How Decisions Affect Balance of Payments

Balance of payments has a great impact on the movement of exchange rates and international trade. When a country is faced with trade deficits, it’s likely to experience a fall in its reserves and a depreciation of its currency. As a result, decisions made by consumers, firms, and governments affect the balance of payments.

Consumer Spending

As consumers spend, aggregate demand increases. As we know, many countries have a higher marginal propensity to import. When aggregate demand for imports increases, exports fall. An increase in imports above the value of exports (imports > exports) affects the balance of payments. This should consequently, all other things being equal, depreciate the domestic country’s currency.

Consumer spending is instrumental in keeping the economy afloat even in the course of deflation. Stable economic growth scales down unemployment and government borrowing. This is because fiscal authorities collect more revenue under such economic conditions. If consumer spending continues, the economy will most likely go back to an inflationary period.

Governments’ Decisions on Balance of Payments

Direct Control

These are intervention measures governments take to reduce or increase a certain type of payment or receipts in the balance of payment (BOP). To improve a country’s BOP, the government may:

• Prohibit particular luxurious goods, e.g., cars, from getting into the country.
• Use deflationary financial policies that reduce the overall level of prices and income.

Exchange Control

A deficit in a country may compel a government to try to restore the equilibrium of the BOP by restricting payments to other nations. Usually, governments do this by adjusting exchange controls to equate the foreign balance of supply and demand. The objectives of exchange control are:

• To protect the BOP deficit and bring it back to equilibrium.
• To protect a nation from “capital flights”.
• To allow economies and their policies more freedom to act.
• To uphold consistent currency exchange rates between a country and its trade partners.

Firms

International companies and firms provide developing countries with many advantages, such as improving the BOP. Their investment in a country secures the condition of the BOP. Also, these investments lead to a flow of capital. This, in the end, results in the substitution of imports and/or the promotion of exported goods.

Question

A country is restricting payments to other nations. This is most likely an example of a (an):

1. Consumer spending decision.
2. Direct control by the government.
3. Exchange control by the government.

Solution

The corrects answer is C.

Exchange controls are government-imposed limitations on the purchase or sale of currencies. These controls aim at stabilizing the economy by limiting in-flows and out-flows of currency.