Open Economy Macroeconomics:The Balance of payment and the exchange rate

Balance of Payments

The balance of payments provides us with important information about whether or not a country is “paying its way” in the international economy.

What is the Balance of Payments? 

The balance of payments (BOP) records all of the many financial transactions that are made between consumers, businesses and the government in the UK with people across the rest of the World. The BOP figures tell us about how much is being spent by British consumers and firms on imported goods and services, and how successful UK firms have been in exporting to other countries and markets. It is an important measure of the relative performance of the UK in the global economy. At AS level we focus only on one part of the balance of payments accounts. This section is known as the current account. We will go through the make-up of this account in a later section.

Why is the export sector of the economy vital for the UK?

  • Aggregate demand and the multiplier: An increasing share of Britain’s national output isexported overseas as the nation becomes ever more integrated into the global economy.Export earnings are an injection of AD into the circular flow. If British companies can successfully sell more goods and services overseas, the rise in exports boosts national income and should have a positive multiplier effect on the national income, output and employment.
  • Manufacturing industry: Export sales are particularly important for manufacturing industry where exports are a high % of total production. Thousands of jobs depend directly on the performance of the export sector and even more are affected in supply industries. Select this link for more articles on British manufacturing industry
  • Regional economic health: The relative success of failure of export industries is important for certain regions of the UK. When export sales dip (for example as a result of a global downturn or the impact of the strong exchange rate), output, employment and living standards comeunder threat and threaten to widen the existing north-south divide.


Trade in goods includes items such as:
Manufactured goods
Semi-finished goods and components
Energy products
Raw Materials
Consumer goods
(i) Durable goods e.g. DVD recorder and new cars
(ii) Non-durable goods e.g. foods and beverages
Capital goods (e.g. new plant and equipment)

Trade in services includes:
Banking, insurance and consultancy services
Other financial services including foreign exchange and derivatives trading
Tourism industry
Transport and shipping
Education and health services
Services associated with research and development
Cultural arts

Trade in goods

Trade in goods includes exports and imports of oil and other energy products, manufactured goods, foodstuffs, raw materials and components. Until recently this was known as visible trade – i.e. exporting and importing of tangible products. Since 1986 the net balance of trade in goods for the UK has been in deficit. And as the following chart shows, the trade deficit in goods has increased enormously in the last few years. In 2005 there was a record trade deficit of £66 billion, over three times the deficit seen in 1998.

Trade in services

Overseas trade in services includes the exporting and importing of intangible products – for example, Banking and Finance, Insurance, Shipping, Air Travel, Tourism and Consultancy. Britain has a strong trade base in services with over thirty per cent of total export earnings come from services.

The balance of trade in services has been positive for many years. In 1999 the UK became the second largest exporters of services in the world and in 2004 the UK achieved its highest ever annual trade surplus in services although there was a smaller surplus in 2005 partly because of higher insurance payouts arising from the effects of Hurricane Katrina in the United States. Strong surpluses are especially common in financial and business services and hi-tech knowledge services.

But the UK runs a deficit in international travel and transportation in part because of the growth of demand for overseas holidays as living standards have improved. Once again, rising incomes have caused a large rise in the demand for overseas leisure and business travel and the sustained strength of the exchange rate against most European currencies and the rapid expansion of low cost airlines offering short haul overseas breaks has also played its part.

Britain has a comparative advantage in selling financial services to the rest of the world. London is one of the three main financial centres in the world and has the largest share of trading in many international financial markets. Many overseas banks have established themselves in London’s money and capital markets. And numerous British financial businesses have world class status in their areas of expertise.  Our UK based commercial banks, fund managers, securities dealers, futures and options traders, insurance companies and money market brokerage businesses are part of a complex network of financial and business services that represent a huge asset for the UK balance of payments accounts.

Measuring the current account

The current account balance comprises the balance of trade in goods and services plus net investment incomes from overseas assets. Net investment income arises from interest payments, profits and dividends from external assets located outside the UK. We also add in the net balance of private transfers between countries and government transfers (e.g. UK government payments to help fund the various spending programmes of the European Union).

The net investment income flow for the UK is positive – a reflection of the heavy investment overseas in recent years by British businesses and individuals. The transfer balance is negative – one reason is that the British government is a net contributor to the EU budget.

The current account of the balance of payments

The current account balance is essentially a reflection of whether the British economy is paying its way with other countries. The annual balance is volatile from year to year, because each of the four component parts is subject to wide fluctuations.


Balance of trade in goods

Balance of trade in services

Net Investment Income

Current transfers

Current account balance



£ billion

£ billion

£ billion

£ billion

£ billion





























































Source: Office of National Statistics

What are the main questions that concern economists regarding these figures?

  • Causation: Why does the UK now run such large trade deficits in goods?
  • Consequences: Does it really matter if the British economy is running persistent current account deficits?
  • Correction: Which demand and supply-side economic policies are likely to be most effective in improving our trade balances in the years ahead?

The underlying causes of the UK trade deficit

It is useful to group the explanations for the record trade deficit in goods into short-term, medium-term and long-term factors. Some relate to the demand-side of the economy, others to supply-side economic influences

Short-term factors

  • Strong consumer demand: Real household spending has grown more quickly than the supply-side of the economy can deliver, leading to a very high level of demand for imported goods and services
  • High income elasticity of demand for imports: Evidence suggests that UK consumers have a high income elasticity of demand for overseas-produced goods – demand for imports grows quickly when consumer demand is robust.  Nicholas Fawcett and Michael Kitson in a recent article in the Guardian estimated that the income elasticity is around +2.3 suggesting that a 2% increase in real incomes boosts demand for imports by 4.6%. Because the overseas demand for UK exports rarely keeps pace with the surging demand for imported products, so the trade deficit widens when the economy enjoys a period of consumption-led growth.
  • The strong exchange rate has helped to reduce the UK price of imports causing an expenditure-switching effect away from domestically produced output.
  • The weakness of the global economy and in particular the slow growth in the Euro Zone has damaged UK export growth. Nearly 60% of UK manufactured goods exports and over 50% of our exports of services are to fellow members of the European Union.

Medium-term factors

  • UK trade balances have been affected by shifts in comparative advantage in the international economy – for example the rapid growth of China as a source of exports of household goods and other countries in South-east Asia who have a cost advantage in exporting manufactured products
  • The availability of imports from other countries at a relatively lower price inevitably causes a substitution effect from British consumers.

Longer-term factors

  • Much of our trade deficit is due to structural rather than cyclical factors
  • Our trade performance has been hindered by supply-side deficiencies which impact on the price and non-price competitiveness of British products in global markets - non-price competitiveness factors such as design and product quality are now more important for trade than merely price alone.
    • A relatively low rate of capital investment compared to other countries
    • The persistence of a productivity gap with our major competitors – measured by differences in GDP per person employed or per hour worked – this is linked to low investment and also to the existence of a skills-gap between UK workers and employees in many other countries
    • A relatively weak performance in terms of product innovation – linked to a low rate of business sector spending on research and development
  • The UK manufacturing sector has been in long-term decline for more than twenty years. This is known as a process of deindustrialisation. Although we still have some world class manufacturing companies, the size of our manufacturing sector is not large enough both to meet consumer demand in the UK and also to export sufficient volumes of products to pay for a growing demand for imports

What does a current account deficit mean?

Running a sizeable deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending.  The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

The Effects of Changes in the Balance of Payments on the UK Economy

Consider the effects of a slowdown in exports and a faster growth in imports of goods and services caused by a rise in the value of sterling against other currencies that leads to a worsening of the balance of payments. This has further effects on the economy as a whole:

  • Reductions in demand in the circular flow:  There will be a net fall in AD because more money is leaving the circular flow of income (through imports) than is coming in from exports. An inward shift of AD would lead to a contraction along the SRAS curve.
  • Lost jobs: There will be a loss of employment if exporting industries require less labour and if UK businesses lose market share and output to cheaper imports from overseas.
  • Dip in business confidence and investment: A fall in business confidence and a decline in capital investment spending by UK exporting firms whose order books are less full and whose profits take a hit from a fall in demand from overseas.
  • Reductions in inflationary pressure: Lower inflation because imports coming into the UK are cheaper and a fall in AD takes the economy further away from full capacity. Reduced inflationary pressure might then persuade the Bank of England to reduce interest rates to provide a boost to macroeconomic activity.

The exchange rate and the balance of payments

Changes in the exchange rate can have a big effect on the balance of payments although these effects are subject to uncertain time lags. When sterling is strong then UK exporters found it harder to sell their products overseas and it is cheaper for UK consumers to buy imported goods and services because the pound buys more foreign currency than it did before.

The Balance of Payments and the Standard of Living

A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In the short term if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. However, in the long term if the trade deficit is a symptom of a weak economy and a lack of competitiveness then living standards may decline.