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Balance of Payments Theory



According to the Balance of Payments theory, changes in a country’s national income affect the country’s current account. Consequently, the exchange rate is adjusting to a new level to achieve a new balance of payments equilibrium.


Before moving forward, let us define the balance of payments and the balance of trade.


What is the Balance of Payments?

The balance of payments is a general account that incorporates all the payments and receipts of the residents of a country in their transactions with residents of foreign countries. This account includes a great variety of transactions:

(i) Traded goods and services

(ii) Income from foreign investment

(iii) New investment

(iv) Foreign aid

(v) Capital flows between central banks and treasuries (cash or gold)

The annual payments and receipts of each country must be equal. Any inequality leads to a deficit or a surplus in the balance of payments.

■ Payments > Receipts = Deficit

■ Payments < Receipts = Surplus


The Current Account and the Capital Account

The balance of payments account contains two sub-accounts: the current and the capital accounts.

(i) The current account includes exports and imports of goods and services as well as unilateral transfers.

(ii) The capital account includes payments of debts and claims (no matter the period)


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What is the Balance of Trade?

The balance of trade is a smaller account that includes only the traded goods and services. The balance of trade is the difference between the value of the traded goods and services that are imported and exported by a country.

■ Imports > Exports = Trade Deficit

■ Imports < Exports = Trade Surplus

The balance of trade includes two categories of trade balances: (i) the balance of merchandise trade for tangible goods, and (ii) the balance of services


Calculating the Equilibrium

In theory, the national income minus the national expenditure of a country must be equal to the difference between savings and investment and the difference between imports and exports.

■ I − E = X – M = S − C


I = Income | E = Expenditure | X = Exports | M = Imports | S = Savings | C = Investment


The Relationship between the National Income, the Current Account, and the Exchange Rate

Assuming that the level of interest rate is stable, if the national income of a country is rising, the demand for foreign goods is rising too. That stronger demand leads to an increased amount of imports and a new equilibrium in the current account balance. In that case, the exchange rate of the country works as a transmission mechanism for restoring the balance of payments equilibrium. Practically, the exchange rate of that country will depreciate to make imports more expensive and thus restore the balance between exports and imports.

On the other hand, if the national income is falling, the imports will shrink and the exchange rate will appreciate restoring the equilibrium in the current account balance.


Adding the Effect of an Interest Rate Hike

If the national income of a country increases, the domestic central bank will be tempted to raise the level of interest rates. The higher the real interest rates the lower the demand for consumption and the lower the country's imports. Therefore, higher interest rates restore the balance of payments equilibrium.

On the other hand, if the national income is falling, the interest rates will fall too to stimulate domestic demand, and the equilibrium in the current account will be restored.


■ Summarizing the Transmission Mechanism:

(i) National Income Change > Change in Real Demand > Change in Current Account > Change in the Interest Rates to achieve equilibrium

(ii) National Income Reverses > Reverse in Current Account > Reverse in the level of Interest Rates > Balance of Payments new equilibrium



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