CHAPTER 48: POLICIES TO CORRECT DISEQUILIB RIUM IN THE B ALANCE OF PAY MENTS:
48.1: The com ponents of the balance of paym ents
- Current account:
+ Trade in goods (electronics, mobiles, textiles).
+ Trade in services (tourism, education, banking).
+ Primary income (earnings on investments, wages, and dividends).
+ Secondary income: Transfers like foreign aid, donations, remittances - does not involve
transactions of goods/services.
- Financial account:
+ FDI: Long-term investment in foreign businesses, such as a company building a factory abroad.
+ Portfolio investment: Shorter-term movements of financial investment including bank deposits,
bank loans and inter- government loans that move between countries.
+ Reserve assets: Changes in foreign currency, gold, and special drawing rights (SDRs) held by the
central bank.
+ Deficit: A financial account deficit occurs when more capital leaves the country than enters it (hot
money outflow).
- Causes:
+ Higher interest rate abroad: Investors move funds to countries offering better
returns.
+ Lack of confidence: Economic/political instability.
+ Expectations: If investors expect the domestic currency to depreciate, they move
funds abroad.
+ Hot money outflow: Speculative capital quickly leaves in search of higher returns.
- Effects:
+ Exchange rate depreciation.
+ Capital flight → reduces:
- Domestic investment.
- Tax revenue.
- Employment.
- Economic growth.
+ Not always bad:
- If deficit results from firms investing abroad → future profits, interest,
dividends return.
- Short-term hot money outflow → less serious.
- Long-term structural lack of confidence → serious.
+ Depends on:
- Size.
- Duration.
- Economic conditions.
+ Surplus: A financial account surplus occurs when more capital enters the country than leaves it → net
capital inflow.
- Causes:
+ Strong economic prospects.
+ High domestic interest rate.
+ Stable currency.
- Effects:
+ Finances CA deficit.
+ Increases investment → more capital available for infrastructure/business expansion.
, + Employment and growth.
+ Future outflows: Foreign investors will repatriate profits/dividends.
+ Currency appreciation.
- Capital account:
+ Capital transfers: Debt forgiveness, investment grants, or migrants' transfers (moving personal
assets)
+ Non-produced, non-financial assets: Sales or purchases of intangible assets like patents, copyrights,
trademarks, or land rights.
- Net errors and omissions:
+ Current account + financial account + capital account + net error = 0.
+ Why do they occur: Time lags, under-reporting, recording errors,...
+ Positive NEO: Suggests unrecorded inflows are larger than unrecorded outflows.
+ Negative NEO: Suggests unrecorded outflows are larger than inflows.
48.2: Eff ect of fi scal, m onetar y, su pply-side, pr otectionist and exchange r ate policies on the balance
of paym ents.
- Fiscal:
+ Contractionary:
- Benefits:
+ Reduces aggregate demand → lowers imports.
+ Helps reduce the current account deficit.
+ May reduce inflation → improves export competitiveness.
+ Useful if the deficit is caused by excessive domestic demand.
- Limitations:
+ Slows economic growth.
+ Increases unemployment.
+ Ineffective if the deficit is structural (e.g., lack of competitiveness).
+ Time lag before impact is felt.
+ Expansionary
- Benefits:
+ If targeted at infrastructure/education → improves productivity.
+ May strengthen long-run export competitiveness.
+ Can stimulate domestic industries to substitute imports.
- Limitations:
+ Increases aggregate demand → increases imports.
+ Likely worsens current account deficit in short run.
+ May cause inflation → reduces export competitiveness.
+ Increases government debt.
- Monetary:
+ Contractionary:
- Benefits:
+ Reduces spending and imports.
+ Attracts capital inflows → improves financial account.
+ May appreciate currency → reduces imported inflation.
- Limitations:
+ Currency appreciation may reduce export competitiveness.
+ Higher borrowing costs reduce investment and growth.
+ May cause recession.
+ Effectiveness depends on interest rate sensitivity of capital flows.
+ Expansionary:
, - Benefits:
+ Depreciation may improve export competitiveness.
+ Stimulates domestic production.
+ Can improve the current account if exports rise significantly.
- Limitations:
+ Encourages imports via higher income.
+ Capital outflow may worsen financial accounts.
+ Risk of inflation.
+ May cause instability if investors lose confidence.
- Supply-side:
+ Benefits:
- Improves productivity and efficiency.
- Enhances export competitiveness.
- Reduces structural current account deficits.
- Sustainable long-term solution.
- Does not reduce growth like contractionary policies.
+ Limitations:
- Expensive to implement.
- Long time lag before results.
- No guarantee of success.
- Depends on global demand conditions.
- Protectionist:
+ Benefits:
- Directly reduces imports.
- Immediate improvement in current account.
- Protects infant or strategic industries.
- May reduce unemployment in protected sectors.
+ Limitations:
- Retaliation from trading partners.
- Higher domestic prices → inflation.
- Reduced competition → inefficiency.
- Violates free trade agreements (e.g., WTO rules).
- Temporary solution; does not improve competitiveness.
- Exchange rate policies:
+ Appreciation:
- Benefits:
+ Reduces imported inflation.
+ Cheaper imports reduce production costs.
+ May improve living standards.
- Limitations:
+ Exports become less competitive.
+ Worsens current account.
+ May increase unemployment in export industries.
+ Depreciation:
- Benefits:
+ Exports become cheaper.
+ Imports become more expensive.
+ Can significantly improve current account (if Marshall-Lerner condition holds).
+ Encourages domestic production.
48.1: The com ponents of the balance of paym ents
- Current account:
+ Trade in goods (electronics, mobiles, textiles).
+ Trade in services (tourism, education, banking).
+ Primary income (earnings on investments, wages, and dividends).
+ Secondary income: Transfers like foreign aid, donations, remittances - does not involve
transactions of goods/services.
- Financial account:
+ FDI: Long-term investment in foreign businesses, such as a company building a factory abroad.
+ Portfolio investment: Shorter-term movements of financial investment including bank deposits,
bank loans and inter- government loans that move between countries.
+ Reserve assets: Changes in foreign currency, gold, and special drawing rights (SDRs) held by the
central bank.
+ Deficit: A financial account deficit occurs when more capital leaves the country than enters it (hot
money outflow).
- Causes:
+ Higher interest rate abroad: Investors move funds to countries offering better
returns.
+ Lack of confidence: Economic/political instability.
+ Expectations: If investors expect the domestic currency to depreciate, they move
funds abroad.
+ Hot money outflow: Speculative capital quickly leaves in search of higher returns.
- Effects:
+ Exchange rate depreciation.
+ Capital flight → reduces:
- Domestic investment.
- Tax revenue.
- Employment.
- Economic growth.
+ Not always bad:
- If deficit results from firms investing abroad → future profits, interest,
dividends return.
- Short-term hot money outflow → less serious.
- Long-term structural lack of confidence → serious.
+ Depends on:
- Size.
- Duration.
- Economic conditions.
+ Surplus: A financial account surplus occurs when more capital enters the country than leaves it → net
capital inflow.
- Causes:
+ Strong economic prospects.
+ High domestic interest rate.
+ Stable currency.
- Effects:
+ Finances CA deficit.
+ Increases investment → more capital available for infrastructure/business expansion.
, + Employment and growth.
+ Future outflows: Foreign investors will repatriate profits/dividends.
+ Currency appreciation.
- Capital account:
+ Capital transfers: Debt forgiveness, investment grants, or migrants' transfers (moving personal
assets)
+ Non-produced, non-financial assets: Sales or purchases of intangible assets like patents, copyrights,
trademarks, or land rights.
- Net errors and omissions:
+ Current account + financial account + capital account + net error = 0.
+ Why do they occur: Time lags, under-reporting, recording errors,...
+ Positive NEO: Suggests unrecorded inflows are larger than unrecorded outflows.
+ Negative NEO: Suggests unrecorded outflows are larger than inflows.
48.2: Eff ect of fi scal, m onetar y, su pply-side, pr otectionist and exchange r ate policies on the balance
of paym ents.
- Fiscal:
+ Contractionary:
- Benefits:
+ Reduces aggregate demand → lowers imports.
+ Helps reduce the current account deficit.
+ May reduce inflation → improves export competitiveness.
+ Useful if the deficit is caused by excessive domestic demand.
- Limitations:
+ Slows economic growth.
+ Increases unemployment.
+ Ineffective if the deficit is structural (e.g., lack of competitiveness).
+ Time lag before impact is felt.
+ Expansionary
- Benefits:
+ If targeted at infrastructure/education → improves productivity.
+ May strengthen long-run export competitiveness.
+ Can stimulate domestic industries to substitute imports.
- Limitations:
+ Increases aggregate demand → increases imports.
+ Likely worsens current account deficit in short run.
+ May cause inflation → reduces export competitiveness.
+ Increases government debt.
- Monetary:
+ Contractionary:
- Benefits:
+ Reduces spending and imports.
+ Attracts capital inflows → improves financial account.
+ May appreciate currency → reduces imported inflation.
- Limitations:
+ Currency appreciation may reduce export competitiveness.
+ Higher borrowing costs reduce investment and growth.
+ May cause recession.
+ Effectiveness depends on interest rate sensitivity of capital flows.
+ Expansionary:
, - Benefits:
+ Depreciation may improve export competitiveness.
+ Stimulates domestic production.
+ Can improve the current account if exports rise significantly.
- Limitations:
+ Encourages imports via higher income.
+ Capital outflow may worsen financial accounts.
+ Risk of inflation.
+ May cause instability if investors lose confidence.
- Supply-side:
+ Benefits:
- Improves productivity and efficiency.
- Enhances export competitiveness.
- Reduces structural current account deficits.
- Sustainable long-term solution.
- Does not reduce growth like contractionary policies.
+ Limitations:
- Expensive to implement.
- Long time lag before results.
- No guarantee of success.
- Depends on global demand conditions.
- Protectionist:
+ Benefits:
- Directly reduces imports.
- Immediate improvement in current account.
- Protects infant or strategic industries.
- May reduce unemployment in protected sectors.
+ Limitations:
- Retaliation from trading partners.
- Higher domestic prices → inflation.
- Reduced competition → inefficiency.
- Violates free trade agreements (e.g., WTO rules).
- Temporary solution; does not improve competitiveness.
- Exchange rate policies:
+ Appreciation:
- Benefits:
+ Reduces imported inflation.
+ Cheaper imports reduce production costs.
+ May improve living standards.
- Limitations:
+ Exports become less competitive.
+ Worsens current account.
+ May increase unemployment in export industries.
+ Depreciation:
- Benefits:
+ Exports become cheaper.
+ Imports become more expensive.
+ Can significantly improve current account (if Marshall-Lerner condition holds).
+ Encourages domestic production.
