Causes of a balance of payments disequilibrium
A balance of payments disequilibrium refers to a situation when the payments into and out of an economy do not balance – either because payments going abroad are greater than payments received (a deficit), or when payments going abroad are less than payments received (a surplus).
The payments refer to those from the current account, and from the financial and capital account. Focus tends to go mainly on the current account balance, but changes in the financial and capital account are also important. Flows into the financial and capital account help achieve an overall balance.
The balance of payments will always balance in an accounting sense because the double-entry bookkeeping convention ensures an overall balance. This means that a net deficit recorded on the current account will be balanced by a net surplus on the financial account.
This should not be confused with a disequilibrium which refers to imbalances that arise before any accounting adjustments are made.
Structural or cyclical?
Deficits and surpluses can either be structural - where there is a tendency for the account to remain in deficit or surplus over an extended period of time - or cyclical - where the deficit or surplus is temporary, and related to changes in the business cycle. Given that a cyclical disequilibrium will self-correct, we will focus on the causes of a structural disequilibrium:
Causes of a structural deficit - demand side factors
- Excessive domestic GDP growth can increase expenditure on imports - as an economy grows imports increase relative to exports.
- Conversely, weak overseas GDP growth, or overseas recession, reduces demand for imports.
- An over-valued currency, which deters exports and encourages imports - remember the SPICED acronym.
Imports are a positive function of income [M = fY], with ‘f’ the marginal propensity to import (or mpm, for short). So, as income rises, imports rise with it. The mpm indicates the amount of new imports resulting from a given amount of new national income (GDP).
The assumption is that exports are a function of overseas’ GDP, hence the export line has a zero gradient.
As GDP increases (from Y to Y1), imports rise (from a to b), opening up a deficit of b to c. The greater the mpm the larger the trade deficit (c to d) as a result of growth.
Causes of a structural deficit - supply side factors
- Low productivity (output per hour worked) is a major constraint on a country's ability to supply to the rest of the world. A poor level of productivity could be caused by lack of investment in new technology and insufficient innovation.
- Relatively high domestic inflation can cause export prices to be uncompetitive.
- Poor export performance because of inferior quality or marketing or other non-price factors.
- Barriers to trade imposed on exports, limiting ability to supply, and if using tariffs, export prices rise.
- Import dependency - a country can become dependent on imports which gradually worsens the current account. This is especially worse if the imported goods are essential, such as imported energy.
- De-industrialisation - this is a slow process whereby a country's industrial base declines and relies on the export of non-industrial goods, including services and tourism.
- Bottlenecks in the supply chain causing domestic supply problems.
- Ineffective micro and macroeconomic policy - for example, weak monetary policy failing to control domestic inflation
It should be noted that the supply-side factors relate to the competitiveness of domestic products abroad.
Consequences of a deficit
The consequences of a current account deficit depend on where the deficit arise from (demand or supply-side?); whether it is structural or cyclical, and how large the deficit is as a proportion of GDP. Typical consequences are:
Consequences of a deficit on the balance of payments
- Given that, in simple terms, a deficit occurs when M is greater than X, the effect will be a reduction in aggregate demand (AD).
- This can reduce growth or lead to a recession.
- Less growth may work into the labour market and reduce demand for labour, which is a derived demand.
- This could lead to a rise in unemployment.
- There may be pressure on the government to introduce corrective policies, such as deflation or 'belt tightening' - tighter fiscal and monetary policy. There may be a temptation to pursue protectionist policies.
- There is likely to be downward pressure on the exchange rate, which could lead to trade improvements in the future.
Assuming the trade deficit arises from a fall in exports relative to imports, demand for a country's currency will fall as less domestic currency is required by foreign importers.
At the existing exchange rate (of £1=$1.40), a deficit will arise. However, this will result in a fall in the exchange rate and move the economy back towards a trade balance (or current account balance) in the future.
One advantage of a floating exchange rate is that an adjustment of the currency will help rebalance the balance of payments.