Policies To Correct Disequilibrium In The Balance of Payments (Copy)
11.1.1 Components of the Balance of Payments Accounts
- Balance of Payments (BoP):
- A record of all economic transactions between residents of a country and the rest of the world during a specific period.
- Current Account:
- Records trade in goods and services, income from investments, and current transfers (e.g., remittances, foreign aid).
- Components:
- Trade Balance: Exports minus imports of goods.
- Services Balance: Exports minus imports of services.
- Primary Income: Earnings from investments abroad minus payments to foreign investors.
- Secondary Income: Transfers without return (e.g., gifts, aid).
- Financial Account:
- Records capital flows related to financial assets and liabilities.
- Includes foreign direct investment, portfolio investment, and changes in reserves.
- Capital Account:
- Records capital transfers and acquisition/disposal of non-produced, non-financial assets (e.g., patents, copyrights).
- Usually smaller than current and financial accounts.
11.1.2 Effect of Fiscal, Monetary, Supply-Side, Protectionist and Exchange Rate Policies on the Balance of Payments
| Policy Type | Effect on BoP |
|---|---|
| Fiscal Policy | – Reducing government spending or increasing taxes lowers aggregate demand → reduces imports → improves current account. |
| – Expansionary fiscal policy can worsen BoP due to increased imports. | |
| Monetary Policy | – Higher interest rates attract foreign capital → improve financial account. |
| – Higher rates can appreciate currency → reduce export competitiveness → worsen current account. | |
| Supply-Side Policies | – Improve competitiveness by lowering costs → increase exports → improve current account. |
| – Long-term positive effect on BoP. | |
| Protectionist Policies | – Tariffs, quotas reduce imports → improve current account short term. |
| – Can provoke retaliation → reduce exports → worsen BoP long term. | |
| Exchange Rate Policies | – Depreciation makes exports cheaper and imports more expensive → improves current account. |
| – Appreciation has opposite effect. |
11.1.3 Difference Between Expenditure-Switching and Expenditure-Reducing Policies
- Expenditure-Switching Policies:
- Aim to redirect spending from imported goods to domestic goods.
- Examples:
- Currency depreciation to make imports more expensive.
- Tariffs or quotas on imports.
- Encourage domestic consumption and export growth.
- Expenditure-Reducing Policies:
- Aim to reduce overall national expenditure to decrease imports.
- Examples:
- Contractionary fiscal policy (higher taxes, lower spending).
- Contractionary monetary policy (higher interest rates).
- Reduce aggregate demand and import demand.
- Key Difference:
- Switching changes the composition of spending; reducing changes the total level of spending.
Diagrams
Diagram 1: Balance of Payments Accounts Structure
Balance of Payments
_________________________
| |
| Current Account |
| - Trade in Goods |
| - Services |
| - Income |
| - Transfers |
|_______________________|
| |
| Financial Account |
| - Foreign Investment |
| - Portfolio Flows |
| - Reserves |
|_______________________|
| |
| Capital Account |
| - Capital Transfers |
| - Non-financial Assets|
|_______________________|
Diagram 2: Effects of Exchange Rate on BoP
Price Level
↑
| Depreciation → Exports ↑, Imports ↓ → BoP improves
| Appreciation → Exports ↓, Imports ↑ → BoP worsens
Diagram 3: Expenditure-Switching vs Expenditure-Reducing Policies
Aggregate Expenditure (AE)
↑
| /
| / Expenditure Switching: Change composition from imports to domestic
| /
|_______/__________________ Expenditure Reducing: Lower overall spending reduces imports
| | |
| AE1 AE2
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Economics Full Scale Course