Balance of Payments & Exchange Rates

Balance of Payments & Exchange Rates

The balance of payments (BoP) records all international transactions. Exchange rates determine the price of one currency in terms of another. Together, they are central to understanding international macroeconomics.

The Balance of Payments

Structure

Account	Components
Current account	Trade in goods (visible balance), trade in services (invisible balance), primary income (investment income, wages), secondary income (transfers, aid, remittances)
Capital account	Capital transfers, non-produced/non-financial assets (patents) — small in practice
Financial account	Foreign direct investment (FDI), portfolio investment, reserve assets, other investment

The BoP must always balance: Current + Capital + Financial + Errors & Omissions = 0.

If the current account is in deficit, the financial account must be in surplus (capital inflows finance the deficit).

The UK Current Account

The UK has run a persistent current account deficit since the early 1980s:

• Goods deficit: UK imports more manufactured goods than it exports (deindustrialisation)
• Services surplus: UK has a strong services sector (financial services, insurance, consulting)
• Primary income: fluctuates with overseas investment returns
• The deficit has been ~3-5% of GDP in recent years

Causes of a Current Account Deficit

• Strong domestic demand: rising incomes suck in imports (high income elasticity of demand for imports)
• Uncompetitiveness: higher relative inflation, lower productivity, strong exchange rate
• Structural factors: comparative advantage shifted away from manufacturing
• Exchange rate: an overvalued currency makes exports expensive and imports cheap
• Low savings ratio: consumption exceeds income → spending on imports

Significance of a Current Account Deficit

Arguments it matters:

• Must be financed by capital inflows (foreign borrowing or selling assets) → increasing foreign liabilities
• If financed by short-term "hot money", reversal could cause a currency crisis (Asian crisis 1997)
• May indicate declining competitiveness and structural economic problems
• Persistent deficit may eventually lead to exchange rate depreciation

Arguments it does not matter:

• In a floating exchange rate system, the BoP self-corrects (deficit → depreciation → exports cheaper → deficit narrows)
• Capital inflows may reflect the UK being an attractive destination for investment (FDI, portfolio)
• The UK's deficit is largely financed by stable long-term investment, not volatile hot money
• The financial account surplus mirrors the current account deficit — it is an accounting identity

Exchange Rates

Exchange Rate Systems

Floating exchange rate: determined by market forces of supply and demand (UK, US, eurozone)

• Advantages: automatic adjustment to BoP imbalances, monetary policy independence, no need for reserves
• Disadvantages: volatility creates uncertainty for trade and investment, may overshoot equilibrium, speculative attacks

Fixed exchange rate: government/central bank pegs the rate to another currency or gold

• Advantages: stability reduces exchange rate risk, encourages trade and investment, imposes discipline on monetary policy
• Disadvantages: requires large foreign currency reserves, loss of monetary policy independence, may be set at the wrong level, vulnerable to speculative attacks (UK ERM crisis 1992)

Managed float: predominantly market-determined but with occasional central bank intervention (many countries in practice)

Determination of Floating Exchange Rates

The exchange rate is determined by supply and demand for a currency in the foreign exchange market.

Demand for sterling comes from:

• Foreign buyers of UK exports (need £ to pay)
• Foreign investors in UK assets (FDI, portfolio investment, bank deposits)
• Speculators expecting £ to appreciate

Supply of sterling comes from:

• UK buyers of imports (sell £ to buy foreign currency)
• UK investors abroad
• Speculators expecting £ to depreciate

Factors Affecting Exchange Rates

Factor	Effect on Exchange Rate
Interest rates	Higher UK rates → capital inflows → demand for £ rises → appreciation
Inflation	Higher UK inflation → exports less competitive → demand for £ falls → depreciation
Economic growth	Strong growth → attracts investment → appreciation (but also pulls in imports → could depreciate)
Current account	Persistent deficit → net outflow of £ → depreciation pressure
Speculation	Expectations of appreciation → self-fulfilling buying → appreciation
Political stability	Stability attracts investment → appreciation (Brexit uncertainty → sharp depreciation 2016)
QE/money supply	Expanding money supply → depreciation

Effects of Exchange Rate Changes

Depreciation (fall in the value of the currency):

Impact	Explanation
Exports become cheaper abroad	Improves price competitiveness → export volume rises
Imports become more expensive	Domestic consumers switch to home-produced goods → import volume falls
Current account improves	But depends on Marshall-Lerner condition and J-curve
Cost-push inflation	Higher import prices raise production costs and consumer prices
AD increases	Net exports improve → AD shifts right → growth and employment

Appreciation (rise in the value of the currency):

• Opposite effects: exports dearer, imports cheaper, current account may worsen, lower inflation, AD falls

The Marshall-Lerner Condition

A depreciation will improve the current account only if the sum of PED for exports + PED for imports > 1.

• If demand is elastic (combined PED > 1): volume effects outweigh price effects → deficit narrows
• If demand is inelastic (combined PED < 1): higher import prices worsen the deficit initially

The J-Curve Effect

In the short run, a depreciation may initially worsen the current account:

• Contracts are pre-agreed in foreign currency
• Import volumes do not adjust quickly (inelastic in short run)
• Higher import prices increase the import bill

Over time, volumes adjust (consumers and firms respond to new prices) → current account improves → the path traces a "J" shape.

Policies to Correct a Current Account Deficit

Policy	Mechanism	Evaluation
Depreciation	Makes exports cheaper, imports dearer	Depends on Marshall-Lerner; may cause inflation; if floating, market-determined
Deflation (demand reduction)	Lower AD → lower incomes → fewer imports	Works but at cost of growth and employment; politically difficult
Supply-side policies	Improve productivity and competitiveness	Long-term solution but slow; no guarantee of export improvement
Protectionism (tariffs, quotas)	Directly reduce imports	Retaliation risk; WTO rules; reduces consumer choice; protects inefficient firms

Exam Technique

• Always link the current account to the financial account — one mirrors the other
• Draw exchange rate diagrams (price of £ on Y-axis, quantity of £ on X-axis)
• Use the J-curve to explain why depreciation may not immediately improve the BoP
• Apply Marshall-Lerner when evaluating whether depreciation will work
• Discuss whether a current account deficit is a problem or a sign of strength (attracting investment)
• Reference UK examples: Brexit depreciation (2016), ERM crisis (1992), persistent services surplus