Question

Discuss how the balance of payments can affect a nation's economy. What types of policies should be put in place to correct trade imbalance? Discuss with peers. Please post with 200+ words.

Answer 1

The balance of payments is the record of all international trade and financial transactions made by a country's residents.

The balance of payments has three components. They are the current account, the financial account, and the capital account. The current account measures international trade, net income on investments, and direct payments. The financial account describes the change in international ownership of assets. The capital account includes any other financial transactions that don't affect the nation's economic output.

A country's balance of payments tells you whether it saves enough to pay for its imports. It also reveals whether the country produces enough economic output to pay for its growth. The BOP is reported for a quarter or a year.

A balance of payments deficit means the country imports more goods, services and capital than it exports. It must borrow from other countries to pay for its imports. In the short-term, that fuels the country's economic growth. It's like taking out a school loan to pay for education. Your expected higher future salary is worth the investment.

In the long-term, the country becomes a net consumer, not a producer, of the world's economic output. It will have to go into debt to pay for consumption instead of investing in future growth. If the deficit continues long enough, the country may have to sell off its assets to pay its creditors. These assets include natural resources, land, and commodities.

A balance of payments surplus means the country exports more than it imports. Its government and residents are savers. They provide enough capital to pay for all domestic production. They might even lend outside the country.

A surplus boosts economic growth in the short term. It has enough excess savings to lend to countries that buy its products. The increased exports boosts production in its factories, allowing them to hire more people.

In the long run, the country becomes too dependent on export-driven growth. It must encourage its residents to spend more. A larger domestic market will protect the country from exchange rate fluctuations. It also allows its companies to develop goods and services by using its own people as a test market.

The ways to reduce the trade deficit are:

1. Consume less and save more. If US households or the government reduce consumption (businesses save more than they spend), imports will drop and less borrowing from abroad will be needed to pay for consumption. This means that consumption taxes—like those that nearly all other countries in the world have—could help reduce the deficit, by discouraging consumption, increasing saving, and reducing the government deficit. In contrast, an unfunded tax cut, such as the one proposed by the administration, will expand the deficit because the government will be consuming more relative to its earnings.
2. Depreciate the exchange rate. Trade deficit reversals are typically driven by a significant real exchange rate depreciation. A weaker dollar makes imports more expensive and exports cheaper and improves the trade balance. Given the dollar is the world's reserve currency, and still regarded as the safest for investors, it tends to run stronger than other currencies. But when foreign governments actively push the dollar up to maintain their surpluses, the United States could counteract interventionby selling dollars and buying foreign currencies. The administration could also encourage the adoption of other major currencies, such as the euro, yen, or renminbi, as alternative reserve currencies. A weaker dollar would be good for the US economy, but relinquishing the role as the dominant currency would reduce the power of the United States in global markets and the seigniorage (profit) earned.
3. Tax capital inflows. One of the reasons that the United States runs a trade deficit is because borrowing from abroad is cheap and easy. If it were more expensive, US citizens and the government would borrow less. A tax on (non–foreign direct investment) capital inflows that rises with the size of the inflow could reduce excessive borrowing for consumption and help close the government imbalance. While some worry that capital controls could distort asset prices and reduce investment, they could also curb excessive speculative investment, such as happened before the financial crisis.