The macroeconomic aims of government: balance of payments stability

Published by Patrick Mutisya · 14 days ago

IGCSE Economics – Government Macro‑economic Intervention: Balance of Payments Stability

Government Macro‑economic Intervention

Objective: Balance of Payments (BoP) Stability

The balance of payments records all economic transactions between residents of a country and the rest of the world over a period of time. A stable BoP is a key macro‑economic aim because large deficits or surpluses can lead to exchange‑rate volatility, loss of foreign reserves, and pressure on domestic employment and inflation.

1. Components of the Balance of Payments

The BoP is divided into three main accounts:

  • Current Account – trade in goods and services, net income, and net transfers.

  • Capital Account – transfers of non‑produced, non‑financial assets.

  • Financial Account – direct investment, portfolio investment, other investment, and changes in reserves.

For the current account we can write:

\$\text{Current Account} = (X - M) + \text{Net Income} + \text{Net Transfers}\$

where \$X\$ = exports, \$M\$ = imports.

2. Why Governments Seek BoP Stability

  • Prevents excessive depreciation or appreciation of the domestic currency.

  • Maintains confidence of foreign investors and trading partners.

  • Protects domestic employment in export‑oriented sectors.

  • Reduces the need for emergency borrowing or depletion of foreign reserves.

3. Policy Instruments Used to Achieve BoP Stability

Policy ToolTargeted BoP ComponentTypical Effect on BoPPotential Side‑effects
Exchange‑rate Intervention (buying/selling foreign reserves)Overall BoP (through reserve changes)Depreciates currency if reserves are sold; appreciates if reserves are bought.May deplete reserves; can trigger inflation if currency depreciates.
Tariffs and Import QuotasCurrent Account – Trade BalanceReduce imports → improve trade balance.Higher consumer prices; possible retaliation from trading partners.
Export SubsidiesCurrent Account – Trade BalanceBoost export volumes → improve trade balance.Fiscal cost; may breach WTO rules.
Capital Controls (taxes, limits on foreign investment)Financial AccountRestrict capital outflows → reduce deficit in financial account.Can deter foreign direct investment; may create black markets.
Monetary Policy (interest‑rate changes)Financial Account & Current AccountHigher rates attract foreign capital → improve financial account; may appreciate currency, reducing exports.Higher rates can slow domestic growth and increase unemployment.
Fiscal Policy (government spending & taxation)Current Account (via domestic demand)Reduced spending lowers import demand → improves trade balance.Can increase unemployment if cuts are too deep.

4. Exchange‑Rate Regimes and BoP Stability

Different exchange‑rate arrangements give governments varying degrees of control over the BoP:

  1. Fixed (or pegged) exchange rate – government commits to maintaining a set rate, using reserves to intervene. Provides high BoP stability but requires large reserve holdings.

  2. Managed float (dirty float) – central bank occasionally intervenes to smooth excessive movements. Balances stability with flexibility.

  3. Floating exchange rate – market determines the rate. BoP adjustments occur automatically through currency movements, but can be volatile.

Suggested diagram: “Managed Float – Central Bank Intervention” showing the exchange‑rate line, market equilibrium, and zones where the bank buys/sells reserves.

5. Evaluating the Effectiveness of BoP Policies

  • Short‑run vs long‑run impact – Some measures (e.g., tariffs) may improve the trade balance quickly but can harm growth over time.

  • Policy mix – Combining exchange‑rate policy with fiscal and monetary measures often yields more sustainable stability.

  • External constraints – WTO rules, IMF conditions, and global capital mobility limit the range of feasible actions.

6. Summary Checklist for Exams

  • Define the balance of payments and its three main accounts.

  • Explain why a stable BoP is a macro‑economic aim.

  • Identify at least three government policy tools used to improve BoP stability and state their likely effect.

  • Compare the advantages and disadvantages of fixed, managed, and floating exchange‑rate regimes in relation to BoP stability.

  • Discuss the possible trade‑offs (e.g., inflation, unemployment, foreign‑investment attraction) when using these policies.