Economics Unit 2

Student Handout
Balance of Payments

Balance of payments

This is a statement of a country’s trade and financial transactions with the rest of the world over a
particular period of time usually one year. Put another way: A nation’s balance of payments is the
sum of all the transactions that take place between its residents and the residents of all foreign
nations. These transactions include exports and imports of goods and services, tourist
expenditures, interest and dividends received or paid abroad and purchases and sales of financial
or real assets abroad. The account is divided into two main parts:

 Current accounts – this shows the country’s profits and losses as a result of day to day
activities. It is further broken down into visible and invisible trade.
The visible trade balance (balance of trade) indicates the difference between the value of
merchandise exports and import of goods (raw materials, food stuffs, oil and fuels, semi-
processed and finished manufactures). ‘Visibles’ are so called because they consist tangible
goods that can be seen directly and recorded by the country’s customs or excise authorities as
they move into or out of the country.
The second group of transactions makes up the invisible trade balance (trade in
services). These transactions include earnings from and payments for, such services such as
banking, insurance, transportation and tourism. It also includes interest, dividends and profits
on investments and loans and government receipts and payments relating to defense and
upkeep of embassies. ‘Invisibles’ are so called because they represent transactions that
cannot be seen directly but can only compiled indirectly from company returns, government
accounts, foreign currency purchases and sales data from banks.
This segment also includes current transfers which the Bank of Jamaica refers to as taxes
and income, remittances, premiums and claims on non-life insurance.

 Capital and Financial account – this section is further sub-divided into two categories
namely: The Capital Account and the Financial Account. The capital account is made up of
a number of elements including: Capital transfers and the acquisition/disposal of non-
produced, non-financial assets. Capital transfers include the transfer of ownership of fixed
assets, transfer of funds linked to the disposal/acquisition of fixed assets and the cancellation
of a country’s debt by its creditors. The acquisition/disposal of non-produced, non-financial
assets includes items such as patents, leases, purchases and sales of land by foreign
embassies.
Financial Account covers direct investments, portfolio investments, other investments and
changes in reserves. The reserves refer to the foreign exchange a country has available for
financing balance of payment problems or other financial needs.

The current account balance and capital and financial account balance together with the
balancing item (which includes errors and omissions in recording transactions and leads and lags
in currency payments and receipts), results in the balance for official financing. This figure
shows whether the country has incurred an overall surplus or deficit. If the balance of payments

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is in surplus, the country can add to its international reserves and, if necessary, repay borrowings.
If it is in deficit, this has to be covered by running down its international reserves or by
borrowing.

Balance of Trade
This represents the difference between the values of goods a country’s imports and exports.
When exports exceed imports the balance is said to be favourable because there is a surplus.
However, when imports exceed exports the trade balance is said to be unfavorable or adverse.

Balance of payments Accounts

CURRENT ACCOUNT
Trade in goods (Merchandise trade)
Exports 1,350.8
Imports 2,825.3
Balance on trade in goods -1,474.5

Trade in Service
Transportation -236.4
Travel 930.6
Other services -344.2
Balance on trade in service 350.0
Balance on trade in goods and services -1,124.5

Other Income flows

Compensation of employees 65.1
Investment income -450.8
Official transfers 83.7
Private transfers 716.8
414.8
Current account balance -709.7

CAPITAL & FINANCIAL ACCOUNT

Capital account
Official capital transfers 2.2
Private capital transfers -23.7
-21.5
Financial Account
Other official Investment 351.5
Other Private investment (including errors &
Omissions) 887.3

Reserves -507.6
709.7
0.0

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According the Balance of Payments Convention a negative reserve figure in the B.O.P means
that the reserves account has increase, i.e. money is taken from the financial account and place in
the international reserves, visa versa.
It follows that in some years, a nation must make an in-payment of official reserves too its
capital and financial account in order to balance it with the current account. In these years, a
balance of payments deficit is said to occur. In other years, an out-payment of official reserves
from the capital account and financial account must occur to balance that account with the
current account. This out-payment adds to the stock of official reserves. A balance of payments
surplus is said to exist in these years

Balance of payments Deficit and Surplus

This means a there is a persistent and a large negative balance. This can be due to excessive
purchases of foreign goods and services or excessive Jamaican investments overseas. A balance
of payment surplus means that the foreign exchange coming into the country is higher than the
foreign exchange being sent out.

Balance of payment problems

Before discussing these problems let’s make a distinction between balance of payments
equilibrium and disequilibrium:
 Equilibrium – this refers to a situation where manageable deficits are cancelled out by
modest surpluses over a period of time. Under such circumstances there is no tendency for
exchange rate to change. Two situation of equilibrium might be:
o Where the imports of goods and services exceeds exports but where this is offset by
an inflow of foreign direct investment, that is, current account deficit is
counterbalanced by a financial account surplus
o Where the exports of goods and services exceed imports but there is substantial
investment abroad by companies and residents. Here a current account balance is
recorded, but is matched by a deficit on the financial account.

 Disequilibrium occurs when, over a particular period of time, a country is recording

persistent deficits or surpluses in its balance of payments. As a result exchange rate may be
overvalued or undervalued on the foreign exchange market. Disequilibrium in the balance
of payments can arise where:
o The imports of goods and services exceed exports and the financial account is in
deficit
o Exports of goods and services may just exceed imports but there is a persistent deficit
on the financial account
o While unlikely, there may be a large surplus on the current account, generating an
overall balance of payments surplus.

Causes of balance of payment disequilibrium

1. The economy has high propensity to import goods. Consequently, a substantial deficit will
be recorded annually on the trading account. This problem is persistent in most developing

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 economies as such countries have very limited domestic production and have to rely on
imported goods for much of their consumer demand.
2. There is a lack of confidence in a particular economy, resulting in few capital inflows. There
may even be a situation of an exodus of capital from the economy. This may be influenced
by the political, social and economic condition of the country.
3. A period of expansion in the macro-economy may lead to an increase in consumer spending
power and thus more is spent on imported goods rather than locally produced goods.

Consequences of balance of payments disequilibrium

There are consequences of disequilibrium in the balance of payments for both the domestic and
external economy:
Domestic:
 There will be a pressing need for corrective action. This need will be evidenced through a
domestic economy which is characterized as having a very narrow type of economic
structure and still heavily dependent on agriculture. As a result, a number of sectors have
suffered de-industrialization, so increasing the demand for imported goods. This will lead to
long-term unemployment.

 Lack of investment – due to low business confidence, foreign investors may become
increasingly reluctant to invest in an economy with a balance of payment equilibrium
because of the risks that are involved. Economic prospects will be uncertain and there is a
likely possibility that the currency may be devalued.

 There may be a reduction in the stocks of certain exotic imported consumer goods (e.g.
perfume, designer clothes) and the general range will be restricted often to products not
produced domestically. Imports are also likely to have higher rates of tax imposed on them
in order to restrict consumption

External:
 The government may be pressured to introduce or upgrade the methods of protection to
save the local industry.

 The disequilibrium on the balance of payment account may lead to a devaluation of the
local currency which will in turn increase import prices, reduce export prices and lower
confidence in the local economy.

Policies to correct balance of payments disequilibria

Policies to remove balance of payments deficits can be categorized under the following headings
 Expenditure switching policies
This is any action taken by the government which is designed to persuade purchasers of
goods and services both locally and abroad to purchase more of domestically produced goods
and services and less of the goods and services produced by other countries. Such policies
are not designed to reduce the total amount spending in a country but rather to re-direct or
switch spending to the country’s product. As a result there should be a reduction in import

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 expenditure and a rise in export earnings. The former will lead to a fall in the supply of the
country’s currency on the market and the latter will lead to an increase in the demand for the
country’s currency. (Brainteaser: How will this affect exchange rate?)
Expenditure switching utilizes the following measures: tariffs, quotas, exchange controls and
export subsidies

 Expenditure dampening policies

This policy involves actions taken by a government designed to reduce the total level of
spending in an economy. As a result there will be a reduction in spending on imported goods
and services and while domestic producers may opt to sell most of their goods abroad. This
policy includes deflationary (contractionary) fiscal policy where T will be increased and G
reduced. This will lead to a reduction the marginal propensity to import. A deflationary
monetary policy may also be implemented where interest rates will be increased and money
supply reduced.

 Devaluation – the country can devalue its currency thereby making its exports cheaper to
foreign buyers. This will lead to an increased in exports, ceteris paribus, and hence improve
the trade balance. A devaluation of the currency will also result in a reduction in the demand
for imports and these goods will become relatively more expensive.

Other policies may include such things as:

 Promotion of exports through advertisements
 Produce more products and export the excess
 Grant subsidies to producers (supply-side policy)