Factors Affecting Balance of Payments

The difference between what a country exports and what it imports is called net exports (X-M). If exports exceed imports, then we have a trade surplus. However, if imports exceed exports, then we have a trade deficit.

A trade deficit indicates that we are consuming more than we produce.  The United States currently has a trade deficit.

The trade deficit can be expressed in terms of savings and investments as follows:

(X – M) = (S-I) + (T-G)

In the above equation, S – I is the private saving balance, that is, the difference between private sector savings (S) and investment (I). T – G represents government savings, that is, the difference between tax collected (T) and government spending (G). If government spending is more than tax collected, there will be government deficit. (X – M) is the net exports and is called the current account balance.            

Let’s understand the importance of the above equation.

Let’s say at the current level of income and employment, the current account balance is zero.

Also, let say that the private saving balance (S – I) = 100. If we substitute these numbers in the above equaition, then (T-G) must be -100. If private sector savings increase to 200, the government deficit must become -200 inorder to keep the current account balance zero. 

We will have a current account deficit if we have a large government deficit, low private savings and high domestic investments. A current account deficit is matched by an inflow of foreign investment.

A current account deficit means that either the private sector or the government (or both) has negative saving. In many cases, it is the government that overspends its budget. Or maybe both sectors have negative savings. To reduce the current account deficit, there are only two ways. Increase net private saving or increase net government saving.Marshall-Lerner condition states that a depreciation of domestic currency can improve a country’s balance of payments only when the sum of the demand elasticity of exports and the demand elasticity of imports exceeds unity.