2.1.4 - Balance of payments

2.1.4 - Balance of payments

The balance of payments helps us track how an economy is connected to the rest of the world. It records money flowing in and out through trade, income, transfers and investment, so it gives a broader picture than exports alone. In Theme 2, the key part to understand is the current account, but it makes more sense once you first learn to follow the money.

Follow the Money

The simplest rule is to follow the money, not the product. If money enters the UK, that is recorded as a positive entry. If money leaves the UK, that is recorded as a negative entry.

Definition: Balance of payments

A record of all financial transactions between one country and the rest of the world over a period of time.

This is why imports are negative and exports are positive. A German car entering the UK is an import because money leaves the UK to pay for it. A US tourist paying for a hotel in Edinburgh is buying a UK service, so money enters the UK and it is recorded as an export of services.

The balance of payments has two broad parts at this level. The current account records trade, income, and transfers. The capital and financial account records other money flows linked to saving, investment, speculation, and official financing. In Theme 2, almost all of your attention should stay on the current account.

Inside the Current Account

The current account has four components, and exam questions often test whether you can distinguish between them clearly.

Definition: Current account

The part of the balance of payments that records trade in goods, trade in services, primary income, and secondary income.

Trade in goods covers physical products that cross borders, sometimes called visibles. This includes raw materials, components, and finished products such as oil, steel, cars, or clothing.

Trade in services covers intangibles, sometimes called invisibles. Examples include tourism, insurance, transport, banking, and professional services. If a Singaporean firm pays a London law firm for advice, the UK has exported a service because money comes into the UK.

Primary income is income earned from factors of production and ownership of assets. It includes wages, interest, profits, and dividends flowing between countries. For example, dividends received by a UK investor from shares in a US company count as a primary income inflow.

Secondary income covers current transfers where nothing current is received in return. Common examples are foreign aid payments, contributions to international organisations, and remittances sent to family members abroad.

Formula: Trade balances

Balance of trade in goods=visible exports−visible imports\text{Balance of trade in goods} = \text{visible exports} - \text{visible imports} Balance of trade in services=invisible exports−invisible imports\text{Balance of trade in services} = \text{invisible exports} - \text{invisible imports} Balance of trade=trade in goods+trade in services\text{Balance of trade} = \text{trade in goods} + \text{trade in services}

That combined figure is what people usually mean when they talk about the trade balance.

Common mistake

Do not treat the current account and the trade balance as the same thing. The trade balance covers only goods and services, while the current account also includes primary income and secondary income. A country can therefore have a trade deficit that is partly offset by income flows or transfers.

The UK is a useful application. It has run a deficit on trade in goods in every year since 1983 because it imports many manufactured products, but it has run a surplus on trade in services in every year since 1966, especially in areas such as finance, insurance, and higher education.

Reading the Balance

When all four components are added together, we get the current account balance.

Formula: Current account

Current account=trade in goods+trade in services+primary income+secondary income\text{Current account} = \text{trade in goods} + \text{trade in services} + \text{primary income} + \text{secondary income}

It can also be summarised as:

Current account=balance of trade+net income and current transfers\text{Current account} = \text{balance of trade} + \text{net income and current transfers}

If inflows on the current account are greater than outflows, there is a current account surplus. If outflows are greater than inflows, there is a current account deficit.

Definition: Current account deficit

When the value of outflows on the current account is greater than the value of inflows over a period of time.

Exam tip

Do not confuse a current account deficit with the overall balance of payments being "out of balance". The current account can be in deficit, but that deficit is financed through the capital and financial account, by borrowing, by selling assets, or by reserve changes, so the balance of payments as a whole still balances in accounting terms.

A current account deficit is not automatically a sign of failure. It can happen because domestic demand is strong, so households and firms buy more imports as incomes rise. But a large and persistent deficit can also suggest a competitiveness problem if domestic producers struggle to sell abroad.

Exam tip

How a current account deficit is financed matters as well as its size. A deficit funded by stable long-term investment is usually less risky than one relying heavily on short-term borrowing or volatile financial inflows that can reverse quickly if confidence falls.

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