4.2 The balance of payments

• Balance of payments

  ''The record of all financial transactions between one country and the rest of the world.'' It is used to record the UK's trading performance.
• Current account


  The record of trade in goods and services, income flows and transfers between one country and the rest of the world
• Balanced current account


  Where the sum of exports plus the inflow of income and transfers is equal to the sum of imports plus the outflow of income and transfers
• Current account surplus

  Where the sum of exports plus the inflow of income and transfers is greater than the sum of imports plus the outflow of income and transfers
• Current account deficit

  Where the sum of exports plus the inflow of income and transfers is less than the sum of imports plus the outflow of income and transfers
• The 4 main components of the current account are:

  • Trade in 'goods' -> This shows the balance of earnings from exports and spending on imports of goods.
  • Trade in 'services' -> This shows the balance of earnings from exports and spending on imports of services.
  • 'Primary income' -> This is the net flow of profits, interest & dividends from investments in other countries and net remittance (transfer of income) flows from migrant workers.
  • 'Secondary income' -> Included here are bilateral aid flows, military grants, transfers to international organisations (e.g. the EU, NATO, the UN).
• Current account= The value of goods and services + Balance on primary income + balance on secondary income
• Calculating the current account balance:

  1)In more difficult questions, you will need to calculate the balance in each of the 4 separate parts.

  2)The trade balance can be calculated using this formula:

  Trade balance = Total value of exports - total value of imports

  3)Once you have calculated all 4 balances, add these together.

  4)You must use a + or - in your answer.

  -If the result is NEGATIVE, it is a current account deficit

  -If the result is POSITIVE, it is a current account surplus.
• Anything which ADDS money to the economy is a credit item.

  • Credits are -> Money from export sales; interest, profit and dividends received by UK residents on Investment overseas; Money received into the UK economy by UK residents working in other countries.
  • If credits > debits, there is a surplus.
• Anything which results in money LEAVING the UK economy is a debit item.

  • Debits are -> Money spent on imports; interest, profits and dividends paid out by UK firms & banks to overseas residents; Transfers by the UK govt. to the UN and NATO.
  • If debits > credits, there is a deficit.
• A cause of a balance of payments DEFICIT is strong economic growth. *see diagram* Here, as output increases more people will be employed. Consumers will benefit from an increase in disposable income, which will lead to a rise in consumer spending. Some of these goods would be imports, so there is a rise in the value of imports and in the trade deficit.
• A cause of a balance of payments DEFICIT is the exchange rate. When it is very high (sterling is worth more than dollars) then UK exports to the US will be more expensive but US imports into the UK will be cheaper. Hence, there is an increase in imports bought, and a decrease in exports sold.
• A cause of a balance of payments DEFICIT is loss of absolute advantage. If this happens in the production of a certain type of good, then we no longer specialise in these areas and no longer sell as many exports, so there is a fall in export sales. This loss of advantage may be caused by (see explanations in notes):

  • Higher labour costs in the UK
  • Low productivity growth
  • Relatively poor product innovation.
• A cause of a balance of payments SURPLUS is strong economic growth in other countries. This means these countries will have more money with which to buy UK exports.
• A cause of a balance of payments SURPLUS is weak economic growth in the UK. This results in consumers having lower levels of disposable income, which will reduce consumer spending, including imports. With a fall in the value of imports, the current account may find itself in surplus.
• A cause of a balance of payments SURPLUS is a fall in the exchange rate. This means UK exports will be cheaper in overseas markets, whilst imports into the UK will become more expensive. This means a rise in UK exports sold, and a fall in imports bought, will cause a current account surplus.
• A current account DEFICIT is important because:

  • It means that more money is leaving the economy (to pay for imports and also financial transfers) than there is entering the economy. This has a deflationary impact on the economy as (X-M) is negative and therefore AD is falling *see diagram*. This leads to lower economic output and potentially a rise in unemployment.
  • This may have resulted from a long term structural problem such as low productivity growth. This may not be easy to solve and may take a long time to change.
• A current account DEFICIT isn't important because:

  • It may have resulted from strong economic growth in the country. This will raise incomes and therefore result in UK consumers buying more goods, including imports.
  • If the deficit is only short term in this nature then it will be less of a problem.
  • It depends what the cause is. E.g. if the UK imports large amounts of capital goods which will help to increase productivity in the long run, it will be beneficial.
• The importance of a current account DEFICIT will depend upon:

  • How BIG the deficit is
  • How LONG it lasts for
  • What the imports are i.e capital or non-capital
• A current account SURPLUS is important because:

  • It has a 'reflationary' impact on the economy. As (X-M) is positive, the AD will rise, causing a rise in real GDP. This will increase economic growth, whilst also creating a greater 'derived' demand for labour, leading to a fall in cyclical unemployment. This will lead to wider economic benefits and higher standards of living.
• A current account SURPLUS isn't important because:

  • Rising AD may cause demand-pull inflation *see diagram*. If an economy is already at 'full employment' output then higher AD will only increase inflation.
  • A surplus means that UK goods are being exported, so UK consumers may not be able to buy these goods.
  • A surplus may cause upwards pressure on the exchange rate. With more UK exports being demanded, overseas residents will buy more sterling, leading to a rise in the exchange rate. *See diagram* Higher demand for sterling may cause a rise in export prices.
• The importance of a current account SURPLUS will depend upon:

  • The SIZE of the surplus
  • How LONG the surplus remains