How Decisions Affect the Balance of Payments

The balance of payments has a great impact on the movements 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. It should, 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 a deflation. Stable economic growth scales down unemployment and government borrowing since the fiscal authorities collect more revenue under such economic conditions. If consumer spending continues, the economy will most likely go back to an inflationary period.

The Government’s Decision on Balance of Payments

Direct Control

These are intervention measures taken by the government 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; or
• 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 bring back the equilibrium of the BOP by restricting payments to other nations. Usually, this is done 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 the nation from “capital flights”;
• to allow economies and their policies more freedom to act; or
• to uphold consistent currency exchange rates with the countries that they are trading with.

Firms

International companies and firms mainly provide developing countries with many advantages, such as improving the BOP. Investing in a country will assist the BOP’s condition. Also, investing leads to a flow of capital and results in the substitution of imports and/or the promotion of exported goods.

Question

A country restricting payments to other nations 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.