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Topic 4.2
The Balance of Payments
In this topic, you will learn about what the balance of payments is and why it is important to the economy. You will also learn about the different parts of the balance of payments, including the current account.
Components of the Balance of Payments
Balance of Payments
The balance of payments (BoP) is a document that shows all of the financial transactions between one country and the rest of the world. It is made up of the current account, financial account and capital account
The Four Components
Current Account
Capital Account
Financial Account
Errors and Omissions
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Key Revision Tip
The Current Account is the only component that you need to know about at a GCSE level, however knowing the other three components helps you see where a nation's money goes.
The Financial and Capital Account
Above GCSE Level!
Financial Account
The financial account records cross-border investments and the movement of financial assets. This includes foreign direct investment (FDI) like building a factory abroad, buying foreign shares, and hot money flows in bank accounts
Capital Account
The capital account records the transfer of capital assets. It is generally smaller than the financial account and includes things like the transfer of ownership of fixed assets and the acquisition or disposal of non-produced, non-financial assets like patents, copyrights or savings.
The Balance of Payments Zero Rule
The Formula
Current Account + Capital Account + Financial Account = 0
CA + KA + FA = 0
In economic theory, the Balance of Payments must always sum to exactly zero. The money going out must match the money coming in.
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If a country runs a Current Account deficit (spending more on imports than it earns from exports), it must fund that gap. It does this by running a surplus on the Financial and Capital accounts (borrowing from abroad or selling domestic assets).
Net Errors and Omissions
In reality, millions of international transactions are missed, hidden, or calculated incorrectly, so the accounts never perfectly balance to zero.
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The Fix: Net Errors and Omissions is an entry added to the ledger to correct these statistical mistakes, and balances the balance of payments back to 0
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The Status: Because it is so vital to making the equation work, many economists count Net Errors and Omissions as the fourth distinct part of the BoP.
The Current Account
The current records the trade in goods and services, income flows and transfers between one country and the rest of the world. The current account is made up of the trade balance, primary income (income flows) and secondary income (transfers).
Trade Balance
The trade balance is the difference between what a country exports and what it imports. If exports are greater than imports, the country has a trade surplus; if imports are greater, it has a trade deficit
Primary Income (Income Flows)
Income flows refer to rewards to the factors of production or investment moving between the UK and other countries. Examples include: Wages sent to workers, investment profits, or stock dividends paid between the UK and other countries.
Secondary Income (Transfers)
The international transfer of money, goods, or services without any commercial payment required in return. Examples include: Overseas foreign aid sent by governments or remittances (money sent home by workers to families abroad).
Current Deficit
When the sum of exports of goods and services and inflows of income and transfers is less than the sum of imports of goods and services and outflow of income and transfers
Current Surplus
When the sum of exports of goods and services and inflows of income and transfers is more than the sum of imports of goods and services and outflow of income and transfers
Balanced Current Account
When the sum of exports of goods and services and inflows of income and transfers is equal to the sum of imports of goods and services and outflow of income and transfers
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Key Exam Tip: Don't Lose Marks!
Students frequently confuse a Government Budget Deficit (tax revenue vs. spending) with a Current Account Deficit (trade imports vs. exports). Always double-check which 'deficit' the exam question refers to.
Causes of a current account deficit
There are 8 main reasons why a current account deficit occurs, listed below.
Note: Use the inverse of these points to explain the cause of a surplus on the current account.
High economic growth - Rising local incomes cause people to buy more imported goods and services.
Low productivity and competitiveness - Higher production costs or poorer quality make local businesses lose out to foreign rivals.
Low national savings - When a country spends more than it saves, it relies on heavy borrowing and foreign goods.
Recession in trading partners - Economic slumps in partner nations mean they buy fewer of your exports.
High domestic inflation - Faster price increases at home make local goods cost more than foreign alternatives.
Structural dependence on imports - A lack of local industries or energy resources forces a continuous need to buy from abroad.
High investment income outflows - Large profit or interest payments sent back to foreign investors create a negative primary income balance
Appreciation of exchange rate - A strong national currency makes exports expensive for other countries and imports cheap for local buyers.
Current Account Deficit because Imports > Exports
The Current Account Cycle
There is a trade deficit, and less domestic consumption so AD shifts left
AD multiplier means that people have less income and hence spend less on imports
Exports are now greater than imports, causing a current account surplus and economic growth
Economic growth gives people more income so there are more imports
Evaluating the consequences of a current account deficit
Points
Evaluations
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A current account deficit implies falling demand for domestic goods because imports>exports. There is hence a trade deficit and less domestic consumption which shifts AD left, causing cyclical unemployment. This forces more spending on benefits and less income tax revenue
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More national debt as spending more than earning, which means that the country must do more in order to attract foreign capital to achieve a surplus in the financial and capital accounts to balance out the current account deficit. The national debt can also cause intergenerational inequality.
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If the current account deficit is caused by low productivity, it is especially worrying because firms may have higher average costs, diseconomies of scale, and higher export prices, which reduce exports. As a result, it can take a long time and require significant investment to correct
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AD shifting left leads to lower income which means that people have less to spent on imports, which overturns the deficit, while causing economic growth by causing a trade surplus. People will also spend on domestic goods, increasing consumption, which stimulates further economic growth.
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If the deficit is caused by investment into capital goods or land to bring more into the country, then it is only bad in the short run, because it shifts LRAS right by increasing quality/quantity of FoPs so productive capacity increases. This causes economic growth in long-run
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If the current account is in deficit, then the financial and capital accounts must be in surplus due to the BoP zero rule, which means that there is greater FDI into the country, which means that there is significantly greater investment. This increased investment is good for the economy as it creates jobs, and improves productivity through new technology and skills.
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Key Tip: If an exam question asks about the consequences of a current account surplus, you can just switch these points around and use the converse. For example, one of your points can be that the surplus could be caused by high productivity and competitiveness which is good for the economy, and you can evaluate it by saying that there must be a financial account deficit, implying less FDI.