Sandra, BOP is one of 2 major constraints on growth (other is inflation). When the economy is growting from increasing income, so does imports M = M0 - mY. When imports increase, there is a lower trade surplus or a trade deficit within the current account, thus more income is flowing out of the economy. If it is a trade deficit, funds must be borrowed from overseas to cover this deficit. This is done through investment or finance, which represents itself in the capital and financial account. So basically, when there is a current account deficit, it must be covered from the capital and financial account, CA = CFA. BUT. The inflows from the CFA requires interest repayments, these interest repayments are outflaws which are indicated under 'net income' within the CA. So when CFA flows increases to cover the intial trade deficit, so does the CAD as CFA requires interest. Unless the current account deficit stablise itself, it will result in a vicious debt cycle where economic growth is slowly degraded due to higher leakages to the international market.
High CAD means eventually lower exchange rate, as more $A are flooded onto the market. This means higher levels of imported inflation. Thus we see government using contractionary policies to counter it.
High CAD means that investors are has less confidence within the AUstralian economy, so in order to stop these investments from escaping Australia, higher incentives are needed. THis means higher interets rates. 60+% of AUstralia are assets sold to cover the current account deficit, what if foreign investors sells all of it? we're stuffed... its like an economic nuclear bomb going off.
So basically the balance of payments constraint leads to policy reversal, i.e. that large expansionary policies will result in large contractionary policies. This only occurs if domestic income > world income, if world income > domestic income, should be no problem. Thats why CAD was so sustainable during the 1950s, 60s and early 70s.
