Balance of Payments - National Income
National income and the balance of payments
What are the links between the rate of growth in an economy and movements in the balance of
payments? Normally, as domestic incomes rise we expect to see an increased demand for
imports. This can come from both consumers and firms. The extent to which imports rise when
incomes grow is shown by the income elasticity of demand for imports. In the diagram below,
spending on imports is assumed to be directly linked to the level of national income. The higher
the marginal propensity to consume the steeper will be the gradient of the import function.
Exports are assumed to be exogenous of the level of domestic national income.
If the marginal propensity to import is high then imports will rise quickly when the economy
experiences economic growth. Unless there is a corresponding rise in the volume of exports sold
overseas, the balance of trade will worsen.
The balance of payments and living standards
A common misconception is that balance of payments deficits are always bad for the economy.
This is not necessarily true. In the short term if a country is importing a high volume of goods
and services this acts as a short-term boost to living standards since it allows consumers to buy a
higher level of household durables and other items. A widening trade deficit might also be the
result of an increase in imports of capital equipment and technology which will provide a boost
to a country’s potential national output. If imports of investment goods improve our
competitiveness, this raises the prospect of an increase in employment and real incomes arising
from a better supply-side economic performance.
However in the long term, if the trade deficit is a symptom of a weakening domestic economy
and a lack of international competitiveness then living standards may