A-Level Economics Notes on Balance of Payments

Definitions

1. Balance of Payments (BoP): A record of all economic transactions between the residents of a country and the rest of the world in a given period.
2. Current Account: Records the trade of goods and services, primary income, and secondary income transactions between residents and non-residents.
3. Capital Account: Records capital transfers and transactions in non-produced, non-financial assets.
4. Financial Account: Records transactions involving financial assets and liabilities between residents and non-residents.
5. Trade Balance: The value difference between exported and imported goods and services.
6. Exports (X): Goods and services sold by a country to residents of other countries.
7. Imports (M): Goods and services purchased by a country from residents of other countries.
8. Net Exports: The value of a country’s exports minus its imports.
9. Services: Intangible economic activities such as tourism, banking, and education provided to foreign residents.
10. Primary Income: Income from foreign sources due to labor and investment, including wages and dividends.
11. Secondary Income (Transfer Payments): Transfers of money or goods for which no service or good is exchanged in return, such as remittances and foreign aid.
12. Direct Investment: Investment in a foreign enterprise to obtain a significant degree of influence or control.
13. Portfolio Investment: Investment in foreign stocks, bonds, or other financial instruments for financial return rather than control.
14. Other Investment: Transactions involving loans, deposits, and trade credits not classified as direct or portfolio investments.
15. Reserve Assets: Foreign currency and securities held by a central bank to finance trade imbalances and stabilize the nation’s currency.
16. Exchange Rate: The price of one nation’s currency in terms of another nation’s currency.
17. Devaluation: A reduction in the value of a nation’s currency with respect to foreign currencies.
18. Revaluation: An increase in the value of a nation’s currency with respect to foreign currencies.
19. Foreign Exchange Reserves: Holdings by the central bank of foreign currencies for use in balancing the payments from year to year.
20. Net Errors and Omissions: The “balancing item” in the BoP that accounts for unrecorded or misrecorded transactions.
21. Balance of Payments Surplus: When the combined balance of the current, capital, and financial accounts is positive, indicating more inflows than outflows of funds.
22. Balance of Payments Deficit: When the combined balance of the current, capital, and financial accounts is negative, indicating more outflows than inflows of funds.

Balance of Payments: Simplified Explanation

The Balance of Payments is like a record book that keeps track of all money coming into and going out of a country. It’s divided into three main sections: the Current Account, the Capital Account, and the Financial Account.

Current Account: The Day-to-Day Transactions

Think of the current account as the day-to-day money movement due to regular business activities and other immediate transfers.

1. Trade Balance:

• Exports: When a country sells goods like cars, food, or services like education to someone in another country, it’s called an export.
• Imports: When a country buys goods like oil or services like banking from another country, it’s called an import.
• Trade Balance: If a country sells more than it buys, it has a trade surplus. If it buys more than it sells, it has a trade deficit.

2. Services:

• This is similar to goods but includes things you can’t touch, like insurance services, banking, and tourism.

3. Primary Income:

• Money made from investments abroad or sent back home by people working in foreign countries.

4. Secondary Income:

• Money that moves between countries without a good or service being provided in return, like financial aid or gifts.

Capital Account: Big, One-Off Changes

The capital account records rare or one-time changes in financial assets, like when a country sells a big asset that it won’t sell again soon.

1. Capital Transfers:

• When debts are forgiven or when immigrants bring in their personal belongings as they move into a country.

2. Sales and Purchases of Non-Produced Assets:

• When a country sells rights to natural resources or purchases a patent.

Financial Account: Investment Flows

The financial account is all about investments and loans going in and out of the country.

1. Direct Investment:

• When a company from one country builds a factory in another country, that’s direct investment.

2. Portfolio Investment:

• Buying stocks or bonds from another country. It’s like buying a tiny piece of a company or lending money to a government.

3. Other Investment:

• Other ways money moves, like bank loans or construction projects.

4. Reserve Assets:

• The government’s savings in foreign currency, which it can use to help manage the country’s money value.

Why the Balance of Payments Matters

The BoP tells us if a country is spending more money abroad than it’s making from its foreign sales. If a country is spending too much, it might have to borrow from other countries, which can be risky. If it’s making more than it spends, it might be saving a lot or investing in other countries.

Adjusting the Balance

When a country’s BoP is off-balance, it can adjust by changing the value of its currency, changing how much the government spends, or by influencing how much its citizens save and spend.

Challenges with Balance of Payments

1. Deficits and Surpluses:

• A deficit means a country owes more to other countries than it has coming in. A surplus means the opposite. Both can cause problems, like economic instability or tension with other countries.

2. Policy Responses:

• The government might let its currency become cheaper to make its exports more attractive. Or it might use taxes to discourage people from buying too much from abroad.

3. International Considerations:

• If one country has a big deficit or surplus, it affects other countries too. It can lead to disagreements and affect international loans and investments.