1. THE BALANCE OF PAYMENTS

2. THE STRUCTURE OF THE BALANCE OF PAYMENTS
OBJECTIVES
Define the term ‘balance of payments’
Outline the role of balance of payments
Distinguish between debit items and credit items in the balance of payments
HOMEWORK: components of B.O.P accounts

3. Definition
Balance of payments(BOP) refers to a record of the value of all transactions of a country with the rest of the world over a period of time.

4. Role of BOP
It shows all payments received from transactions with other countries, called CREDIT
It shows all payments made from transactions to other countries, called DEBIT

5. Distinguish between credit and debit items in a BOP
Any transactions that lead to money entering the country from abroad e.g. export goods such as cash crops, food crops, manufactured goods, etc
exportation of services such as tourism, skills, etc
It gives a positive value
Any transactions that lead to money leaving the country to go abroad e.g. import goods such as food items, manufactured goods, machinery, etc
Importation of services such as tourism, expertise, insurance, etc
It gives a negative value

6. COMPONENTS OF BOP CURRENT ACCOUNT
It is a measure of the flow of funds from trade in goods and services, plus other income flows
It is divided into FOUR components:
Balance of trade in goods/ Visible trade balance/Merchandise account/Balance of trade
Balance of trade in services/ Invisible trade balance/Net services
Income/Net investment income
Current transfers

7. Balance of trade in goods/ Visible trade balance/Merchandise account/Balance of trade
It measures the revenue received from the export of tangible goods minus the expenditure on the imports of tangible goods over a given time period
NOTE:
Exports lead to inflow of money while imports lead to an out flow of money
There is a surplus when X>M
There is a deficit when M>X

8. Balance of trade in service/ Invisible trade balance/Service balance/Net services
It measures the revenue received from the export of services minus the expenditure on the imports of services over a given time period
Examples of these services include:
Banking
Insurance
Tourism
Transport
Postal and courier services
Communication services
Financial services

9. Income/Net investment income
It is a measure of the net monetary movement of profit, interest, and dividends moving into and out of the country over a given period of time, as a result of financial investment abroad.
Examples:
Profits, Interests and Dividends from portfolio
Direct investments
Compensation of employees (wages and salaries)
Returns from rental resources e.g. granting fishing, grazing mining, and forestry rights.

10. Current transfers
It is a measurement of the net transfers of money, often known as net unilateral transfers from abroad.
It refers to transfers with nothing received in return
Examples:
Worker’s remittances
Donations
Grants
Foreign aid
Food aid and emergency aid after natural disasters.

11. The sum of net export of goods and services, net income and net current transfers over a period of time is defined as current account balance. It is referred to as a current account surplus if it is positive while a current account deficit if it is negative.

12. NOTE:
The current account of the balance of payments of a country is composed of the sum of the balance of trade (recording exports minus imports of goods) plus the balance on service, or invisible balance (recording exports of service minus imports of services), plus net income plus net transfers.
The most important part of the current account in most countries is the balance of trade.

13. CAPITAL ACCOUNT This section of the BOP includes the following:
Capital transfers receivable and payable i.e. the net monetary movements gained or lost through actions such as the transfer of goods and financial assets by migrants entering or leaving the country.
Note: These items of value that have not been produced e.g. land or natural resources.
Other examples include:
Gift taxes
Inheritance taxes
Death duties
Debt forgiveness

14. 2. Transaction in non – produced, non- financial assets This consists of the net international sales and purchases of non – produced assets such as land and the rights to natural resources, and the net international sales and purchases if intangible assets such as patents, copyrights, brand names or franchises. NOTE: THE CAPITAL ACCOUNT IS SMALL AND OF MINOR IMPORTANCE

15. FINANCIAL ACCOUNT This account includes investments and assets.
It measures the net change in foreign ownership of domestic financial assets.
If foreign ownership of domestic financial assets > domestic ownership of foreign financial assets, then there is more money coming into the country than going out and so there is a financial account surplus.
The vice versa leads to a financial account deficit.

16. COMPONENTS OF THE FINANCIAL ACCOUNT
Direct investment: this is also referred to as Foreign Direct Investment (FDI) when a resident in one country acquires control or a significant degree of influence on the management of a firm in another economy (normally more than 10%)
It is a measure of the purchase of long – term assets.
It includes things such as:
Buying of property
Outright purchasing of a business
Purchasing of stocks or shares in a business.

17. 2. PORTFOLIO INVESTMENT
It refers to a measure of stock and bond purchases – these do not lead to a lasting interest in a company.
It includes:
Treasury bills
Government bonds
Saving account deposits
NOTE: THESE ASSETS ARE SIMPLY BORROWING AND LENDING ON THE INTERNATIONAL MARKET.

18. 3. RESERVE ASSETS/ OFFICIAL RESERVES
This includes the assets that the Central Bank holds to finance balance of payments needs and to intervene in the foreign exchange market
It includes the reserves of gold and foreign currencies which all countries hold.
It is movements into and out of this account that ensures that the BOPs will always balance to zero.

19. CURRENT ACCOUNT =
CAPITAL ACCOUNT + FINANCIAL ACCOUNT+
NET ERRORS AND OMISSIONS

20. RELATIONSHIP BETWEEN CURRENT ACCOUNT AND THE EXCHANGE RATES
A deficit in the current account of the BOP results in a downward pressure on the exchange rate of a currency.
This mostly affects the fixed exchange rate more than the floating exchange rate.
A surplus in the current account of the BOP may result in an upward pressure on the exchange rate of the currency.

21. HL: CONSEQUENCES OF CURRENT ACCOUNT AND CAPITAL IMBALANCES
CONSEQUENCES OF A CURRENT ACCOUNT DEFICIT
If the current account is in deficit, the capital account will have to be in surplus in order balance the current account benefit.
It means the economy is not earning enough FOREX from its imports and income earnings from abroad to finance its imports.

22. SOLUTION
Running down FOREX reserves – this can only be down for a short period of time because these reserves are limited.
Surplus from the combined Capital and Finance Accounts:
This can only be done it two ways:
Sale of domestic assets (businesses, stock or property) to foreigners – they might want at low prices. This may lead to loss of economic sovereignty.
Borrowing from abroad – this involves future repayment either in the short or long run – opportunity cost will be diversion in the future of national income; since repayment is in FOREX and this implies diversion away from purchase of import consumer or capital goods

23. METHODS OF CORRECTING A PERSISTENT CURRENT ACCOUNT DEFICIT
1. Expenditure reducing strategies – this includes policies that decrease AD ( decrease spending on imports), for example contractionary fiscal and monetary policies. Decrease in AD will lead to decrease in inflation, exports may benefit from increased competitiveness.
Shrinking imports and increasing exports will help narrow the current account deficit.

24. 2. Expenditure switching policies - this includes devaluation, as well as increased trade protection that renders imports more expensive.
NOTE – devaluation increases exports but may leads to inflation.
Trade protection restricts imports but may lead to trade friction.

25. 3. Supply – side policies – these are more of a long run nature and they include decreasing domestic monopoly power, increasing labor market flexibility and improving incentives.
They increase the competitiveness of the economy and especially of the export sector.

26. IS A CURRENT ACCOUNT SURPLUS A PROBLEM? DISCUSS!
QUESTION?
IS A CURRENT ACCOUNT SURPLUS A PROBLEM? DISCUSS!

27. THE MARSHALL-LERNER CONDITION
DEVALUATION (SHARP DEPRECIATION) WILL IMPROVE A TRADE DEFICIT IF: PED (X) + PED (M) > 1

28. http://www.youtube.com/watch?v=VgCFN9M2aFE ( The Marshall Lerner
condition)

29. THE J – CURVE EFFECT
(J – curve)

30. REFERENCES
Blink and Dorton, (2012), Economics: Course Companion, Oxford University Press, New York
Ziogas, C., (2012), IB study guide, Oxford university Press, New York.
Welker’s Wikinomics videos lectures.