BALANCE OF PAYMENTSObjectives:

1.Define Balance of Payments (BOP);2.List the constituent components of the BOP;3.Distinguish between BOP and balance of trade;4.Describe the entries that would appear in the BOP account;

Balance of Payments

http://www.youtube.com/watch?v=qb8tClyrt6A

Definition

The BOP is a record of all financial dealings over a period of time between economic agents of one country and all other countries.

Three Components

Current Account Where payments for

the purchase and sale of goods and services are recorded. (BOT)

Factor Incomes (interest and dividends from international loans and investments)

Net transfer payments (foreign aid)

Capital Account Where flows of

money associated with domestic and foreign investment are recorded.

The Current Account Balance (two components) Visible Trade

Trade in goods Visible Exports Visible Imports

Balance of Visible Trade/Balance of Trade Relationship between

the value of exports and the value of imports.

Trade Surplus Favourable

Trade Deficit Unfavourable

Invisible Trade Trade in services

Invisible Exports – services rendered

Invisible Imports – services gained

Balance of Invisible Trade The relationship

between the value of invisible exports and value of invisible imports.

Invisible Trade Surplus

Invisible Trade Deficit

Question

Distinguish between the Balance of Trade and the Terms of Trade.

Terms of Trade

The Terms of Trade looks at the relationship between the price received for exports and the amount of imports we are able to buy with that money.

Average Price of Exports

Terms of Trade = ---------------------------------------- x 100

Average Price of Imports

Current Account - Invisibles

Egs. Financial services such as banking and insurance Transportation services such as shipping and air

travel Tourism Transfers of money resulting from the loan of

factors of production abroad, for instance, a Trinidadian teacher working in England and sending back money to his family in Trinidad would create an invisible import for England and invisible export for Trinidad and Tobago. An outflow of money means that this is classified as an

import. An inflow of money means an export.

Current Account Balance

The Current Account Balance is the relationship between the Balance of Visible Trade and the Balance of Invisible Trade is called the Current Balance.

Net Effect is either a Current account surplus or Current account deficit.

Activity 1

A country has the following international transactions on current account: Exports of manufactured goods $20bn; vx Imports of food $10bn; vm Earnings from foreign tourists $5bn; ivx Interest, profits and dividends paid to foreigners $4bn; ivm Purchase of oil from abroad $8bn; vm Earnings of nationals working overseas which are repatriated

$7bn; ivx Sale of coal to foreign countries $2bn; vx Payments by foreigners to domestic financial institutions for

services rendered $1bn. ivx(a) Which of these items are (1) visible exports; (2) visible imports;

(3) invisible exports; (4) invisible imports?(b) Calculate: (1) the balance of trade; (2) the balance on invisible

trade; (3) the current balance.

Capital Account

Official Capital Flows. Private Capital Flows. The difference between all inflows and

outflows of capital is termed as the Capital Account Balance.

Egs. Of Capital Flows

Foreign Direct Investment (FDI) Financial Portfolio Investment eg.

Purchase of shares in different countries. Hot Money

What is FDI?

According to the International Monetary Fund, foreign direct investment, commonly known as FDI, "... refers to an investment made to acquire lasting or long-term interest in enterprises operating outside of the economy of the investor.“

Retrieved from: http://usforeignpolicy.about.com/od/introtoforeignpolicy/a/what-is-FDI.htm

Advantages

One of the advantages of foreign direct investment is that it helps in the economic development of the particular country where the investment is being made.

FDI has the potential for job creation and employment, which is often followed by higher wages.

Resource transfer, in terms of capital and technical knowledge, is also a key motivator that encourages inward FDI.

FDI provides the benefits of reduced cost through the realization of scale economies, and coordination advantages

Activity 2

Would the following be given a plus or a minus sign on the balance of payments account of the United Kingdom? Investment overseas by UK residents. Foreign currency lending abroad by UK banks. Borrowing from banks abroad by general

government. Portfolio investment in the UK by overseas

residents. Deposits with and lending to banks abroad by

the UK non-bank private sector.

Official Financing

Must the BOP always balance? YES How?

Repayment of money borrowed if you have a surplus and Official Reserves ie hold some money.

Borrowing will occur instead of repaying in the event of a Deficit and withdrawing from reserves.

Causes, Consequences, Solutions

Increasing demand for imported g&s.

Falling demand for exports of g&s. An increase in holidays taken

abroad. A decrease in visitors to the country. Individual and governmental

transfers out of the country being greater than those coming in.

Investment incomes being paid out to foreigners being greater than investment incomes coming in.

A greater value of investments being made abroad by domestic residents than foreign investors are making in the domestic country.

Unemployment might increase.

Falling foreign exchange reserves.

Exchange rate depreciation.

Causes of BOP Deficits Consequences of BOP Deficits

Deficit Solutions

Reduction of aggregate demand through deflationary monetary and fiscal policy.

Import controls Devaluation

BOP Surpluses

Falling demand for imported g&s. Increasing demand for exports of

g&s. A decrease in holidays taken abroad. An increase in foreign visitors to the

country. Individual and governmental transfers

into the country being greater than transfers out.

Investment incomes paid into the country to domestic investors who invested abroad being greater than those being paid out to the foreigners.

Greater investments in the local economy by foreigners than foreign investment made by domestic residents abroad.

Falling unemployment

Increase in reserves

Exchange rate appreciation

Causes Consequences

Solutions to BOP Surpluses

Increasing aggregate demand through reflationary monetary and fiscal policy.

Reduction of import controls. Revaluation of the currency.