The Balance of Payments is a record of a country’s transactions with the rest of the world. It shows the receipts from trade. It consists of the current and financial account.
1. Current account
This is a record of all payments for trade in goods and services plus income flow it is divided into four parts.
- Balance of trade in goods (visibles)
- Balance of trade in services (invisibles) e.g. tourism, insurance
- Net income flows (wages and investment income)
- Net current transfers. (e.g. govt aid)
Financial account
This is a record of all transactions for financial investment. It includes:
- Net investment from abroad (e.g. A UK firm buying a factory in Japan would be a debit item)
- Net financial flows – These are mainly short term monetary flows such as “hot money flows” to take advantage of exchange rate changes
- Reserves
- (note the Financial Account used to be called the Capital Account)
Capital Account
This refers to the transfer of funds associated with buying fixed assets such as land
- Balancing Item
In practice when the statistics are compiled there are likely to be errors therefore the balancing item allows for these statistical discrepancies.
Balance of Payments Equilibrium
- In a floating exchange rate the supply of currency will always equal the demand for currency, and the balance of payments is 0.
- Therefore if there is a deficit on the current account there will be a surplus on the financial / capital account.
- If there was an increase in interest rates this would cause hot money flows to enter into the UK, therefore there would be a surplus on the financial account
The appreciation in the exchange rate would make exports less competitive and imports more competitive therefore with less exports and more imports there would be a deficit on the current account.
Factors affecting balance of payments
A current account deficit could be caused by factors such as.
- High rate of consumer spending on imports (during economic boom)
- Decline in international competitiveness making countries exports less competitive
- Overvalued exchange rates which makes exports relatively more expensive
Cyclical Nature of Current Account
In the UK, a current account deficit often increases after a period of economic growth. Higher economic growth leads to higher consumer spending and therefore more spending on imports.
In an economic downturn, spending on imports usually declines leading to a smaller current account deficit.
