BALANCE OF PAYMENTS Definition This is a record of all monetary payments between one country and the rest of th e world

over a period of time. Measurement The balance of payments account is split into 3 sections, the Current, C apital and Financial Account. You need to be mostly concerned with the Current account. Current Account: 1. Trade in Goods: e.g. export of medicine to South Africa [ + or credit] w hilst import of food from France [ - or debit]. 2. Trade in Services: e.g. export of insurance and other financial services , tourism into the UK are credits whilst purchase of a USA television programme would be a debit. 3. Income flows: income from investments is the main component - interest, profits and dividends (IPD) from overseas assets such as bank deposits, UK owned companies overseas, shares quoted on foreign stock markets but held by UK resid ents (less IPD earned in the UK by foreign held assets). 4. Current transfers eg UK contribution to EU; aid to developing countries; net remittances from migrants and immigrants. In this category, no goods or ser vice is being exchanged, just a flow of money. Financial Account On any day most money flows between countries are financial investment; this can be short term (opening foreign bank accounts for speculative purchases of forei gn currency), medium to long term (foreign shares) and long term (buying foreign companies). The financial account records the purchase and sale of these assets and any government use of the official reserves to buy and sell other currencie s. However, the income earned on these assets (=IPD) each year is recorded in th e Current Account (income from Investment) 7 Capital Account This is a minor part of the Balance of Payments, and includes government investm ent grants, and the purchase or sale of non-produced, non financial assets such as patents, trademarks and land for foreign embassies. Net errors and omissions Formerly known as the balancing item, this figure is included to ensure that the current account, plus the capital account plus the financial account equals zer o. Overall Balance of Payments Account Allowing for errors and omissions in the data, the sum of these three accounts = 0. This means that a current account deficit is matched by an overall surplus on the capital and financial account. To see why this is true, imagine I buy a new BMW direct from Germany (current ac count inflow). To get the euros I need I will have to give up (sterling) and purc hase euros (financial account outflow). So the purchase of the BMW has two equal but offsetting entries in the BOP accounts. Causes of a Current Account deficit 1. High levels of income (economic growth) in the domestic economy. Imports tend to have a high income elasticity of demand so that, in a boom, imports are 'sucked' into the economy. The UK has a high marginal propensity to import (MPM ), therefore economic growth usually results in greater demand for imports. 2. An overvalued exchange rate which makes exports less price competitive i n foreign currency and imports more price competitive in Sterling. 3. High unit labour costs the average cost of labour per unit of output (perh aps a reflection of low investment in capital and labour in the past and hence l ower productivity) means that average production costs may be higher than our co mpetitors, again making UK goods seem less price competitive. Higher wage costs in the UK than in low cost LEDC manufacturers would also raise our unit labour c osts.

4. Poor non price competitiveness of UK goods in terms of quality, design, reliability, delivery times, after sales service may mean the 'taste' for UK goo ds is low. However, the current deficit is not such a problem if: it is only short term and is caused by high rates of economic growth which shoul d subside if it can be easily financed, perhaps by investment inflows on the financi al account the deficit is caused by the import of raw materials and capital equipmen t which will be used to produce final goods for export or helps to raise product ivity Policies to remove the Current Account deficit Although there are several policy options, including reducing AD and consumption and so import spending, or devaluating the exchange rate or being protectionist , the policy favoured by the UK government is to focus on increasing competitive ness by applying Supply Side policies these policies will aim to boost productivit y and so lower the UK s unit labour costs: increase investment (perhaps through lower corporation tax) and thus capital per worker and productivity increase spending on education and training to improve human capital encourage R & D spending to promote the use of new technology, perhaps by giving tax breaks on profits reinvested into R & D