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Study Notes

2.1.4 Balance of Payments (Edexcel)


Last updated 19 Sept 2023

This Edexcel study note covers the Balance of Payments

a) Components of the Balance of Payments:

The balance of payments (BoP) is a record of all economic transactions between a country and the rest of the world. It is divided into two main components: the current account and the capital and financial account.

Current Account:

  1. Balance of Trade in Goods: It measures the difference between the value of a country's exports and imports of tangible goods (e.g., machinery, cars, and clothing). A trade surplus occurs when exports exceed imports, and a trade deficit occurs when imports exceed exports. Example: China consistently runs a trade surplus due to its strong manufacturing sector, exporting products worldwide.
  2. Balance of Trade in Services: It accounts for the value of services traded internationally, such as tourism, financial services, and consulting. A surplus occurs when a country exports more services than it imports. Example: The United States often has a surplus in services trade due to its leadership in technology and financial services.
  3. Income Balance: This includes earnings from abroad (e.g., dividends, interest, and wages) and payments made to foreign investors. A surplus indicates that a country earns more from its foreign investments than it pays to foreign investors.
  4. Current Transfers: This category includes foreign aid, remittances sent by migrant workers, and other unilateral transfers. It can be positive (inflows) or negative (outflows).

b) Current Account Deficits and Surpluses:

  • A Current Account Deficit occurs when a country's imports of goods, services, income, and transfers exceed its exports in those categories. It implies that the country is spending more than it is earning from the rest of the world.

Example: The United States has often had a current account deficit, as it imports more goods and services than it exports.

  • A Current Account Surplus occurs when a country's exports of goods, services, income, and transfers exceed its imports. It implies that the country is earning more than it is spending internationally.

Example: Germany has frequently had a current account surplus due to its strong export-oriented economy.

c) Relationship between Current Account Imbalances and Other Macroeconomic Objectives:

  • Impact on Exchange Rates: A persistent current account deficit may lead to a depreciation of the country's currency, making exports more competitive and imports more expensive. This can help correct the deficit.
  • Impact on Economic Growth: A surplus can lead to higher savings and investment, potentially boosting economic growth. However, a persistent deficit may lead to unsustainable borrowing.
  • Impact on Employment: A trade surplus may support job creation in export-oriented industries, while a deficit can lead to job losses in import-competing sectors.
  • Impact on Inflation: A depreciating currency (due to a deficit) can lead to imported inflation, affecting the domestic price level.

d) Interconnectedness of Economies through International Trade:

  • International trade fosters economic interdependence among countries. One country's economic policies and developments can have ripple effects globally.

Example: The 2008 financial crisis in the United States had global repercussions, as it led to reduced demand for imports from other countries, affecting their economic growth.

  • Supply chain integration: Many products involve components from multiple countries. Disruptions in one country can disrupt global supply chains.

Example: The COVID-19 pandemic disrupted supply chains worldwide, affecting industries from electronics to pharmaceuticals.

  • Benefits of trade: International trade allows countries to specialize in producing what they are most efficient at, leading to efficiency gains and a higher standard of living.

Example: Switzerland specializes in the production of high-quality watches, benefiting from a strong reputation in the global market.

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