Globalization: Foreign Exchange and Balance of Payments

Globalization: Foreign Exchange and Balance of Payments

The many nations of the world, and their economies, have become increasingly inter-related in recent years. This trend is expected to only grow. This has led to the term "global economy". Technology is a driving force for this trend. Global markets have developed as a result of rapid advances in communications and transportation.

The issues are complicated – any given policy is likely to benefit one segment of the economy while hurting another segment. Weighing the costs and benefits of one policy choice against another often requires value judgements.

Foreign Exchange

When a buyer in one country purchases a good or service from a supplier in another country, the exchange that takes place is paid for in the currency of the seller's country. The buyer needs to have the currency of the seller in order to make the purchase. This can be in the form of the physical currency of the seller, but most often such an exchange would take place using an electronic transfer of funds to an account valued in that currency. The physical transfer of one currency to another, in other words buying paper money or coins in a foreign currency occurs mostly for the purpose of tourism.


Either way, transferring funds from one currency to another involves the foreign exchange market.


Foreign exchange market: a global market in which people trade one currency for another.

The foreign exchange market is not a physical market located in a specific location. It is a global market located throughout the world, often involving electronic transfers through large banks.

When funds valued in one currency are exchanged for funds valued in another currency, the relative value of one currency in terms of the other currency determines the amounts of currencies that are exchanged. This creates a price for the two currencies in terms of each other: the price is called the exchange rate.

Exchange rates are determined by relative values, so they can be found by dividing a specific quantity of one currency by a quantity of equal value of the other currency. Once you know the exchange rate, you can translate a specific amount of one currency to the equivalent amount of another currency either by multiplying or dividing one currency's quantity by the exchange rate. Whether you have to multiply or divide depends on which way the exchange rate is quoted: whether it is quoted as currency A in terms of currency B, or currency B in terms of currency A.

The foreign exchange market works just like any other market in the sense that prices are determined by supply and demand. In the case of the foreign exchange market, it means that exchange rates are determined by the supply and demand for currencies.

One currency appreciates in value when its value rises in relation to another currency, and depreciates in value when its value falls in relation to another currency.

Since goods and services sold for export involve an exchange of currencies, the exchange rate will affect the price that consumers have to pay for imports. This means that goods and services in one country can become relatively more or less expensive than goods and services in another country, due only to a change in the exchange rate between the two currencies.

When a country's currency appreciates in value against another currency, that country's goods and services become more expensive for the other country's citizens.

When a country's currency depreciates in value against another currency, that country's goods and services become less expensive for the other country's citizens.

With increasing globalization, supply and demand forces mean that currency exchange rate changes will alter a country's balance of trade. An appreciated currency will create fewer exports and more imports, decreasing the balance of trade and real GDP. The reciprocal: a depreciated currency will create more exports and fewer imports, increasing the balance of trade and real GDP.

Balance of Payments

Balance of payments is not the same thing as balance of trade.

Balance of payments: a record of a country's trade with the rest of the world.

This record includes transactions involving accounts in goods, services, and financial assets. Balance of trade involves only one such account, as explained below. Balance of payments, by definition, must always be zero: debits equal credits. Each transaction involves an equal amount of something received and something given up. If someone mentions a surplus or deficit in the balance of payments, they are really talking about something else. Using such terminology can be misleading.

The balance of payments is divided into two broad categories: the current account, and the financial account.

The current account in turn is divided into four categories: the merchandise account, the services account, the income account, and the unilateral transfers account. Each of these accounts can carry a surplus or a deficit balance, and so can their sum (the balance of the current account).

A brief description of each of these four accounts:

Merchandise account: transactions involving goods traded between countries. The export of a good is a positive (credit) entry in the merchandise account. The import of a good is a negative (debit) entry in the merchandise account. The merchandise account is important because exports represent production for the domestic economy, while imports represent spending on goods that are not part of domestic production. Exports represent activity within the economy, including jobs, business creation, and economic growth. Imports represent goods that have been purchased from potential competitors of domestic producers, which would mean a loss of jobs, business, economic growth.

This is important politically, especially when the political concern is loss of jobs and business within specific sectors of the economy (such as manufacturing), or entire industries.

This political concern is one of the main considerations whenever trade barriers are being considered. On the other hand, imports represent goods that can be produced more efficiently elsewhere, so that domestic resources can be re-allocated to more efficient uses. This re-allocation of resources means that the overall economy can produce more with the same amount of resources. The result is more, not less, in terms of jobs, business, and economic growth. See the section on specialization and trade for an explanation of this concept.

The merchandise account is an example of economic forces that decrease economic activity in one sense while increasing economic activity in another sense. How a person interprets this discrepancy will likely influence which policies that person will support.

Balance of trade usually refers to the balance in the merchandise account.

Services account: transactions between countries involving services. This account includes tourism and transaction costs, such as transportation costs for merchandise transactions.

Income account: transactions involving income between countries. Investment income and wages earned in another country is a positive (credit). Investment income and wages earned from domestic activity by foreigners is a negative (debit).

Unilateral transfers account: transactions between countries in which only one country actually receives something. This would include gifts and pensions. This account has political implications, especially regarding immigration policy. A foreign national who earns money in the domestic economy but sends some of the money earned to family members in another country is creating a negative (debit) in the unilateral transfers account.

The merchandise account comprises by far the largest portion of the current account. For this reason, the current account balance and the merchandise account balance are both sometimes referred to as the balance of trade.

Recall that the balance of payments includes both the current account and the financial account. The financial account represents the flow of money between countries. It basically includes the other side of the entries in the current account. For example, exports would mean that goods are transferred out of the country, but an equal value of money is transferred into the country. The flow of goods would be reflected in the current account while the flow of money would be reflected in the financial account.

Every transaction involves an equal value of credits and debits. This means that if either the current account or the financial account reflects a surplus, the other one must reflect a deficit of the same amount.

What all of this means in terms of GDP, debt, and political implications:

Recall that when calculating GDP, exports are added and imports are subtracted. Exports represent production that is produced domestically but not consumed domestically. Imports represent domestic consumption that does not add to production, so imports have to be subtracted when computing GDP in order to reflect production.

When the value of exports and imports are not equal, then consumption does not equal production. The difference between the two represents borrowing. If imports are greater than exports, represented by a debit balance in the current account and a credit balance in the financial account, then the country is a net debtor nation. It borrows more money from the rest of the world than it loans to the rest of the world. If exports are greater than imports, the country is a net creditor nation. This has political implications, as debt implies money owed.

A trade deficit is not the same thing as the national debt, although politicians often imply that it is. A trade deficit is a net debit in the current account of the balance of payments. The national debt is a completely different concept: it represents the total outstanding balance of all government obligations to pay back creditors, which in reality are investors in government securities.