should mention [Supply of (currency A) in the global market]
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Neither a high or low exchange rate is really better than one and other, thus you will observe most countries aim to keep their currency stable avoiding it from appreciating or depreciating by pegging it to another currency or using foreign exchange reserves to keep it stable.
A current account deficit
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Current account deficit can result in a depreciation of the currency as discussed previously, because the country is readily supplying its currency in the international market, by importing more goods than exporting.
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To correct this deficit the country may have to borrow funds if its not able to finance it with the investments, leading to debt accumulation. Countries also have a credit rating that may be affected if the country accumulates a lot of debt
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However the central bank can increase the interest rates to encourage investments instead of having to borrow funds to correct the deficit. This of course means that there will be more foreign ownership of domestic assets, which may lead to lesser house-ownership rates.
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However Investors may still be weary to invest as credit rating of the country may fall or if they expect the currency to be depreciated/devalued as their investments will thus lose value, existing investors may even leave the market and invest in foreign assets. This will put further downwards pressures on the currency as its foreign investments will deplete.
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A deficit may also signal a problem with economic growth if it is due to a lack of exports, that is the aggregate demand of the economy is too low as X-M or exports-Imports is too low or negative.
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A persistent deficit may lead to the country’s government implementing expenditure switching policies to reduce import expenditure or provide export subsidies to producers.
How to correct it
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We mentioned the possible solutions in brief, let’s discuss about them
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An unmentioned ‘solution’ was letting the floating exchange rate correct it; doing nothing. Pure floating exchange rates work solely based on the demand and supply of the currency, as previously discussed if there is a deficit due to importing the exchange rate will depreciate further until importing is too costly. This would reduce imports and also encourage exports due to their affordability. Although it may take a long time to actually correct itself as there maybe other problems that caused the deficit other than importing.
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Expenditure switching policies are self explanatory, they aim to switch expenditure from imports to exports in this case, so the citizens rather spend on domestic products, helping to improve the deficit. This is a trade protection policy and so may result in foreign partners enacting retaliatory protectionist policies that would curb the ability for a country’s exports to remain stable or increase.
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An alternative is Expenditure dampening policy which aims to reduce aggregate demand of the country, not only for imports but also domestic products, this is often achieved by reducing disposable(untaxed) income or encouraging saving by increasing interest rates. A fall in aggregate demand can lead to GDP reducing and unemployment increasing.
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Export subsidies are implemented to reduce costs of production and encourage production, however these may be long term and thus benefits would take time to appear along with obvious opportunity costs.
A current account surplus
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A surplus would occur when the country is persistently exporting more than their import volume.
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This causes their currency in a free floating exchange rate to appreciate, however as previously mentioned this means that foreign investments would reduce affecting the financial account, but this also means that domestic firms can instead investment more into the economy as they will be making more profits along with domestic consumption rising as profits across the board would rise. Net exports rising means the aggregate demand of the country increases which would put inflationary pressures on the price level of goods in the economy, although this may be equalized by the deflationary pressures brought about due to the increasing demands for more affordable imports and reducing costs of production for firms, although this depends on the reliance of firms on imported raw materials.
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Aggregate demand rising also brings about employment as aggregate supply must increase to avoid demand pull inflation. Not only due to increasing demand but also due to increasing investments into the economy. More employment would mean more incomes on average which would add to the aggregate demand and thus to the need of more employees. Exports becoming more expensive reduce their international competitiveness as mentioned in prior slides, this reduction in competitiveness will depend on the PED; an elastic PED will result in major reduction. Vice versa.
Marshall lerner condition
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We stated that generally a currency depreciation or devaluation would result in a improving current account deficit.
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However this benefit is limited by the marshall lerner condition; if the combined PEDs of exports and imports is more than 1/elastic only then would it actually be helpful.
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If it is inelastic than it would actually be more detrimental. If you connect this to PED values it makes sense as there wouldn’t be a more than proportional increase in demand.
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The condition is that The current account deficit only improves if the cummulative PEDs are more than 1
The J-Curve
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Like all things in life, a depreciation of the currency wont cause immediate improvement in a current account deficit, it takes some time.
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Consumers and producers themselves take time to adjust to the price change and may not even adjust until they are sure that prices are going to remain stable for some time. So initially it may actually lead to worsening deficit due to the inelastic demand in short term.
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This graph is easy to explain with the marshall lerner curve, we see that initially the deficit worsens, this is the adjusting period where PED remains inelastic however eventually once both parties have adjusted the condition is met and cumulative PEDs add up to greater than 1 causing the deficit to improve leading to a surplus.
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