Macroeconomics - Module 3 - 04 Balance of Payments

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BALANCE OF PAYMENTS

Learning Objectives:

1. Describe the components of the balance of payments;

2. Identify the different types of imbalance within the balance of payments;

3. Explain the causes of imbalances within the balance of payments;

4. Identify the policy measures for correcting imbalance within the balance ofpayments.

During a given year, Jamaicans like nationals of other countries, engage in a vast number

and variety of transactions with residents of other countries. They import, export, engage

in service transactions, receive or send gifts abroad, obtain net income from overseas,

receive loans or make payments on loans received and undertake or receive foreign

investment.

All these transactions together comprise the international trade and payments of

Jamaica. However, to analyze and evaluate these transactions they must be classified and

aggregated to make a Balance of Payments (BOP) statement.

The Balance of Payments is a summary of all economic

transactions between domestic and foreign residents during

a given period of time, usually one year.

The main purpose of keeping these records is to inform government authorities of the

overall international economic position of the country in order to assist them in arriving

at decisions on monetary and fiscal policy, on the one hand, and trade and payments

policy on the other. -Balance of payments statistics are therefore helpful to government

authorities charged with maintaining macroeconomic stability.

Principles and Concepts

Balance of payments accounting is governed by a set of principles and conventions that

ensures the systematic and coherent recording of transactions, which are consistent

across countries and over time. These principles and concepts will be discussed and

where necessary practical examples will be used to explain the concepts. They are:

1. Double Entry System

2. Concept of Economic territory and Residence3. Valuations and Time of Recording

4. Concept of Economic Transactions

1. Double Entry System

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The balance of payments is constructed according to the principles of double-entry

bookkeeping. Under this system a transaction is represented in the balance of payment by

two entries with equal values. One of these entries is designated a credit and the other a

debit.

There are some basic rules governing how entries are recorded in the balance of

payments. A credit entry is recorded when the transaction gives rise to a receipt by adomestic resident from a foreign resident. The receipt itself may take the form of an

increase in the resident's foreign assets or balances of foreign currencies. Whatever its

form, the receipt is recorded as a debit entry. Conversely, any transaction that gives rise

to a payment by a resident to a foreign resident is recorded as a debit entry. The payment

that results from this transaction is recorded as a credit entry.

The double entry approach can be demonstrated with some hypothetical examples.

Example 1

Let us assume Alcoa, a mining company in Jamaica exports US$2.0m worth of bauxite to

Jimpex a company in the USA and Jimpex pays for the bauxite by depositing US$2.0m to

Alcoa's bank account. Table 1 shows the entries that would be made in Jamaica's

balance of payments:

Exports will appear as a credit entry because they give rise to receipts from abroad and

the receipt, which represents a claim on non-residents, appears as a debit entry in the

financial account.

Conversely, imports of foreign goods and services will appear as debits in the balance of

payments as these transactions give rise to payments to the rest of the world. The

corresponding payments, which resulted from the increase in liabilities to foreigners, are

recorded as credit entries.

To illustrate, let us assume Jamaica imports US$150 million worth of oil. In the balance

of payments of Jamaica (see table 2) the oil import is recorded as a debit entry, as it gives

rise to a payment by a resident to a non-resident. The corresponding payment, which

resulted from the increase in Jamaica's liabilities to foreigners, is recorded as a credit

entry.

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Example 2

Let us now assume that Jamaica borrows US$100 million dollars from the World Bank

and the proceeds of the loans are deposited at the Bank of Jamaica (BOJ). Table 3 shows

the entries that would be made in Jamaica's balance of payments:

Table 3

The loan, which gives rise to a receipt is recorded in the balance of payments of Jamaica

as a credit entry and the actual proceeds from the loans - the foreign currency receipt- is

recorded as a debit entry.

If all the principles of the BOP manual are adhered to then the sum of all the credit

entries should be identical to the sum of all the debit entries and the net balance of all

entries in the BOP statement, including changes in the reserves of the Central Bank,

should be zero. In practice, however, when all the actual entries are summed the resulting

balance will invariably show a net credit or a net debit. That balance is the result of

incomplete coverage of transactions, use of non-uniform prices and inconsistent times of

recording and conversion practices.

The custom in BOP accounting is to show the net balance of all the actual transactions as

"net errors and omissions". This entry is equal to the difference in the credit and debit

entries, but with the sign reversed. Thus if the balance of the recorded components is a

credit, the item for net errors and omissions would be shown as a debit of equal value and

vice versa.

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The custom in BOP accounting is to show the net balance of all the actual transactions as

"net errors and omissions". This entry is equal to the difference in the credit and debit

entries, but with the sign reversed. Thus if the balance of the recorded components is a

credit, the item for net errors and omissions would be shown as a debit of equal value and

vice versa.

Relatively large and persistent net errors and omissions are cause for concern as they are

indicative of statistical error, major discrepancies or improperly recorded information.

2. Concept of Economic Territory and Residence

The identification of transactions between residents and nonresidents underpins the

balance of payment compilation process. For balance of payments purposes, the concept

of residence is not based on nationality or legal criteria but rather on the transactor's

centre of economic interest. Of importance too is the necessity to identify the economic

territory of the country to which the concept of residence is to be applied. This is so as

the boundaries recognized for political purposes may not necessarily coincide with those

for economic purposes.

A country'seconomic territoryconsists of a geographic area, administered by a

government. In addition to including the air space, and territorial waters over which the

country has jurisdiction, the economic territory of a country also includes territorial

enclaves in the rest of the world. These enclaves are clearly identified areas located in

other countries that are owned or rented by governments for diplomatic, military,

scientific or other purposes, with the agreement of the country where the land area is

located. So for example, the Jamaican embassy in Washington DC is regarded as a part of

the economic territory of Jamaica. Similarly Guantanomo Bay in Cuba is a part of theeconomic territory of the USA as is the US Embassy in Jamaica.

The concept of residence is defined broadly to include two main types of institutional

units:

(1) households and individuals that comprise a household and

(2) the legal and social entities of that economy such as the government, and

enterprises (profit and nonprofit) operating in the economy, whether foreign owned

or not.

As far as individuals are concerned, the concept of residence is based mainly on the

principle of "centre of interest". It is generally accepted that if a person resides for more

than a year in a given economy, he or she is considered to be a resident of that economy.

So if a Jamaican resident leaves Jamaica and returns to his/her household within a year,

the individual continues to be a resident even if he or she makes frequent trips outside

Jamaica. The individual's centre of economic interest remains in the economy in which

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the household is resident. In the same vein, tourists are residents of the country from

which they come rather than the country they are visiting.

However, there are exceptional circumstances whereby individuals are regarded as

residents, for BOP purposes, even though they reside outside of their country for more

than a year.

a. Studentsshould be treated as residents of their countries of origin however long

they study abroad, as long as they remain members of households in their home

countries.

b. Military personnel and civil servants, including diplomatsemployed abroad in

government enclaves are all regarded as residents of the country from which they

originate as those enclaves form part of the economy of the employing government.

The government employees working in these enclaves continue to have centres of

economic interest in their countries of origin for however long they work in the

enclaves. Therefore if a Jamaican diplomat/civil servant is posted to the Jamaican

Embassy in Washington for three years that employee continues to be a Jamaican

resident while he works in the enclave.

3. Valuations and Time of Recording

a) Valuation

A consistent method of valuing transactions is required for the compilation of the

balance of payments statement. All transactions are valued at market prices. This

is the price that willing buyers pay to acquire a good or service from willing sellers

and the exchanges are made between independent parties and on the basis of

commercial considerations only. Inconsistent valuations lead to different debit and

credit entries being made for the same transaction thus resulting in "net errors andomissions" in the BOP.

b) Time of Recording

In the double entry system of the balance of payment it is important that both

entries relating to a transaction are recorded at the same time. However, while this

is the ideal data recording methodology, it is not always possible, thus resulting in

errors and omissions" in the BOP. An entry is recorded in the balance of payments

when a transaction involves a change of ownership or where a change of ownership

is not obvious the transaction is recorded when the parties enter it in their

accounts.

4. Concept of Economic Transactions

The primary concern of the BOP is not confined to payments, as the name would

suggest, but rather with transactions. A transaction involves the change of

ownership of goods and/or financial assets, the provision of services, labour and

capital.

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The most numerous and important transactions in the balance of payments are

classified as exchanges. This refers to transactions in which economic values are

provided or received in exchange for other economic values. These values consist of

real resources (goods, services and income) and financial items.

a) Transactions classified as exchangesThis form of transaction requires a transactor to provide an economic value

to another transactor and receives in return an equal value. Listed below

are some examples of this type of transaction:

- Purchases and sales of goods and services against financial items - e.g. the

sale of bauxite for foreign exchange.

- Barter - e.g. the exchange of bauxite for motor vehicles.

- The interchange of financial items for other financial items - e.g. the sale of

securities for money.

b) Transactions classified as transfersThere are also transactions in which a transactor provide an economic value

to another transactor and does not require an economic value in return. The

required offsetting entries, in the BOP, for these transactions are recorded as

transfers. Listed below are some examples of this type of transaction:

- The provision or acquisition of goods and services without aquid pro quo-

e.g. donation of medical supplies by USA government to government of

Jamaica.

- The provision or acquisition of financial items without aquid pro quo- e.g.

debt forgiveness.

MAJOR CATEGORIES IN THE BALANCE OF PAYMENTS

The BOP is divided into two main categories according to the broad nature of the

transactions. These categories are:

1. The Current Account

2. The Capital and Financial Account

1. CURRENT ACCOUNT:The current account includes all transactions (excluding those

recorded in the capital & financial account) between resident and non-resident entities

that that involve economic value.

This account is sub-divided into:

a. Goods (also called Merchandise Trade Balance)

b. Services

c. Net Property Income (also called Net Factor Income from

Abroad)

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d. Current transfers

a. Goods: This accounts for the import and export of goods or tangible

commodities. The difference between exports and imports of tangible

goods is the trade balance, sometimes called the visible trade balance.

b. Services:This accounts for the import and export of services. Servicesare often called invisibles because they are not tangible. It covers

travel, transportation and other services.

i. Travelcovers goods and services acquired from an economy by non-resident

travelers for business and personal purposes during their visits (of less than

one year). Expenditures made by seasonal workers (e.g. Jamaican farm

workers) and those for educational and health-related purposes made by

students and medical patients are recorded in this sub-account.

ii. Transportationcovers all transportation services (sea, air and land), boughtand sold, that involve the carriage of passengers, movement of goods

(freight), charter of carriers with crew and other supporting services.

iii. Other Servicesare accorded great prominence in the balance of payments

and reflect the growing importance of international services in world trade.

Other Services consist of the purchase and sale of:

Communication services Computer and information services

Construction services Royalties and licences fees

Insurance services Personal, cultural and recreational services

Financial services Government services

c. Income: This reflects the net income related to the compensation or

reward to factors of production used and rendered between one

country and the rest of the world.

For instance, production may take place in a country, but the factors

of production may be owned by foreigners. In this scenario, the factor

rewards would go the foreign owners. The reverse is also true where

nationals of a country have stakes in foreign investments.

The difference between all inflows of income and outflow of income

gives the income balance, which is the equivalent to the Net Factor

Income from Abroad adjustment required to convert GDP into GNP.

d. Current Current transfers are unilateral transfers with

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Transfers:nothing received in return. It tracks the "one-way" transfer of funds

from one country to another that are made without any exchange or

goods and services in return. These payments are merely gifts from

one country to another. The gift might come from a person, business,

or government. Foreign aid payments from one government to another

are an important part of unilateral transfers.

These include remittances, donations, aids and grants, official

assistance and pensions.

Now that we have covered the four basic components, we need to look at the mathematical

equation that allows us to determine whether the current account is in deficit or surplus

(whether it has more credit or debit). This will help us understand where any

discrepancies may stem from, and how resources may be restructured in order to allow for

a better functioning economy. The formula is:

Current Account Balance = X M + NY + NCT.

where: X = Exports of goods and services

M = Imports of goods and services

NY = Net income abroad

NCT = Net current transfers

What Does the Current Account Balance Tell Us?

Theoretically, the balance should be zero, but in the real world this is improbable, so if

the current account has a deficit or a surplus, this tells us something about the state of

the economy in question, both on its own and in comparison to other world markets.

A surplus is indicative of an economy that is a net creditor to the rest of the world. It

shows how much a country is saving as opposed to investing. What this means is that the

country is providing an abundance of resources to other economies, and is owed money in

return. By providing these resources abroad, a country with a CAB surplus gives

receiving economies the chance to increase their productivity while running a deficit. This

is referred to as financing a deficit.

A deficit reflects an economy that is a net debtor to the rest of the world. It is investing

more than it is saving and is using resources from other economies to meet its domesticconsumption and investment requirements. For example, let us say an economy decides

that it needs to invest for the future (to receive investment income in the long run), so

instead of saving, it sends the money abroad into an investment project. This would be

marked as a debit in the financial account of the balance of payments at that period of

time, but when future returns are made, they would be entered as investment income (a

credit) in the current account under the income section.

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A current account deficit is usually accompanied by depletion in foreign-exchange assets

because those reserves would be used for investment abroad. The deficit could also signify

increased foreign investment in the local market, in which case the local economy is liable

to pay the foreign economy investment income in the future.

It is important to understand from where a deficit or a surplus is stemming becausesometimes looking at the current account as a whole could be misleading.

2. CAPITAL AND FINANCIAL ACCOUNT:

The Capital and Financial Account records transactions that directly affect the

wealth and debt of the country. This account tracks the flow of currency and other

monetary assets used to purchase financial and physical assets. This part of

balance of payments tracks domestic investment in the foreign sector and foreign

investment in the domestic sector.

The account is sub-divided into two main categories:

a. The Capital Account, and

b. The Financial Account

A deficit or surplus in the capital account is matched by an opposite surplus or deficit in

the current account.

a. The Capital Account

The capital account is equal to capital transfers, and the sale of natural and

intangible assets to foreigners minus the capital transfers, and the purchase offoreign natural and intangible assets by a countrys residents.

The Capital Account covers

(i) capital transfers and

(ii) the acquisition/disposal of non-produced, non-financial assets.

Capital transfersinclude debt forgiveness and migrants transfers (goods and

financial assets accompanying migrants as they leave or enter the country). In

addition, capital transfers include the transfer of title to fixed assets and the

transfer of funds linked to the sale or acquisition of fixed assets, gift andinheritance taxes, death duties, uninsured damage to fixed assets, and legacies.

Capital transfers include the transfer of ownership of fixed assets, the transfer of

funds linked to disposal/acquisition of fixed assets and the cancellation of debt by

creditors.

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Acquisition and disposal of non-productive, non-financial assetsrepresent

the sales and purchases of non-productive assets, such as the rights to natural

resources, and the sales and purchases of intangible assets, such as patents,

copyrights, trademarks, franchises, and leases. It also includes purchases and

sales of land by foreign embassies.

b. The Financial AccountThe financial account, a subdivision of the capital account, lists trade in assets

such as business firms, bonds, stocks, and real estate.

The Financial Account covers

(i) direct investment,

(ii) portfolio investment,

(iii) other investments (trade credits, loans, currencies and deposits)

(iv) changes in reserves.

(i) Direct investmentis the category of international investment in which a residententity in one economy acquires or disposes of 10 per cent or more of the ordinary

shares or voting power of an enterprise located in another economy and has an

effective voice in management. The resident entity is referred to as the direct

investor and the enterprise is the direct investment enterprise. The components of

direct investment are: equity capital, reinvested earnings and inter-company debt

transactions.

(ii) Portfolio Investmentcovers transactions in equity securities and debt securities.

With respect to equity a portfolio investment would imply less than 10 per cent

ownership of the voting power of an enterprise located in another country. Debt

securities include bonds and notes, money market instruments and financial

derivatives. The essential characteristic of these instruments is that they are

tradable. This means these instruments offer investors the flexibility to shift

invested capital from one instrument to another.

(iii) Other investmentis a residual category that includes all financial transactions

not covered in direct investment, portfolio investment or reserve assets. It includes

trade credits, (the direct extension of credit by suppliers to buyers of goods and

services), loans to finance trade, other loans and advances and financial leases.

(iv) The Reservesrepresent the foreign exchange which the country has available forfinancing an imbalance of payments with the rest of the world. An increase in the

reserves of a country (a debit) indicates that there was a surplus from the

remanding non-reserve transactions, indicating an overall surplus for the balance

of payments and vice versa.

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A distinction is made between gross foreign reserves and net foreign reserves. In

the case of Jamaica, gross foreign reserves represent the official holdings of foreign

assets, by the Central Bank and the Central Government, while gross foreign

liabilities are principally liabilities of the Central Bank to the International

Monetary Fund (IMF). The difference between the gross foreign assets and

liabilities gives the net international reserve position of the country. This can be

disaggregated into the net international reserves of the Central Bank and theexternal assets of the Central Government.

A country's monetary authority normally should not permit reserve holdings to

decrease below the level considered minimally appropriate or adequate for the

country.A common measure of the adequacy of reserve holdings is the ratio

of reserve assets to import of goods and services. This ratio is sometimes

expressed as the number of weeks worth of imports of goods and services that

could be paid for from the of gross reserve assets. The international benchmark for

reserve adequacy is 12 weeks of imports of goods and services.

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MAIN SOURCES OF DATA

There are three main sources of data for compiling the balance of payments of Jamaica.1. Surveys

2. Foreign exchange records

3. Administrative and other documentary sources

1. Balance of payments surveysof business enterprises and other organizations are

conducted at least once per year. Information is requested regarding a company's

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transactions with the rest of the world. Like all statistical surveys, there are

problems such as nonresponse and incomplete coverage for which estimates have

to be done. Since the repeal of the Exchange Control Act, the annual survey has

been one of the main sources of data.

2. Foreign exchange recordsare also a useful source of balance of payments

statistics. However, such records do require adjustments with regard toclassification and timing before they satisfy the needs of the balance of payments

compiler. Many of the items in the services and financial accounts are prepared

from consolidated foreign exchange reports received from the authorized foreign

exchange dealers.

3. Administrative records, particularly those kept by government institutions

provide data on items such as merchandise trade, foreign loans and official

transfers. External trade data is compiled by The Statistical Institute of Jamaica

(STATIN) from records maintained by Customs. Estimates of receipts from foreign

travel are derived from the number of visitors in various categories compiled by theJamaica Tourist Board together with the average expenditure of each category. The

Bank of Jamaica generates information on the country's foreign exchange reserves

in keeping with the Bank's role as custodian of such reserves.

OVERALL SURPLUS AND DEFICIT OF THE BALANCE OF PAYMENTS

In instances where there is an overall balance of payments deficit, the amount of foreign

exchange held by the country is depleted. The reverse is also true, as where there is a

balance of payments surplus, the foreign exchange held by the country increases.

The Central Bank or monetary authority of a country keeps amounts of foreign exchange

in its vaults for official purposes. As such, these foreign currency holdings are called

official foreign exchange reserves. For instance, if global disturbances due to natural

disasters or other circumstances cause exports to be significantly curtailed, then the

Central Bank would be able to use its foreign exchange reserves to cover imports and

other essential foreign payments such as foreign debt servicing.

As indicator of how long the country could sustain its current level of imports using its

foreign exchange reserves, the import cover ratio is calculated. This simply divides the

official foreign exchange reserves balance by the level of monthly imports.

In addition to this role, foreign exchange reserves can also be used to manipulate the

exchange rate. This will be discussed in the next topic: Exchange Rates.

CURRENT ACCOUNT DEFICITS

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The Balance of Payments account tells an important story of the overall level of

participation of a country in the international environment. In the complex world of

international trade and capital movements, there is a systematic relationship where

countries are intertwined by their dependence on each other for supplies, markets for the

various goods and services produced and international finance. The health of this

relationship needs to be maintained in order for it to successfully continue into the long

term. This is because, if a country would like to continue to import foreign goods on along term basis, then it needs to keep earning sufficient foreign exchange to finance such

imports. If not, the current account would be in deficit and imports would have to be

financed by borrowing foreign exchange. Many developing countries face the dilemma of

large current account deficits over extended periods of time. This typically leads them to

depend on international lending institutions such as the International Monetary Fund for

assistance to finance such deficits. Such borrowing, however, is usually accompanied by

severe economic conditionality or strict measures such as major cut-backs on government

spending which aggravate poverty.

CAUSES OF A CURRENT ACCOUNT DEFICIT

The current account deficit occurs when imports of goods and services, investment

income outflows and outward transfers exceed the exports of goods, services, investment

income inflows and inward transfers. Some of the causes of a current account deficit are:

1. Low Competiveness. If a countrys manufacturing and service industries lack

competitiveness, then it would experience difficulty in selling its products in foreign

markets. As such, its level of exports would be low. In addition, the lack of

competiveness on the part of domestic industries would encourage consumers to

purchase products from more efficient foreign producers. This would lead to a high

level of imports, which combined with low exports would result in a currentaccount deficit.

Domestic industries may lack competiveness if needed resources are simply

unavailable. It may also arise if small scale production is employed which prevents

the attainment of economies of scale. Even if there is large scale production, the

employment of obsolete technology may also result in high costs and hence low

competitiveness. Finally, high domestic inflation could also lead to an erosion of

domestic competitiveness.

2. An overvalued exchange rate. If the exchange rate is set at a level which makesimports cheap relative to domestically produced goods and services, then imports

would rise. Furthermore, an overvalued exchange rate would also make exportable

goods seem expensive to foreigners which would lead to a decline in exports. Both

of these combined would result in a current account deficit.

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3. Rapid growth in income. As income increases, consumption rises and as such

the level of imports increases. If exports remain unchanged, then a rise in income

would result in a rise in imports and hence a deficit in the current account.

4. Huge capital inflows. If a country benefits from large capital inflows which result

in a surplus in the capital account, it is likely that the current account in future

years would be negatively impacted. This is because foreign investments generateinvestment income to the foreign investors which are outflows in the current

account.

PROBLEMS WITH A CURRENT ACCOUNT DEFICIT

A deficit represents a net withdrawal from the circular flow of income by the foreign trade

sector. As such, aggregate expenditure within the domestic economy falls, leading to a

decline in income via the multiplier process. This may also result in the creation of a

deflationary gap where cyclical unemployment exists. In addition, a current account

deficit caused by huge importation is usually financed by borrowing from overseas. Thisgives rise to significant interest payments which leads to an exacerbating if the deficit.

Such interest payments may also be a burden on GNP since it is an outflow of net

property income from abroad.

MEASURES USED TO ELIMINATE A CURRENT ACCOUNT DEFICIT

There are a host of different measures which a government can use to eliminate a current

account deficit. These include:

1.Expenditure Reducing Measures

2.Expenditure Switching Measures

3.Export Subsidies

4.Enhanced Competitiveness

1. Expenditure Reducing Measures:

These are deflationary or contractionary measures that decrease national income.

This is because imports are said to be induced, i.e., rise as income increases and

likewise fall as income decreases. Exports on the other hand are said to be

autonomous to the level of national income. Hence, as income decreases, imports

fall while exports remain unchanged causing the deficit to be eliminated. This is

shown by a movement along the import function in the diagram (Figure 1) from

point A to point B. As a result of the decrease in the level of imports, the currentaccount improves, possibly resulting in an overall balance.

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Figure 1: Contractionary Policy and the Current Account Balance

2. Expenditure Switching Measures:

This includes all measures designed to switch expenditure away from imports and

towards domestically produced goods, such as:

Devaluation or depreciation of the exchange rate. This will be discussed in

more detail in the topic: Exchange Rate. A devaluation applies if there is a fixed

exchange rate, while a depreciation occurs if there is a floating exchange rate

regime. Both measures result in an increase in the price of foreign currencies

and by extension, imports become more expensive and domestic exports

become cheaper in foreign markets. Assuming that the demand for imports is

elastic, then overall, as imports become more expensive, expenditure on imports

would fall, leading to a decline in outflows in the current account. If the

demand for exports is elastic, as it becomes cheap, export revenues would rise,

leading to an increase in inflows in the current account.

Both of these effects reinforce each other as a means of eliminating the deficit

in the current account. The requirement that the demand for imports and

exports are elastic is known as the Marshall-Lerner condition. If this condition

does not hold, then the devaluation or depreciation would not help to eliminate

the current account deficit.

Introduction of protectionist policies. This option eliminates a current

account deficit by curtailing the amount of imports via the implementation of

policy measures which seek to protect the home market from importedproducts.

Subsidizing import substitutes.This option requires allocations of subsidies

directed at local production, with the objective of lowering cost of production

import substitutes. This is seen to be necessary, as the lowered cost of

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domestic output would encourage consumers to purchase such products as

opposed to foreign manufactured goods.

3. Export Subsidies:

An export subsidy is a payment to a domestic producer who exports a good abroad.

This can also be used independently or in conjunction with other policies for thepurpose of eliminating a current account deficit. Because of the subsidizing of

domestic exports, producers are able to reduce production cost which improves the

competitiveness of their output in the international markets. This should therefore

serve to boost export earnings and thereby eliminate the current account deficit.

The first two measures, expenditure reducing and expenditure switching, may be regarded

as complements rather than competing measures. This is because the government might

initially undertake expenditure reducing policies in order to create spare capacity in the

economy. Afterwards, it would implement expenditure switching policies which would

divert demand away from imports to domestic output. Since there is spare capacity in the

economy, domestic firms would be able to increase output and meet the increase in

domestic demand.

CURRENT ACCOUNT SURPLUSES

If one country has a current account surplus, then its trading partner would inevitably

have a current deficit. China currently has the largest current account surplus in the

world and its main trading partner, the USA, has the largest deficit in the world. As a

result, current account surpluses can result in retaliation where the deficit country cuts

back on importation possibly leading to a deficit in the surplus country. If both countries

had neither deficits nor surpluses then no such feedback effects would occur.

METHODS OF ELIMINATING A CURRENT ACCOUNT SURPLUS

1. Revaluation or appreciation of the exchange rate. This refers to an increase in

the exchange rate under the fixed exchange rate and floating exchange rate

respectively. This policy action makes imports appear cheaper to domestic

consumers and exports more expensive to foreigners as the external value of the

countrys currency increases. As a consequence, the value of imports rises while

the value of exports declines thus eliminating the surplus.

2. Remove protectionist measures. The removal of protectionist policy would

encourage increased importation and thus eliminate the surplus by allowing

imports to increase.

3. Expansionary policy. Any increase in domestic income brought about by

expansionary policy would lead to a rise in imports with no change in the level of

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exports. As a consequence, outflows in the current account rise, with inflows held

constant. Eventually this leads to an elimination of the surplus. This is shown in

Figure 2 where the level of export is constant at $40 million. If income is at YR

imports are $10 million and there is a surplus of $30 million. As income increases

from YRto YSthere is an expansion in imports as shown by the movement along the

import schedule from R to S. As a result imports rise to $40 million and the

current account surplus is eliminated.

Expansionary Policy and the Current Account Balance

GLOSSARY OF FREQUENTLY USED TERMS

Balance of Payments Manual: This is the standard issued by the International

Monetary Fund (IMF), which provides guidance to member countries in the compilation of

balance of payments statistics.

Transaction: A transaction is an economic flow between residents and non-residents.

Transactions involve changes in ownership of goods and financial assets/liabilities, the

provision of services, labour and capital and transfers in cash and kind.

Compensation of Employees: This is income received as remuneration for work. It

includes wages and salaries paid to employees, commissions, bonuses, payments in kind

and incentive payments in a given time period.

Direct Investor: The direct investor may be an individual; an incorporated or

unincorporated private or public enterprise or any other organization that owns direct

investment enterprises in an economy other than the one in which the direct investor

resides.

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Direct Investment Enterprise: A Direct Investment Enterprise is an incorporated or

unincorporated company in which a direct investor acquires 10 per cent or more of its

ordinary shares or voting power. Most Direct investment enterprises are either branches

or subsidiaries.

Foreign Assets: Foreign assets refer to a country's claim on foreigners.

Foreign Liabilities: Foreign liabilities refer to a country's indebtedness to foreigners.

Trade Credits: This is credit that one non-financial firm extends to another for goods and

services transactions.

Equity: The value of the ordinary shares issued by a company.

Monetary Policy: Monetary policy describes the use of variations in the quantity of

money which may raise or lower interest rates, and hence either directly or indirectlylower or raise aggregate demand.

Fiscal Policy: Fiscal policy describes the use of taxation and expenditure by the

government to influence the level of business activity.

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Macroeconomics - Module 3 - 04 Balance of Payments

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