The implications of the Balance of Payment and Net Foreign Wealth
The Balance of Payment (BOP) is a statement that clearly explains and shows all transactions that have taken place in the economy between one country and the rest of the world over a defined period. It includes two accounts that show different effects of the transactions on the economy. The two accounts of the Balance of Payment are the current account and the capital account. The transactions taking place in the economy involve imports and exports as a result of international trade. An economy’s Balance of Payment is an important feature of its international accounts.
The current account of the Balance of Payment is prepared using transactions involving goods, services, current transfers, and investment income. Similarly, the capital account of the Balance of Payment shows the transactions involving the central bank reserve and the financial instruments in the capital market. The main difference between the two accounts is the fact that calculations in the national output in terms of production are only recorded in the current account. The sum of all transactions in the economy should always equal to zero as every debit transaction in the current account is recorded as a credit in the capital account. Similarly, a credit transaction in the current account is usually recorded as a debit in the capital account.
All export transaction is recorded in the current account of the Balance of Payment and when payment of these transactions take place, the transaction is recorded in the capital account. A Balance of Payment deficit occurs when the economy cannot make payments for imports using capital export. The economy at a Balance of Payment deficit will be required to pay for the imports using the central bank reserve to correct the economic imbalance. In reality, the economy is always at an imbalance due to the difficulty of recording every transaction taking place in the economy.
The Balance of Payment is crucial in the formulation of international macroeconomic policies that are used to correct economic problems and imbalances. Deficits and surpluses in the Balance of Payment create an economic imbalance and have varying effects on the country’s economy. A balance of Payment deficit will occur to an economy that imports more than it exports to other countries. Consequently, the economy is forced into borrowing to pay off the excess import. In the short run, a Balance of Payment deficit would cause economic growth but its long-term effect is increased government borrowing and depreciation of the local currency.
The implication of a Balance of Payment surplus is also an economic imbalance. A surplus in the Balance of Payment occurs when the economy export level exceeds the import level. A surplus promotes economic growth and development. When the export of the economy is greater than the imports the national income level increases. The government can finance development projects across the country. A balance of Payment surplus will cause export dependency in the long run and the economy will not function to its potential. The economy should provide sufficient capital to pay off the domestic producers of goods and services.
The net foreign wealth is the value of assets that an economy holds in a foreign country less than the value of wealth owned by foreigners in the domestic markets. The balance of Payment affects the net foreign wealth of an economy. When the country has fewer transactions in the foreign economy, the net foreign wealth of the economy decreases due to less income made in the foreign economy. Similarly, when the country has more financial transactions in the foreign economy compared to foreigners in the domestic market, the net foreign wealth of the economy increases substantially.
The Intertemporal Model of the Current Account
Over time, many economies in the world have suffered from the Balance of Payment deficit. Due to reduced trade barriers, economies can freely transact leading to an increase in the borrowing and lending of finances. Financial crises have occurred over time with economic imbalances leading to macroeconomic problems. The current account of the Balance of Payment cannot be run on a deficit for prolonged periods. The Intertemporal approach of the current account deficit is to analyze the deficit in terms of the differences between savings and investment in the economy.
The current account should be viewed as a change in the net foreign wealth of the country to address any deficit. Differences between the net savings and the net investment of the economy can be crucial in coming up with ways of formulating macroeconomic policy to solve any deficit. Traditionally the current account was seen as the net export value of an economy but these changes when using the intertemporal model. Savings and investments decision of the country’s economy is based on the value of the macroeconomic factor. Macroeconomic factors affect the prices of goods and services in the economy and consequently, the value of transactions changes over time.
The intertemporal current account model is broadly divided into two categories. The first category is the deterministic model which is based on the assumption of perfect insight of the economy coupled with complete information of variables. In this model, the consumers in the economy discount the value of future utility to the marginal utility of transactions. The income received from financial transactions by the government is spent on private sector consumption to speed up economic development. A Consumption tilting then arises due to the difference in the prevailing market interest rate and the domestic rate of time preference in compensation of uncertainty and risk in the market.
The other category is the stochastic model of the current account. The model is based on changing relevant macroeconomic factors to address the problem of uncertainty in the economy. When transactions occur in the economy, uncertainty occurs due to the riskiness of investment projects. The main problem of the model is to find consistency in the values for investments, government consumption, the production level, and the savings of the economy. A combination of the two group models can be used to address the current account deficit in the economy. Future consumption levels are impacted by the intertemporal model of the current account in solving the underlying Balance of Payment deficits.
Theories of Exchange Rate Determination in the Short-run and Long run
There are several theories put forward to explain how the exchange rate is determined in the economy. One of the earliest theories put forward is the mint parity theory of exchange rate. This theory was only used for economies using the same metallic standard. The standard model of comparison in the economy was the use of gold to determine the strength of a specific economy. The exchange rate was determined based on the weight value of gold at that particular period in time. The central bank was only willing to buy a certain amount of gold at the prevailing market prices. This way a standard for comparison of the strength of several economies was determined at the same time.
Modern theories have been established to help determine the exchange rate in both the short run and the long run. Purchasing power parity theory is an ideal theory that helps economists determine the prevailing exchange rates in the economy. According to the theory, the equilibrium exchange rate of the economy is based on the purchasing power of two different paper currencies. The rate of exchange between the two currencies is affected by the prices of goods and services in the two economies. The purchasing power theory is further divided into two models that can be used to simplify the determination of the equilibrium exchange rate.
The absolute purchasing power theory is based on the relationship between the internal purchasing strength of two different purchasing units of the currencies. The amount of goods the currency can buy in the home economy is compared to the number of units it can purchase in the foreign market. The absolute purchasing power theory however has significant shortcomings. The theory bases the strength of the money in absolute terms only making it unreliable as it does not incorporate other factors of the currency.
The other version is the relative purchasing power theory. This model is based on changes in the equilibrium exchange rate between two currencies. The price indices of the current and the base period are used to determine changes in the equilibrium exchange rate. The purchasing power parity is then determined using the quotient of their specific purchasing power. Consequently, differences in the purchasing power quotient can be used to explain which of the two currency is stronger thereby determining the ideal exchange rate.
The short-run exchange rate is determined by the demand and supply of the currency in the economy. How frequent the currency is used in transactions is the economy explains the demand for the currency in the market. Speculations on future demand levels of the currency in the economy can affect the value of the currency. The supply of the currency in the economy is also an import factor in the short run and affects the exchange rate values. How much of the currency is in circulation in the economy helps in determining the supply of that currency in the market. When the supply of the currency is greater than its demand, the value of the currency will reduce in the short run. Similarly, when the demand for the currency is greater than its supply in the market, the value of the currency will increase.
In the long run, the exchange rate is affected by many factors and is not only based on the demand and supply of the currencies. The prices of goods in terms of purchasing power affects the value of currencies in the economy. How many units of goods the currency can purchase will affect its value in the long run and change the equilibrium exchange rate. Differences in production levels can also affect the value of currencies in the long run. If an economy has a competitive edge and can produce goods with an edge in the efficiency of cost, its currency will increase in the long run. The level of export and import also affects currency strength. When an economy has greater export, value compared to the import the currency will end up being more valuable in the long run.
Elasticity and Absorption approach of the Current Account
The absorption approach to Balance of Payment and thereby the current account is also known as the Keynesian approach. It is always based on a general equilibrium that can be used to identify deficit and surplus in the current account. It is only effective when based on the income effect of devaluation. The elasticity approach of the current account is based on the price effect on transactions taking place in the economy. The absorption approach indicates that if an economy is experiencing a Balance of Payment deficit then the consumers in the economy are absorbing more than the production level of the economy.
A Surplus of a balance of payment in the absorption approach indicates that the production level of the economy is greater than the absorption level of the citizens in the economy. Therefore, the balance of payment is determined by finding the difference between national income level and the domestic expenditure level. In a situation where there are idle resources in the economy, devaluation raises the exports of the economy and reduces the imports of the country. An increase in the export level and a reduction of the import level will result in a rise in the national income level. The additional national income that is generated in the country’s economy will consequently, increase the economy’s income because of the multiplier effect. The result will be an improvement in the balance of payment situation and the deficit will be solved.
If resources are fully employed in the market, the national income cannot be increased and the devaluation cannot address a balance of payment deficit. This is where the elasticity approach of the current account is used to solve a deficit in the balance of payment, as prices may reduce thereby creating elasticity in prices of goods and services in the domestic market. The net effect of a reduction in price is an increase in demand and the consumer consumption level reducing imports and increasing exports, thereby making the balance of payment situation better. Both the elasticity and the absorption approaches can be used to solve the balance of payment disequilibrium.
The Internal and External Balance and Australian Position in the SWAN Diagram.
The SWAN model of the external and internal stability of the economy is a model that was introduced by Trevor Swan, an Australian economist. The model is used to explain the balance of payment of the economy. It is based on two main assumptions one being the economy operating with little disruption with no restriction and taxes on the transactions taking place in the economy. The other assumption of the model is the absence of capital movement in the economy. A measure between the real expenditure of the economy and the cost ratio is used to determine the balance of payment. The cost ratio is the ratio between the prices of goods and services in the international market and the prices of goods in the domestic economy.
A lower cost ratio will limit the level of export of the economy and will cause import-substituting output. A higher cost ratio will encourage the economy to maximize export production due to the price advantage of the international market and the real expenditure is to maintain full employment in the economy. Positions to the right and above the curve show the inflation level of the economy with domestic real expenditure high relative to exports and import-substituting output. The diagram has the unemployment part below and to the left of the curve.
The other curve in the diagram represents the external balance which is important in determining any imbalance in the balance of payment. A balance of payment deficit is shown in the right and below the external balance curve. Similarly, a balance of payment surplus is indicated in the SWAN diagram in the position of above and to the left of the external balance curve. A complete equilibrium in the economy occurs where the internal and the external balance curves intersect. Movements toward the equilibrium to correct deficits and surplus in the balance of payment are achieved through changing the expenditure levels to influence macroeconomic policy.
Figure 7 The SWAN Diagram
Macroeconomic Policies to Deal with COVID-19
Due to the global pandemic of the Coronavirus, many economies across the globe have been hit severely. The Australian economy has recessed, causing a loss of over a million jobs. The Central bank of Australia has come up with policies to help in strengthening the economy and save Australians during this rough economic time. The pandemic has caused a reduction in the prices of goods and services in the market. Oil is one product experiencing a fall in price in Australia and throughout the world. The bank of Australia has introduced a realistic policy action to help workers and small and medium enterprises from going out of business during this hostile economic period. Economic functions have been implemented to help monetary and fiscal policy to have desirable effects on the economy of Australia.
The central bank has undertaken to reduce the prevailing market interest rates and consequently help households and businesses access financial facilities. It will help small businesses and households to meet the daily costs. Almost all the companies in Australia have had reduced income due to the global Coronavirus pandemic. The central bank has also undertaken to increase government expenditure to help increase the money supply in the economy and help in dealing with unemployment.
The fiscal policy developed by the government was to initiate the recovery of the Australian economy. It has successfully convinced the Australian citizen to stay at home and help in flattening the Coronavirus curve. Essential service providers have been urged to observe social distance and all the other requirements such as having a protective mask. The government has the public confidence and the result is only going to be positive.
Australian Exchange rate regime
The Australian economy uses a floating exchange rate system. It is a system where the exchange rate is determined using the market forces of demand and supply. When the Australian currency has a greater demand in the international capital markets and businesses make payments using the currency, the value of the currency goes up substantially. Similarly, when the supply of the currency in the capital market is greater than the demand, the value of the currency will decline.
Australian economy would not be better off if it decides to use a fixed exchange rate system. The currency has a better chance of appreciating in a floating rate system due to the freedom of the market. A fixed-rate regime would cause stagnation of the currency value against other currencies in the capital market.
Conclusion
The balance of payment is important to the economy of any country. It should always be kept in equilibrium to ensure the economy has the best chance of operating to its potential. Any deficit and surplus in the balance of payment should be resolved by the use of the appropriate macroeconomic policy. The Australian economy has a lot of promise and potential and can grow in their near future despite the ongoing Coronavirus.
References
Adedeji, O.S., 2017. The Balance of Payments Analysis of Developing Economies: Evidence from Nigeria and Ghana. Routledge.
Bussière, M., Karadimitropoulou, A., and León-Ledesma, M.A., 2017. Current account and the real exchange rate: Disentangling the evidence (Vol. 239). Bank of England Working Paper.
Cesaroni, T., and De Santis, R., 2018. Dynamics of net foreign asset components in the EMU. International economics, 156, pp.268-283.
McKibbin, W & Fernando, R, 2020, The global macroeconomic impacts of COVID-19: Seven scenarios, Brookings, <https://www.brookings.edu/research/the-global-macroeconomic-impacts-of-covid-19-seven-scenarios/ (Links to an external site.)>.
Stern, R., 2017. Balance of Payments: Theory and Economic Policy. Routledge.