IGCSE®/O Level Economics 8.2 Balancing international payments

Exports and imports An export is a good or service sold to overseas residents resulting in a flow of income into the exporting country An import is a good or service purchased from overseas producers resulting in an flow of income out of the importing country VISIBLE EXPORT A physical product sold overseas VISIBLE IMPORT A physical product bought from overseas INVISIBLE EXPORT A service sold to overseas residents INVISIBLE IMPORT A service purchased from overseas residents

> < The balance of trade Balance of trade = value of visible exports - value of visible imports Balance of trade surplus Balance of trade deficit > < Total value of visible exports Total value of visible imports Total value of visible exports Total value of visible imports Balance on services = value of invisible exports - value of invisible imports

The balance of payments current account All monetary transactions between a country and the rest of the world are recorded in its balance of payments The balance of payments on current account records how well or how badly a national economy is doing in international trade in goods and services Credits: money received from overseas Balance of trade Balance on services Balance on income Income credits include wages, profits, interest and dividends earned overseas by residents Income debits include wages, profits, interest and dividends paid out to residents of other countries Net current transfers Including payments of taxes and excise duties by visiting residents; cross-border gifts, donations and overseas aid Debits: money paid overseas

The balance on current account

International trade requires the exchange of foreign currencies Indian company uses French advertising company Italian invests in an Argentinian shipping company UK tourist takes holiday in the USA Has to exchange Indian rupees for euros Has to exchange euros for Argentinian pesos Has to exchanges UK pounds for US dollars Payments for imports and exports and for all other international transactions requires the exchange of national currencies. This takes place on the global foreign exchange market

The foreign exchange market (Forex) Forex is the world’s largest financial market. It consists of all those people, organizations and governments willing and able to buy or sell national currencies.

An appreciation in the exchange rate A currency might appreciate because: There is a balance of payments surplus Demand for the currency rises as overseas consumers buy more exports Interest rates rise relative to other countries. This attracts savings from overseas residents Inflation is lower than in other countries so exports will be cheaper and overseas demand for them, and the currency required to pay for them, will rise People speculate the currency will rise in value and buy more of the currency Before: $1 = 2 reals After: $1 = 2.5 reals

A depreciation in the exchange rate A currency might depreciate because: There is a balance of payments deficit Demand for other currencies rises as domestic consumers buy more imports Interest rates fall relative to other countries. People move their savings to bank accounts overseas Inflation rises relative to other countries. This makes exports more expensive and demand for them, and the currency needed to buy them, falls People speculate the currency will fall in value and sell their holdings of the currency Before: $1 = 2 reals After: $1 = 1.8 reals

Exchange rate speculation

Changes in exchange rates will affect product prices A fall (depreciation) in the exchange rate of a currency will make imports to that country more expensive but will lower the price of its exports in overseas markets A rise (appreciation) in the exchange rate of a currency will make imports to that country cheaper but will increase the price of its exports in overseas markets, for example:

Problems with trade imbalances A large and continuous trade surplus can be a problem: Other countries may put political and economic pressure on the government to reduce the trade surplus so they can reduce their trade deficits The boost in income from trade may cause a demand-pull inflation when it is spent in the economy The value of the currency will rise on the foreign exchange market and stay high. This will increase the price of exports overseas and sales could be lost A large and continuous trade deficit can be a problem: It may be the result of industrial decline in the economy It means more income is leaving the economy, leaving less to spend on domestic goods and services The value of the currency will fall on the foreign exchange market making imports more expensive To pay for recurrent deficits a country may have to borrow from overseas. This will increase the public debt and total interest charges

Correcting a trade imbalance A government can try to reduce a trade deficit in the following ways: Do nothing because the exchange rate will depreciate, making imports more expensive (demand will fall) but exports cheaper to buy (overseas demand will rise) Use contractionary fiscal policy, by raising taxes and cutting public expenditure, which can reduce total demand for imports Raise interest rates which can attract an inflow of savings from overseas, and reduce borrowing by consumers which they might otherwise spend on imports Use trade barriers to restrict imported goods A government can try to reduce a trade surplus in the following ways: Do nothing because the exchange rate will appreciate, making imports cheaper (demand will rise) but exports more expensive to buy (overseas demand will fall) Use expansionary fiscal policy which can boost demand for imports through tax cuts and increases in public spending Lower interest rates which can encourage investors to move their savings overseas and also encourage more spending on imports by reducing the cost of borrowing Remove trade barriers