- BOP deficit could be caused by Current Account deficit possibly due to import expenditure (M) exceeding export revenue (X)
- This could be due to a relatively higher rate of inflation in the country relative to other countries. This could be due to increases in cost of production, such as strong increase in wages or fall relative productivity levels.
- Cost of producing goods and services and hence the price at which they are sold is higher, making it less price competitive in international markets as they are now more expensive than the trading partner’s domestically produced goods. Quantity demanded for exports decreases as foreigners switch from that country’s exports to domestically produced goods or to exports from other countries. Assuming demand for exports is price elastic, quantity demanded for exports decreases more than proportionately, hence export revenue (X) falls.
- Also, demand for imports rises as locals switch from domestically produced goods and services to imports, which are now relatively cheaper.
- Hence import expenditure (M) rises. Decrease in X and increase in M cause net export revenue (X-M) to fall.
- Current Account deficit could also be caused by an appreciation of the exchange
- When the currency appreciates, price of exports in foreign currency increases, making exports less price competitive in international markets. Quantity demanded for exports decreases as foreigners switch to domestically produced goods or to exports from other countries.
- At the same time, price of imports in domestic currency decreases, making imports more price competitive in the domestic market. Quantity demanded for imports increases as locals switch from domestically produced goods to imports.
- Assuming the ML condition holds whereby the sum of the price elasticise of export and import is more than 1, (PEDx + PEDm > 1), net export revenue, (X-M) will fall
- Current account deficit could be brought about by a country experiencing a faster rate of economic growth than the countries it exports to. These would be the case if growth is being generated from domestic sources – i.e. there is a domestic consumption boom or increase in government expenditure, rather than increase in net exports.
- An increase in NY will result in domestic consumers demanding more goods and services for consumption, both those which are domestically produced and imports. As a result there will be an increase in import expenditure
- As other countries experience a slower rate of growth, export revenue is not increasing as much. As a result, there is a fall in (X-M)
Body (Capital and Financial Acct Deficit)
- BOP deficit could be caused by capital and financial account deficit, brought about by a net outflow of short or long term capital.
- A net outflow of short-term capital could be brought about by a decrease in relative interest rates, as this means that financial institutions are now able to obtain higher returns on their funds in other countries. This would lead to less short-term capital inflows and/or a more short-term outflow.
A net outflow of long-term capital, in the form of Foreign Direct Investment (FDI) would also cause a BOP deficit. There would be net decrease in FDI flows if the profitability of investment falls. This could result from government policies becoming less favourable, for example a withdrawal of preferential tax concessions or grants. This results in multi-national corporations (MNCs) moving their investments to other countries offering more preferential treatment. It could also be brought about by a deterioration of the investment climate in general. For example, a strengthening in trade union power resulting in more strikes and/or wage demands will induce firms to seek more attractive investment destinations abroad.
Learn from from Anthony Fok – JC Economics Tutor