Definition of Balance of Payments (BOP)

  • The balance of payments represents all the economic transactions in goods, services and assets of the country with the rest of the world during a given period (one year in general).
  • BOP is a record of all international transactions entering and leaving a country.

Balance of payments:

  • Surplus: when exports exceed imports
  • Deficit: when imports exceed exports
  • Equilibrium: exports are equal to imports

3 components of BOP:

  • Current account: controls the flow of funds from imports and exports between countries.
  • Capital account: controls the flow of international capital transactions.
  • Financial account: controls the flow of funds related to investments in companies, real estate and stocks.

Fixed exchange rates and consequences

Advantages of fixed exchange rates

Disadvantages of fixed exchange rates
  • Face the future with more confidence
  • Limit devaluation of competitive currencies
  • More serious cost control by companies
  • Deflationary policies
  • Balance of payment deficit
  • Difficulty in determining the equilibrium exchange rate of each country
  • Governments must hold reserves of foreign currencies

Floating exchange rates and consequences

Advantages of floating exchange rates

Disadvantages of floating exchange rates
  • Ensure balance of payments equilibrium without government intervention
  • No need for governments to hold reserves of foreign currencies
  • Governments can use interest rates to reach full employment
  • Uncertainty
  • Excessive exchange rates
  • Risk of inflation setting in if the government continues to let the currency depreciate

Example

  • The Euro, created in 1999 by European Union is the single currency use by member countries.
  • It is a permanently fixed exchange rate between the countries that use it.