THE BALANCE OF PAYMENTS

THE BALANCE OF PAYMENTS

Money crosses a countryÕs frontiers as a result of international
buying and selling of merchandise (the visible balance of trade);
purchase and sale of services (the invisible balance) and movements
on capital account — short-term, speculative (or Ôhot moneyÕ) flows
or longer-term, cross-border investment in plant, machinery, etc.
Any imports of merchandise, for example UK purchasing Chilean
wine, result in an outflow of money; exports to overseas buyers of,
say, locally produced spirits will conversely bring in earnings.
ÔInvisibleÕ imports are represented by, for example, purchase of
foreign holidays, which causes an outflow of money from a nationÕs
© 2004 Tony Cleaver
trade account. Invisible exports could be profits repatriated from
domestic businesses operating overseas.
The day-to-day money flows on visible and invisible trade are
summed up in the Ôbalance of payments on current accountÕ, sometimes
referred to as the current balance. Add to this the inward or
outward movements of capital on the capital account and you arrive
at the overall net balance or total currency flow.
Net movements of money between countries can have important
implications and it is necessary to examine both causes and effects
of such currency flows.
Causes
As already mentioned, domestic incomes are an important determinant
of import spending. As the former grows, so must the latter —
like all consumption spending. The speculative demand for foreign
bonds is also in part determined by domestic incomes but is perhaps
more affected by changes in interest rates (see Chapter 5). Shortterm
capital flows in particular are highly internationally mobile —
almost perfectly price-elastic. That is, a slight increase in rates of
interest on bonds and securities in country A above those prevailing
in country B will result in cashing in bonds in B and transferring
the money to A. As regards long-term overseas investment, the rate
of interest in the money markets is relevant though we noted in
Chapter 4 that a more important determinant is the expected future
profitability of such investment.
Assuming expectations are exogenously given, we can graph
total currency flows of the balance of payments on axes contrasting
national income with rates of interest.
The BoP line in Figure 6.5 shows all the levels of income and rates
of interest at which a nationÕs balance of payments is in equilibrium.
Consider point Ycb. Derived from Figure 6.2, this shows the unique
level of domestic income where the current account is in balance.
(Recall that any income levels higher than this would see imports rise
and the current balance go into deficit; any lower income would
produce a current surplus.) Overall balance in the BoP requires that
the capital account is in balance at this point also — which it would be
if the domestic interest rate were equal to the prevailing market
interest rate rw obtained elsewhere in the world (Box 6.3).
© 2004 Tony Cleaver
Rate of interest: r
Current account
Surplus Deficit
BoP
r1
rw rw
National income:Y
Ycb Y ∗
Figure 6.5 The balance of payments curve.
World money markets offer a variety of different places you can
invest your funds – some a lot more risky than others. This is
much the same in principle to investing money in your own
country – some projects you might consider putting money into
are less secure than others. The international scene multiplies
potential investment outlets enormously but gilt-edged bonds
in, say, the US government will carry the same rate of interest as
their European equivalents, minus some percentage for the
risk of exchange rate variation over the period you are considering.
For the purposes of this analysis, assuming no surprises,
if market rates of interest in any one country increase or
decrease substantially from what other, equally secure alternatives
are offering then international funds will flow in or out
in immediate response. For example, the London-based business
which has just sold an expensive building and has
several million pounds of cash in its coffers for the time
being will place this on Wall Street, New York, rather than in the
UK if the interest rate differential between the two is tempting
enough.
Box 6.3 World interest rates
© 2004 Tony Cleaver
A countryÕs BoP line rises at a relatively shallow line from this
point rw — signifying it is highly interest-elastic. At income level Y*
the current balance is in deficit (imports of goods and services
exceed exports) but if domestic rates of interest are increased just a
little above world rates (r1 exceeds rw by a narrow margin) then
foreign capital will flood into the country sufficiently for the capital
account surplus to equal the current account deficit. The balance of
payments is maintained.
Balance of payments is thus illustrated for all domestic income
levels and interest rates, though note the more unresponsive, or
price-inelastic are world currency flows the steeper will be this
BoP line.
There is a problem here, however. If a country needs to raise its
interest rate to balance international currency flows it cannot at
the same time use monetary policies to stimulate domestic
spending and investment. As implied in the last chapter, you
cannot use interest rates to regulate the domestic money supply,
open your borders to unrestricted financial markets and use interest
rates to protect the balance of payments. If a country chooses to
opt for these first two variables in the Ôimpossible triangleÕ it
must adopt measures other than monetary ones to adjust its trading
relations.
Astute readers might also have noticed another problem. If
interest rates are increased to secure a capital inflow needed to
balance a current account deficit, then it must repay this capital
sometime. In the future, the nation concerned must somehow
achieve the reverse of this situation: a current account surplus that
therefore allows a capital outflow. Countries cannot increase their
indebtedness forever.
The only long-term, sustainable position for a country in international
trade, therefore, is to secure a level of income Y* that
represents full employment at home with balance in the current
account and balance on the capital account. This would mean a position
on Figure 6.5 where Ycb is consistent with Y* and local rates of
interest equalled the world rate, rw.
How is this possible? The country must adjust its import
spending and export sales such that the current account obtains
balance at a higher income level than illustrated in Figure 6.5. This
© 2004 Tony Cleaver
Like in Figure 6.2, the upper diagram in Figure 6.6 here shows
imports rising with income, exports exogenously given. If
imports were somehow decreased and exports increased by the
government then the two functions X1 and M1 would shift as
illustrated to give a new current account balance at income level
Ycb2.
On the lower diagram, the shift forward in the income level
where the current account balances from Ycb1 to Ycb2 means the
BoP line shifts similarly. Remember that the BoP line shows all
points where the current account and the capital account are
both balanced. The latter is only true where domestic rates of
interest equal rw, the former where national income equals Ycb2.
Line BoP2 now shows these properties. Both capital and current
accounts are thus balanced where Ycb2 equals Y*, which is
consistent with full employment.

can be done in one of two ways (see following sections): either by
direct controls or by devaluing the exchange rate. (Note, if Ycb
cannot be increased then the only other course of action is to reduce
or deflate equilibrium income Y* until it reaches Ycb — not a
pleasant option.)
Direct Controls
One way of reducing imports and increasing exports is for governments
to resort to controls on trade. By imposing TARIFFS or QUOTAS
on imports, and by giving tax concessions or direct payments to
encourage domestic industry to export, a country can improve its
balance of payments. Many different countries have used such policies
at various times in the past but, particularly in the case of a
large economy, they are not at all popular with trade partners.
Direct controls are contrary to the spirit of trade liberalisation and
are likely to provoke retaliation. What then occurs is that trade
barriers go up in one country after another and all suffer in the end
(Box 6.4).