changes in the balance of payments

Money and Banking – Changes in the Balance of Payments (BoP)

1. The Balance of Payments – What it Records

The Balance of Payments (BoP) is a statistical statement that records all economic transactions between residents of a country and the rest of the world over a given period (usually a year). It is divided into three main accounts:

• Current Account (CA)
• Capital Account (KA)
• Financial Account (FA)

In identity form (including the statistical “net errors and omissions”):

$$\text{BoP}= \text{CA}+ \text{KA}+ \text{FA}+ \text{(Net Errors \& Omissions)} = 0$$

A surplus in one account must be offset by a deficit in another (or by a statistical discrepancy).

2. Exchange‑Rate Concepts (Syllabus 11.2)

• Nominal exchange rate (e): price of one unit of foreign currency in domestic currency (e.g. £1 = $1.30). Usually quoted as domestic per foreign.
• Real exchange rate (RER): adjusts the nominal rate for price‑level differences. $$\text{RER}= e\;\frac{P^{*}}{P}$$ where \(P^{*}\) = foreign price level, \(P\) = domestic price level.
• Trade‑weighted (effective) exchange rate: a weighted average of bilateral nominal rates; weights reflect the proportion of trade each partner conducts with the home country.

3. Exchange‑Rate Regimes and Official Adjustments (Syllabus 11.2)

• Fixed (or pegged) system: the central bank commits to buying/selling foreign currency at a predetermined rate. Reserves are used to defend the peg.
• Managed (or “dirty”) float: the rate is market‑determined but the central bank intervenes occasionally to smooth excessive volatility.
• Floating system: the rate is set entirely by market forces.
• Revaluation (fixed system): an official upward adjustment of the peg – the domestic currency becomes stronger.
• Devaluation (fixed system): an official downward adjustment of the peg – the domestic currency becomes weaker.

4. How Exchange Rates Are Determined

Cambridge expects two short‑run approaches:

1. Interest‑Rate Parity (IRP) – asset‑market approach
   • Uncovered IRP: \(e_{t+1}=e_t\left(1+\frac{i-i^{*}}{1+i^{*}}\right)\) where \(i\) and \(i^{*}\) are domestic and foreign interest rates.
   • Covered IRP: forward rate \(F\) satisfies \(F=e\frac{1+i}{1+i^{*}}\).
2. Monetary‑approach (or “price‑adjustment”) model
   • In a flexible‑rate system, the exchange rate adjusts to equilibrate the supply of domestic money with the demand for foreign currency.
   • Higher domestic money supply → depreciation; higher foreign money supply → appreciation.

5. Current‑Account Components (Syllabus 6.3)

Component	What it Measures	Typical Example
Trade in goods	Exports – imports of physical products	Cars, machinery, food
Trade in services	Exports – imports of intangible services	Tourism, shipping, financial services
Primary income	Compensation of employees + investment income (interest, dividends, rents)	UK resident receives interest on a US bond
Secondary income	Current‑account transfers – gifts, remittances, official development assistance (ODA)	Remittance from a migrant worker

6. Capital‑Account Components (Syllabus 6.3)

• Capital transfers – e.g. debt forgiveness, migrants’ transfer of assets.
• Acquisition/disposal of non‑produced, non‑financial assets – e.g. purchase/sale of patents, copyrights, natural resource rights.

Although the capital account is usually small, it is recorded separately from the financial account.

7. Financial‑Account Components (Syllabus 6.3)

Component	Typical Flows
Direct investment (FDI)	Purchase of a controlling stake in a foreign firm; establishment of a subsidiary.
Portfolio investment	Purchase of stocks, bonds, or other securities that do not confer control.
Other investment	Bank loans, deposits, trade credits, and changes in official reserve assets.

8. Effects of Exchange‑Rate Changes on the BoP (Syllabus 11.2)

• Marshall‑Lerner condition: a depreciation improves the trade balance if the sum of the export‑price elasticity (\(\varepsilon_X\)) and import‑price elasticity (\(\varepsilon_M\)) exceeds one. $$\varepsilon_X+\varepsilon_M>1$$
• J‑curve effect: after an abrupt depreciation, the trade balance may initially worsen because import contracts are sticky and quantities adjust slowly. In the medium term the balance improves as volumes respond.
• Overshooting (Dornbusch model): a monetary‑policy‑induced change in the interest rate can cause the exchange rate to move beyond its long‑run equilibrium before settling, amplifying short‑run BoP effects.

9. Development Indicators & Their Relevance to the BoP (Syllabus 11.3)

Indicator	What it Measures	Link to BoP
GDP (nominal)	Total market value of final goods & services produced domestically.	Size of the economy → potential export earnings and import demand.
GNI	GDP + net primary income from abroad.	Appears directly in the current account (primary income).
PPP‑adjusted GDP	GDP expressed in a common price base.	Helps compare real export competitiveness across countries.
HDI	Composite of life expectancy, education and GNI per capita.	Higher HDI → higher consumption of imported consumer goods.
MEW (Mean Equivalent Adult Consumption)	Standardised measure of household consumption.	Useful for estimating the marginal propensity to import (MPI).
MPI (Marginal Propensity to Import)	Change in imports per unit change in national income.	Key parameter in quantitative BoP‑impact calculations.

10. Demography, Income Distribution & Economic Structure (Syllabus 11.4)

• Population growth & age structure affect labour supply, savings rates and thus the current‑account balance.
• Income distribution: a more unequal distribution often raises demand for imported luxury goods, widening the trade deficit.
• Economic structure:
  • Primary‑commodity exporters are vulnerable to terms‑of‑trade shocks.
  • Service‑oriented economies may earn large service‑balance surpluses (e.g., tourism, finance).

11. International Aid, Multinationals, External Debt & Globalisation (Syllabus 11.5)

• Official Development Assistance (ODA) and other transfers are recorded in the current account as secondary income.
• Multinational Companies (MNCs) generate foreign‑direct investment – a major component of the financial account.
• External debt (government, corporate, private) appears under “other investment” in the financial account; debt‑service payments are part of primary income.
• Globalisation accelerates the speed and volume of cross‑border flows, making BoP positions more volatile and increasing the importance of exchange‑rate management.

12. How Money and Banking Influence the BoP

1. Monetary‑policy change (e.g., a shift in the policy rate).
2. Market‑interest‑rate response – short‑term rates move with the policy rate.
3. Capital‑flow reaction – higher rates attract foreign portfolio and FDI inflows; lower rates encourage outflows.
4. Exchange‑rate movement – capital inflows tend to appreciate the domestic currency; outflows cause depreciation. Expectations can generate overshooting.
5. Price‑effect on trade – appreciation makes exports relatively more expensive and imports cheaper; depreciation does the opposite.
6. Trade‑balance adjustment – J‑curve dynamics may cause a short‑run deterioration after depreciation; medium‑run improvement follows if the Marshall‑Lerner condition holds.
7. Overall BoP outcome – the net effect on the current and financial accounts determines whether the BoP moves toward surplus or deficit.

13. Quantitative Illustration of the Monetary‑Policy → BoP Transmission

Assume:

• Reserve‑requirement ratio \(r\) (so money multiplier \(m=\frac{1}{r}\)).
• Change in central‑bank reserves \(\Delta R\).
• Marginal propensity to import \(k\) (same as MPI).

Step‑by‑step impact:

$$\Delta M = m\,\Delta R = \frac{1}{r}\,\Delta R$$ $$\Delta \text{Imports} = k\,\Delta M$$

Numerical example:

• Reserve ratio \(r = 0.10\) → \(m = 10\).
• Central bank purchases foreign reserves worth \$5 bn (\(\Delta R = +5\) bn).
• Resulting money‑supply increase \(\Delta M = 10 \times 5 = \$50\) bn.
• Assume \(k = 0.25\) (25 % of any increase in income is spent on imports).
• Import increase \(\Delta IM = 0.25 \times 50 = \$12.5\) bn.
• All else equal, the current‑account deficit widens by \$12.5 bn.

14. Policy Responses to BoP Imbalances

• Exchange‑rate adjustment – devaluation (fixed) or market‑driven depreciation (flexible) to restore export competitiveness.
• Monetary tightening – raise policy rates to attract capital inflows and curb import demand.
• Fiscal restraint – reduce government consumption that fuels imports.
• Capital controls – limit volatile short‑term flows (e.g., taxes on short‑term portfolio inflows).
• Structural reforms – diversify the export base, improve productivity, develop high‑value services.

15. Summary

Changes in the money supply and banking activity affect the Balance of Payments through three inter‑linked channels:

1. Domestic demand for imports – a larger money supply raises income, which, via the marginal propensity to import, widens the current‑account deficit.
2. Interest‑rate differentials and capital flows – higher domestic rates attract foreign capital, creating a financial‑account surplus (or, conversely, outflows generate a deficit).
3. Exchange‑rate movements – capital flows and expectations move the exchange rate; the resulting price effect on exports and imports generates the short‑run J‑curve and, if the Marshall‑Lerner condition holds, a medium‑run improvement.

Understanding these mechanisms, together with the broader context of exchange‑rate regimes, development indicators, demographic structure, and global capital flows, equips policymakers to maintain external stability while pursuing domestic macro‑economic objectives.