Question

Describe the balance of payments of how international transactions are calculated. What are the problems with focusing too much in the magnitude of trade deficits in goods and services? What additional economic measures should be taken into consideration to diagnose any economic problems?

Answer 1

                                             The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and if a country has paid or given money, the transaction is counted as a debit.

Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice, this is rarely the case. Thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.

• The balance of payments (BOP) is the record of all international financial transactions made by the residents of a country.
• There are three main categories of BOP: the current account, the capital account, and the financial account.
• The current account should be balanced versus the combined capital and financial accounts, leaving the BOP at zero, but this rarely occurs.

The balance of payments (BOP), also known as balance of international payments, summarizes all transactions that a country's individuals, companies, and government bodies complete with individuals, companies, and government bodies outside the country. These transactions consist of imports and exports of goods, services, and capital, as well as transfer payments, such as foreign aid and remittances. A country's balance of payments and its net international investment position together constitute its international accounts.The balance of payments divides transactions in two accounts: the current account and the capital account. Sometimes the capital account is called the financial account, with a separate, usually very small, capital account listed separately. The current account includes transactions in goods, services, investment income, and current transfers. The capital account, broadly defined, includes transactions in financial instruments and central bank reserves. Narrowly defined, it includes only transactions in financial instruments. The current account is included in calculations of national output, while the capital account is not. The sum of all transactions recorded in the balance of payments must be zero, as long as the capital account is defined broadly. The reason is that every credit appearing in the current account has a corresponding debit in the capital account, and vice-versa. If a country exports an item (a current account transaction), it effectively imports foreign capital when that item is paid for (a capital account transaction). If a country cannot fund its imports through exports of capital, it must do so by running down its reserves. This situation is often referred to as a balance of payments deficit, using the narrow definition of the capital account that excludes central bank reserves. In reality, however, the broadly defined balance of payments must add up to zero by definition.

                                              A trade deficit occurs when a country's imports exceed its exports during a given time period. It is also referred to as a negative balance of trade .

The balance can be calculated on different categories of transactions: goods services, goods and services. Balances are also calculated for international transactions—current account, capital account, and financial account.

• A trade deficit occurs when a country's imports exceed its exports during a given period.
• Balances are calculated for several categories of international transactions
• Trade deficits can be shorter or longer term.
• Implications of a trade deficit depend on impacts on production, jobs, national security and how the deficits are financed.

A trade deficit occurs when there is a negative net amount or negative balance in an international transaction account. The balance of payments (international transaction accounts) records all economic transactions between residents and non-residents where a change in ownership occurs. A trade deficit or net amount can be calculated on different categories within an international transaction account. These include goods, services, goods and services, current account, and the sum of balances on the current and capital accounts. The sum of the balances on the current and capital accounts equals net lending/borrowing.This also equals the balance on the financial account plus a statistical discrepancy. The financial account measures financial assets and liabilities, in contrast to purchases and payments in the current and capital accounts.

                                           The most obvious benefit of a trade deficit is that it allows a country to consume more than it produces. In the short run, trade deficits can help nations to avoid shortages of goods and other economic problems. In some countries, trade deficits correct themselves over time. A trade deficit creates downward pressure on a country's currency under a floating exchange rate regime. With a cheaper domestic currency, imports become more expensive in the country with the trade deficit. Consumers react by reducing their consumption of imports and shifting toward domestically produced alternatives. Domestic currency depreciation also makes the country's exports less expensive and more competitive in foreign markets.

                                Trade deficits can create substantial problems in the long run. The worst and most obvious problem is that trade deficits can facilitate a sort of economic colonization. If a country continually runs trade deficits, citizens of other countries acquire funds to buy up capital in that nation. That can mean making new investments that increase productivity and create jobs. However, it may also involve merely buying up existing businesses, natural resources, and other assets. If this buying continues, foreign investors will eventually own nearly everything in the country. Trade deficits are generally much more dangerous with fixed exchange rates. Under a fixed exchange rate regime, devaluation of the currency is impossible, trade deficits are more likely to continue, and unemployment may increase significantly.

The trade deficit is a major component of the current account. The current account, balance of payments measures trade in goods/services and investment incomes/transfers

Reducing the exchange rate (devaluation or depreciation)

Reducing the value of the exchange rate can help to reduce a trade deficit. When the value of the Pound falls it makes UK exports more competitive, increasing quantity demanded. A depreciation also makes imports more expensive, reducing demand for imports and foreign holidays. Therefore, we would expect a depreciation to improve the trade deficit.

However, it is not that simple. It depends upon the elasticity of demand.

• If demand for exports is very inelastic. A fall in price (10%) may lead to only a small fall in demand (1%). Therefore, the value of exports will decrease because the lower price decreases revenue.
• However, if demand for exports is elastic. then a fall in price will lead to a bigger % increase in demand. Therefore, there will be an increase in export revenue.
• The Marshall-Lerner condition states that a depreciation in the exchange rate will improve the current account deficit IF PED x + PED M >1

The effect of a depreciation also depends on other things.

Inflation : If a depreciation causes inflation, then exports may not become more competitive. Therefore, demand will not increase

Global Recession : If the global economy is in recession, demand for exports will fall, even if the Pound depreciates. Alternatively, if the UK is in a boom our demand for imports will keep rising.

Other Policies to Reduce a Trade Deficit

Supply Side Policies – these policies aim to improve the productivity and competitiveness of the economy – making UK exports more competitive and attractive. This helps increase exports.

Deflationary fiscal policy. This involves higher tax and lower government spending. Higher tax reduces consumers’ disposable income leading to a decline in consumer spending and less spending on imports. Also, the deflationary fiscal policy helps reduce inflation and thereby improve the competitiveness of exports.

Deflationary monetary policy could be used. However, higher interest rates would cause an appreciation in the exchange rate and worsen the trade deficit.