LECTURE SEVEN: BALANCE OF PAYMENTS

Lecture Outline
7.1 Introduction
7.2 Objectives
7.3 Definition of Balance of payments
7.4 The current account & Goods Market Equilibrium
7.5 The balance of payments and capital flows
7.6 Policy Dilemma: Internal and External Balance
7.7 Summary
7.8 Exercise
7.9 Further readings

Introduction
Welcome to lecture seven. In the previous lecture we discussed the small open economy. In this
lecture we extend our discussion to include the balance of payments accounts and the interaction
the economy. We end the lecture by looking at the policy dilemma. Enjoy the lecture.
7.2 Objectives

At the end of this lecture you should be able to:

a) Define the balance of payment account
b) Describe current and capital account
c) Explain how the current account affects the goods market
d) Define Internal and External balance
e) Describe the policy dilemma

7.3 Definition of Balance of payments

This is the record of the transactions of the residents of country with the rest of the world. There
are two main accounts in the balance of payments; the current account and the capital account.

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7.3.1 The current account
The current account records trade in goods and services, as well as transfer payments. Services
include freight, royalty payments and interest payments among others. Transfer payments consist
of remittances, gift and grants. The trade balance simply records trade in goods. Adding trade in
services and net transfers to the trade balance, we arrive at the current account, balance.

The simple rule for balance of payments accounting is that any transaction that gives rise to
payment by a country’s residents is a deficit item in that country’s balance of payments. Thus, for
a country like Kenya, import of cars and gifts to foreigners are deficit item in its balance of
payments. Thus, for a country like Kenya, import of cars and gifts to foreigners are deficit items.
Examples of surplus items in Kenya would be sale for land to foreigners, pensions from abroad
received by Kenyan residents among others. The current account is in surplus if exports exceed
imports plus net transfers to foreigners, that is, if receipts from trade in goods and services and
transfers exceed payment on this account.

7.3.2 The capital account

The capital account records purchases and sales of assets such as stocks, bonds and land. The
Kenyan capital account is in surplus (also called net capital inflow) when our revenue from sale of
stocks, bonds, land, bank deposits, and other assets exceed our payments for our own purchases of
foreign assets.

The central point of international payment is very simple: individuals and firms have to pay for
what they buy abroad. If a person spends more than her income, her deficit needs to be financed
by selling assets or by borrowing. Similarly, if a country runs a deficit in its current account,
spending more abroad than it receives from sales to the rest of the world, the deficit needs to be
financed by selling assets or by borrowing abroad. This selling or borrowing implies that the
country is running a capital account surplus. Thus any current account deficit is of necessity
financed by an offsetting capital inflow.
It is often useful to split the capital account into two separate parts:
(i) The transactions of a country’s private sector
(ii) Official reserve transactions.

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A current account deficit can be financed by private residents selling of assets abroad or borrowing
abroad. Alternatively, or as well, a current account deficit can be financed by the government,
which runs down its reserves of foreign exchange, selling foreign currency in the foreign exchange
market. Conversely, when there is a surplus the private sector may use the foreign exchange
revenues to pay off debt or buy assets abroad; alternatively the central bank can buy the foreign
currency earned by the private sector and add it to its reserves.

Thus balance of payment surplus is an increase in official exchange reserves net private capital
inflow. The increase in official reserves is also called the overall balance of payments surplus.

How is the balance of payment account similar to our individual budgets?

7.4 The current account & Goods Market Equilibrium

In this section we fit foreign trade into the IS-LM framework. We assume that the price level is
given and that output demanded will be supplied. In an open economy part of domestic output is
sold to foreigners (exports) and part of spending by domestic residents purchases foreign goods
(imports). This gives the following IS curve

Y = C + I + G + NX as stated earlier

Net exports or the excess of exports over imports, depend on our income, which affects import
spending; on foreign income, Yf, which affects foreign demand for our exports; and on the real
exchange rate, R. A rise in R or a real depreciation improves our trade balance as demand shifts
from goods produced abroad to those produced at home. Thus:

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 NX = X(Yf, R) - M(Yd,R) = NX (Yf,Yd,R))

We can note the following:

• A rise in foreign income, other things being equal, improves the home country’s trade
balance and therefore raises aggregate demand.
• A real depreciation by the home country improves the trade balance and therefore
increases aggregate demand.
• A rise in home income raises import spending and hence worsens the trade balance,
decreases aggregate demand.

7.4.1 Goods Market Equilibrium

The open economy IS curve includes net exports as a component of aggregate demand. Therefore
the level of competitiveness, as measured by the real exchange rate R, affects the IS curve. A real
depreciation causes an increase in the demand for domestic goods, shifting the IS curve to the
right. Likewise, an increase in foreign income and with it, an increase in foreign spending on our
goods will increase net exports or demand for our goods. Thus we have:

Y = C + I + G + NX
IS curve Y = A (Yd,i) + N X (Yd, Yf, R)

The figure below shows the effects of an increase in foreign income. The higher foreign spending
on our goods raises demand and hence, at unchanged interest rates, requires an increase in output.
This causes the IS curve to shift to the right. Thus, the full effect of an increase in foreign demand
thus is an increase in interest rates and an increase in domestic output and employment.

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 The effects of an increase in foreign income

i2
LM

i1
i0
IS1

IS0

Y0 Y1 Y

Using the same figure, we can explain the effect of a real depreciation. A real depreciation (R
increases) raises net exports at each level of income and hence shifts the IS schedule up to the
right. A real depreciation therefore leads to a rise in our equilibrium income.

7.4.2 Repercussion effects

When we increase government spending, our income rises, part of the increase in income will be
spent on import, which means that income will rise abroad, too. The increase in foreign income
will then raise foreign demand for our goods, which in turn add to the domestic income expansion
brought about by higher government spending, and so on.

7.5 The balance of payments and capital flows

We now introduce the role of capital flows within a framework in which we assume the home
economy faces a given price of imports and a given export demand. In addition, we assume that

the world interest rate is given, if.

Next we look at the balance of payments surplus, BP, is equal to the trade surplus, NX, plus the
capital account surplus i.e

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 BP = NX (Yd, Yf, R) + CF (i- if)

This equation shows the trade balance as a function of domestic and foreign income and real
exchange rates, and it shows the capital account as depending on the interest differential. An
increase in income (Yd) worsens the trade balance and an increase in the interest rate (i) above the
world level pulls in capital from abroad and this improves the capital account. It follows that when
income increases, even the tiniest increase in interest rates is enough to maintain an overall balance
of payments equilibrium. The trade deficit would be financed by a capital flow.

7.6 Policy Dilemma: Internal and External Balance

The potential for capital flows to finance a current account deficit is extremely important.
Countries frequently face policy dilemmas, in which a policy designed to deal with one problem
worsen another problem. In particular, there is sometimes a conflict between goals of external and
internal balance. External balance exists when the balance of payments is close to balance. Internal
balance exists when output is at full employment level.

E2 E3

Surplus Surplus
Unemployment Over employment

BP = 0
E1 E2
Deficit Deficit
Unemployment Over employment

Y* Y

In the above figure BP = 0. That is Capital Account + current Account = 0. Our key assumption
of perfect capital mobility forces the BP=0 line to be horizontal. Thus it must be flat at the level
of world interest rate.

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Points above BP=0 schedule correspond to a surplus and points below to a deficit. We have also
drawn full employment output level, Y*. Point E is the only point at which both internal and
external balances are achieved. Point E1 for example corresponds to a case of deficit and un
employment.

We can talk about policy dilemmas in terms of points in the four quadrants of the above figure.
For instance, at point E1, there is a deficit in the balance of payments, as well as unemployment.
An expansionary monetary policy would deal with the unemployment problem but worsen the
balance of payments, thus apparently presenting a dilemma for policy makers. The presence of
interest-sensitive capital flows suggests the solution to the dilemma. If the country can find a way
of raising the interest rate, it would obtain finances for the trade deficit. That means that both
monetary and fiscal policies would have to be used to achieve external and internal balance
simultaneously.

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7.7 Summary
The following important points are worth noting.
1. The balance of payment accounts are a record of the international transactions of the
economy. The current account records trade in goods and services as well as transfers.
The capital account records purchases and sales of assets.
2. The overall balance of payments surplus is the sum of the current and capital account
surpluses. If the overall balance is in deficit, we have to make more payments to
foreigners than they make to us. The foreign currency for making these payments is
supplied by central bank.
3. The introduction of trade in goods means that some of the demand for our output comes
from abroad and that some spending by our residents is on foreign goods. The demand
for our goods depends on the real exchange rate as well as foreign on the level of income
at home and abroad.
4. The introduction of capital flows points to the effects of monetary and fiscal policy on
the balance of payments through the interest rate effects on capital flows. An increase
in the domestic interest rate relative to the world interest rate leads to a capital inflow
that can finance a current account deficit.
5. The potential for capital flows to finance a current account deficit is extremely
important. Countries frequently face policy dilemmas, in which a policy designed to
deal with one pattern worsen another problem. In particular, there is sometimes a
conflict between goals of external and internal balance. External balance exists when
the balance of payments is close to balance. Internal balance exists when the balance
exists when output is at full employment level

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7.8 Exercise
1. Define the balance of payment account.
2. State the difference between the Capital and current account.
3. When is a country in external balance? Internal balance? Should either or both of these
be policy goals?
4. Consider the trade balance effect of a domestic expansion with and without
repercussion effects. Is the trade deficit larger or smaller once repercussion effects are
taken into account?
5. Graphically discuss the effect of a depreciation of the exchange rate on the economy’s
short run equilibrium.

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7.9 Further Readings:
The following books are available for further readings. It would be important for you to read
some if not all so that you can broaden your understanding on the topic. Where later editions
exist, the information may not be found in the exact chapters.

Branson, Williams H, (1989), Macroeconomic theory and policy, 3rd Edition, Chapter 12
Dernburg, Thomas Fredrick,(1985), Macroeconomics: concepts, theories and policies, 7th
Edition, Mc Graw-Hill, Chapter 15 and 16.
Donbusch, Rudiger et al, (2001), Macroeconomics, 8th Edition, Tata Mc Graw-Hill, Chapter 12
Mankiw, N. Gregory, (1999), Macroeconomics, 4th Edition, Worth Publishers, Chapter 8

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