The balance of payments is a record of receipts and payments arising from all economic transactions between a country and the rest of the world over a period of time (usually a year). The BOP comprises of 2 main accounts, the Current Account and the Capital and Financial Account. The Current Account records the country’s trade in goods and services with the rest of the world, as well as income flows and transfers of money and assets across borders. The Current Account includes the (i) Goods balance, (ii) Services balance, (iii) Income balance and the (iv) Net current transfers.
| Explain how an appreciation in the domestic currency can cause a Current Account deficit.
An appreciation of the exchange rate will lead to an increase in the external value of the domestic currency with respect to foreign currencies. The appreciation will lead to an increase in the price of exports in terms of foreign currency in the foreign markets. This will lead to a decrease in the quantity demanded for exports. The extent by which Qdx falls by depends on the price elasticity of demand for exports. At the same time, an appreciation will lead to a decrease in the price of imports in terms of domestic currency. This will lead to an increase in the quantity demanded for imports. The extent by which Qdm increases by depends on the price elasticity of demand for imports. On the overall, if the Marshall-Lerner condition holds i.e the absolute sum of price elasticities of demand for Exports and Imports is more than 1 (|PEDx + PEDm| > 1), an appreciation will lead to a fall in the value of net exports (X-M), thus worsening the BOT and this may eventually lead to a BOP deficit. |
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Explain how higher Economic Growth relative to other countries can lead to Current Account deficit. A relatively higher economic growth rate in a country, like Singapore, relative to other countries can lead to a Current Account deficit. A relatively higher economic growth rate means that the level of real GDP is rising faster than that of other countries. The increase in real national income leads to a rise in the purchasing power of households, leading to an increase in demand for goods and services in general, which includes imports. The increase in demand for imports will lead to an increase in the total import expenditure. Assuming that the total revenue from exports remains unchanged, there will be a fall in the net export revenue, hence the current account and BOT will worsen and may eventually lead to a current account deficit. The extent of this depends on the marginal propensity to import (MPM). If MPM is high, rise in income will lead to significant rise in imports, hence worsening the current account to a large extent. On the other hand, if MPM is low, an increase in income may not increase import expenditure substantially, and will thus have little effect on the Current Account. For example, Singapore has a high dependence on imports, which take up about 150% of GDP. A large proportion of consumption goods, including necessities, in Singapore are imported. In addition, many raw materials and intermediate goods used in production are also imported. This means that the marginal propensity to import is fairly high. Hence a rise in income relative to other countries would lead to a large increase in imports, resulting in a possible current account deficit. |
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Explain how higher domestic inflation relative to other countries can cause a Current Account deficit. When the domestic inflation rate is relatively higher than that of trading partners, exports of that country will become more expensive in the foreign market (i.e less price competitive). Assuming the price demand elasticity of exports is more than 1 (|PEDx| > 1), given the wide availability of substitutes in the global market, the increase in the price of exports will lead to a more than proportionate fall in the quantity demanded for exports. Overall export revenue falls. |
| At the same time, imports will become more price competitive when compared to the domestically produced substitutes in the domestic market. As consumers are inclined to switch to buying the relatively cheaper imports, demand for imports will increase, hence total expenditure on imports will increase.
The net exports revenue (X-M) will hence fall, worsening the current account and the Balance of Payment of the country. This eventually leads to a BOP deficit on the current account. |
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Explain how changes in immigration policies and corporate tax rates on foreign firms can lead to Current Account deficit. Current account deficit can occur when the government relaxes its immigration policies and allows the entry of a larger number of foreign workers into its country. These foreign workers will remit part of their wages back to their home countries. Thus, when there is a rise in the number of foreign workers, there will be an increase in the amount of remittances flowing out of the country. Likewise, when the government reduces the corporate tax rates imposed on foreign firms, it will attract more foreign investors to set up production plants and subsidiaries in this country. These firms will send part of their profits back to their home countries. Thus, when there is an increase in the number of foreign firms, there will be an increase in the amount of profits flowing out of the country. This will worsen the current account and eventually leading to a current account deficit.
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| In conclusion, there are several factors that can lead to a deficit on the current account. This includes the inflation rate of the domestic country relative to that of its trading partners. Relative economic growth is another important factor to consider. |
