Balance of Payments

A nation’s balance of payments represents its economic transactions with the world. The balance of payments consists of two parts, the current account balance and the capital account balance. The two accounts must balance by design. The balance of payments imposes economic constraints on policy-makers, who have several choices in how to achieve a balance of payments, either automatically or through government intervention. The balance of payments is important because it is a great indicator of international trade of a country; thus, national leaders can identify in which areas new policy is needed in order to have a balance of payments.

The Current Account

The current account balance is the nation’s current receipts minus its current expenditures. It includes:

1. Trade in goods in service, exports minus imports

2. Income receipts: on US assets abroad, or paid to foreigners for US assets

3. Net unilateral transfers, such as debt relief.

The Capital Account

The capital account balance is the nation’s capital account inflows minus its capital account outflows. It includes:

1. Foreign direct investment, in which a citizen partly owns and controls a company based in a foreign country, or vice versa

2. Portfolio investment: trading stocks on other nations’ exchanges

3. Checking accounts established abroad by citizens, or in the domestic country by foreigners.

By design, the current account and the capital account must balance. This is because as currency flow out of the country—for example, to import foreign goods—foreigners keep that currency or invest them in assets such as government bonds; a decrease in the current account balance becomes a capital inflow of the same quantity. Sometimes Governments must step in to help achieve a balance of payments.

Achieving a Balance of Payments

There are four main ways of achieving balance. argued that governments have four ways to redress the balance of payments.

1. Adjustment of Reserves. When governments face a surplus of their currency in the global market they can absorb it by selling bonds, thus snatching up excess currency and relieving pressure on the currency. Conversely, a government facing a shortage of currency can buy bonds to increase the supple of currency. Milton Friedman argued that this was impractical because governments will frequently lack enough currency to carry out these policies. In other words, this only works for countries with a lot of reserves.

2. Adjustment in the general level of internal prices and incomes. The central bank can use the interest rate to affect domestic prices and revenues. Friedman assumed this option was politically unviable.

3. Exchange rate adjustments. With a fixed ER regime, this is not a means of achieving balance, as it runs counter to the practice of Fixed ERs. With a flexible or flating ER regime, governments let their exchange rates adjust according to market forces, thus preserving internal prices and incomes, and allowing for balance. According to Friedman this is the best approach.

4. Exchange controls. This option comes in two parts: trade controls and capital controls. Governments can influence the current account through trade and commercial restrictions, like tariff, and the capital account through controls like limits on currency exchange. Friedman believed that this type of government intervention impeded free trade, and thus growth.

References

1. Morrison, James A. "Class 6: Economic Constraints: The Balance of Payments" Sept. 23

2. Grieco & Ikenberry, Ch 3: “The Economics of International Money & Finance.” in State Power and World Markets: The International Political Economy. New York: W.W. Norton & Co., 2003