Balance of Payments

Definition of the Balance of Payments

• The balance of payments is a record of one country's trade dealings with the rest of the world. Any transaction involving UK and foreign citizens is calculated in sterling (UK pounds).

• Dealings which result in money entering the country are credit (plus) items while transactions which lead to money leaving the country are debit (minus) items.

Definition of the Balance of Payments

1. the current account which deal with international trade in goods and services;

2. transactions in assets and liabilities which deals with overseas flows of money from international investments and loans

The balance of payments can be split up into two sections:

Current Account

• The current account consists of international dealings in goods (visible trade) and services (invisible trade).

• Invisible trade includes payments for overseas embassies and military bases: interest, profit and dividends from overseas investment; earnings from tourism and transportation.

The UK in Global Economy:

• UK Balance of Payments, 2003 in £ millions – Current Account

Transactions in Assets and Liabilities

The transactions in assets and liabilities section of the balance of payments shows all movements of money in and out of the country for investment.

This may be direct investment - investment in productive capacity, or portfolio investment - investment in shares or other assets. Changes in assets will be outflows from the UK, as UK investors invest money overseas.

These flows will be debits to the UK Balance of Payments. Changes in liabilities will be credits to the UK Balance of Payments as overseas investors invest money into the UK

UK trade balances with EU and Non-EU countries (£bn, quarterly)

Click on image for further details

Balance of Payments Problems

• Strictly speaking, the balance of payments always balances because of official financing.

• However, a balance of payments deficit means a persistent and large negative balance for official financing. This can be the result of excessive purchases of foreign goods and services or excessive UK investment overseas. In the short term, a balance of payments deficit can be corrected by:

Correcting a Balance of Payments Deficit

Correcting a Balance of Payments Deficit

• continued borrowing of foreign currency;

• increasing interest rates to attract overseas investors;

• imposing exchange controls;

• imposing tariffs and import quotas.

In the long run, the government can correct a balance of payments deficit by reducing demand in the economy for all goods including imports. Reducing UK inflation rates or encouraging a sterling depreciation will also help.

Correcting a Balance of Payments Surplus

An unwanted balance of payments surplus can be the result of excessive foreign investment in the UK. This will place a future strain on the invisible balance. A reduction in interest rates or restrictive exchange controls will correct the surplus.

Exchange Rates

An exchange rate is the price of one currency in terms of another. For the UK, the dollar exchange rate means the number of dollars ($) one pound (£) can buy. The exchange rate is determined by the supply and demand for sterling (pounds) and is $2 per pound in the diagram on the next page

Exchange Rates

Demand for Sterling

Americans want to exchange dollars for pounds for two reasons:

• to buy British goods and services;

• to lend or invest in the UK.

The diagram on the previous page shows the number of pounds demanded at each and every exchange rate. This is the D curve.

Supply of Sterling

Britons want to exchange pounds for dollars for two reasons:

• to buy American goods and services;

• to lend or invest in the USA.

In the diagram above S shows the number of pounds supplied by Britons at each exchange rate.

Changes in the Exchange Rate

A fall in the value of sterling (depreciation) means one pound now buys fewer dollars. Sterling depreciates if Americansdemand fewer pounds (shown in the diagram below) or if UK citizens offer more pounds. UK exports become cheaper and UK imports become dearer. Hence, a sterling depreciation improves the balance of payments.

Changes in the Exchange Rate

A rise in the value of sterling (appreciation) means one pound now buys more dollars. UK exports become dearer and UK imports become cheaper. Hence a sterling appreciation worsens the balance of payments.

References and Further Reading

These pages are based on original material written by Richard Young of Wood Green School Witney. Content has been updated and diagrams added by Biz/ed and Finntrack

Also see: UK Balance of Payments