14.3 The Balance Of Paymets Flashcards
What is the balance of payments?
Record of all the currency flows into and out of a country at a particular time period
What are the three main accounts transactions are broken down in
Current account
Financial account
Capital account
The balance of payments must equal what
0
What is the current account?
Measures all the currency flows into and out pf a country for exports and imports of goods and services, together with primary and secondary income flows
previously known as income flows and transfers
Why is the current account important
Reflects economies international competitiveness and the extent to which it is living within it means
If a county runs a capital account deficit the finance account should be in…
Surplus (same vice versa)
Where are capital flows measured under?
Financial account
What makes up current account
Trade in goods and services
Investment incomes, transfers
What is the financial account?
The part of the balance of payments which records capital flows into and out of the economy
What are the 5 main components of the financial account?
Net portfolio investment
Net direct investment
Financial derivatives and employee shock options
Other capital flows
Drawing on reserves
If a country is living beyond its means by running a current account deficit….
The borrowing which finances the deficit is recorded in either the capital account or financial account
What are the 4 main sections of the current account?
Primary income flows
Secondary income flows
Balance of trade in goods
Balance on trade in services
Why is the current account the most important part of the balance of payments?
Reflects an economy’s international competitiveness and the extent to which the economy is living within its means
What is a current account deficit?
If the currency outflows in the current account exceed the currency inflows
What is a current account surplus?
If receipts exceed payments
Currency inflows in current account exceed currency outflows
Balance of primary income?
Inward primary income flows comprising both inward-income flowing into the economy in the current year generated by UK-owned capital assets located overseas, and outward primary income flows comprising income flowing out of the economy in the current year generated by overseas-owned capital assets located in the UK
Balance of secondary income?
Current transfers e.g gifts of money, international aid and transfers between UK and EU flowing into or out of the UK economy in a particular year
What is visible trade
Trade of goods
What is invisible trade?
Trade of services
What is the balance of trade in goods?
The part of the current account measuring payments for exports and imports of goods. The difference between the total value of exports and the total value of imports is sometimes called the balance of visible trade
What is the balance of trade in services?
Part of the current account, difference between the payments for the exports of services and the payment of the imports of services
What is primary income flows?
Net flows made up of mostly investment income generated from profits, dividends and interest flowing between countries
The profit income generated from overseas investment flows back to the parent company and the uk shareholders
It is an outward capital flow but income generated is current income
(Overseas investment also have a huge role to play)
A significant proportion of the income flows are generated from what?
Portfolio investment
What is portfolio investment?
Investment in financial assets such as shares and bonds
(Interest and dividend payments within the international financial system contribute significantly to primary net income flows
What are secondary income flows?
Current transfers of income arising from such items as gifts between residents of different countries, donations and charities abroad and overseas aid
(Britain has long had a negative secondary income balance caused by UK’s net contribution to the EU budget)
What do outward capital flows do?
Generate inward flows of investment income in subsequent years
Enlarges the stock of capital assets located in other countries, owned by residents and MNCs based in the country exporting capital
What are net income flows?
The difference between inward and outward capital movements
(Positive net outward capital flows over some years mean the country acquired capital assets located in other countries are greater in value than the county’s own assets brought by overseas companies)
What is fdi
Investment in capital assets in one country by a business with HQ in another nation
Very often the overseas company establishes subsidiary companies in the countries in which is it investing
How can long term Croatian flows be explained?
Partly by competitive advantage:
Flows are a response to people’s decisions to invest economic activities and industries located in countries that have a competitive advantage
This takes a long time so the flows are relatively stable
What is portfolio investments
Purchase of a country’s securities (bonds and shares) by residents of another country)
When do portfolio investments occur?
Mangers employed by financial institutions (insurance companies and pension funds)purchase charges issued by overseas companies or securities issued by overseas govs
What has made it easy for UK residents to purchase shares and bonds that are listed on overseas capital markets?
The globalisation of world security markets or capital markets and the abolition of exchange controls between virtually economically developed countries
(Led to massive increase in portfolio investment)
What are toxic assets?
Potential purchaser of a package of financial assets offered for sale by a bank could not know in advance whether assets in the package were of high risk and potentially little value
What actually is hot money
Short-term capital movements (largely speculative)
Why does hot money flows occur?
Because the owners of the funds(include companies and banks as well as private individuals) believe that a quick speculative profit can be made by moving funds between currencies
When a currency is expected to rise—
People by the currency
(Hot money movements)
-also triggered by interest rates and out of currencies with lower interest rates
What can destabilise an exchange rate?
Large-scale hot money flow of funds between currencies
What can destabilise the international money system?
Speculative capital flows between currencies such as the dollar, pound and euro which occupy a central place in the finance of international trade
It is likely there will be a current account surplus when..
Net exports are positive
It is likely there will be a current account deficit when…
Net exports are negative
Diagram for how an increase in exports can affect the national economy
Describe this diagram…
Equilibrium point X(economy in deep recession) AD curve shift from 1 to 2 leads to real output to rise from y1 to y2 with some inflation as prices rise from p1 to p2
As full employment approaches with y2 to y3 export demand becomes inflationary rather than reflationary
Economy ends up at V on its LRAS curve
What is export led growth?
In the short run economic growth resulting from an increase in exports which is one of the components of AD
In the long run economic growth resulting from the growth and increased international competitiveness of exporting industries
What does export led growth do to this diagram
Shift LRAS to the right allowing for AD to increase with less inflation
Are current account deficits a problem?
Short run no
Long run: greater the size greater problem is likely to be (problem likely to be serious If deficit is caused by uncompetitiveness in a countries industries)
Short run-good
Long run-bad (lowers living standards)
In a poor country how can a current account deficit be justified?
Country’s need to import capital capital goods on a large scale to modernise the country’s infrastructure and promote economic development
Do current account budget surpluss cause problems?
-could be inflationary (demand pull inflation if economy is initially close to full capacity)
-one country’s surplus is another country’s deficit(deficit countries may be forced to import controls from which all countries including surplus countries)
What factors may influence a country’s current account balance.
Productivity: improving labour productivity is critical to supply side policy success to improve both price competitiveness and quality competitiveness of a country’s exports in international markets
Inflation: inflation relative to trading competitors (if it is higher exports lose price competitiveness which will deteriorate the current account balance (PEDs of exports and imports may also complicate things here)
Exchange rate: rising exchange rate in another country increases the overseas value of exports reducing their own price competitiveness (PEDs of exports and imports also relaxant
What are the 3 traditional ways to fix inflation?
Deflation (contractionary monetary policy
Expenditure reducing policy
Direct controls(import controls, tariffs quotas ect)
Expenditure reducing policy
Devaluation (lowering exchange rate)
Expenditure switching policies
What is an expenditure-reducing policy?
A gov policy aims to eliminate current account deficit by reducing demand for imports by reducing levels of AD in the economy
Conversely to reduce a current acc surplus AD would be needed to increased and spending on imports would rise
What is an expenditure-switching policy?
Gov policy which aims to reduce a current account deficit by switching domestic demand away from imports to domestically produced goods
Conversely to reduce a current account surplus, the policy would aim to switch domestic demand away from domestically produced goods towards imports
What are direct control?
Involve imposing quotas or even outright bans(embargos) on imports.
These direct cut or prevent expenditure on imports and as a result, people switch their spending from overseas to home-produced goods
Together with imports duties or tariffs, which make imports less price competitive, direct controls do not however the underlying cause current account deficit , namely the uncompetitiveness of a country goods and services
Because a country essentially gains a beggar neighbour advantage at the expense of other countries
What do free market economists believe about protectionism?
Reduces specialisation and causes world trade, world output and economic welfare to fall.
Because if this organisation such as EU and the World Trade organisation have reduced the freedom of individual countries to impose import controls unilaterally to improve their current accounts
If a country wants to reduce a budget account deficit it must choose 1 of these 3 methods…
Deflation ,devaluation or currency depreciation
What depends upon the PED of demands for exports and imports?
The effectiveness of a fall of the exchange rate in reducing the balance of payments deficit
What happens to the exchange rate when demand for exports and imports are price elastic
A fall in the exchange rate is likely to to reduce a current account deficit
Diagram for the effect of a devaluation of the pounds exchange rate on the current accounts of the UK balance of payments
Describe this diagram
On the import side (left), spending falls from area bounded p1 q1 to area q2 p2, higher import prices mean consumers switch to the now cheaper domestically produced substitutes
On the export side exports increase from area bounded p3 and Q3 to area bounded p4 and q4(overall current account improves assuming the demand for imports and exports are price elastic)
Why is the Marshall-Lerner condition needed what what does it say
Why is it needed?: difficult to see what will happen to the current account when demand for exports is inelastic but demand for imports is elastic
What does it say: when the sum of export and import price elasticities are greater than unity, a fall in exchange rate can reduce deficit and a rise in exchange rate can reduce a surplus
Diagram of the J curve effect
If imports and exports are both elastic and spare capacity exists in the economy what will happen to the balance of payments and why.
It will deteriorate because it takes time for demand to adjust to the changes in prices and firms within the country may be unable to increase supply after a fall in the exchange rate
In the short run the Marshall-Lerner condition may not hold because elasticities of demand are lower in the short run than in the long run
(Balance of payments may worsen before it improves, known as the J curve)
In the J curve effect why does the balance of payments initially become worse
The fall in the exchange rate may reduce confidence in the ides that changing the exchange rate is the most appropriate method for running a deficit in the current account deficit in he current account of the balance of payments
What is needed for long term improvements in the current account
(Short term deflation devaluation and direct controls)
Long term: successful supply side policies and supply side-improvements undertaken by FIRMS within the economy
What two conditions are needed for economy to deliver growth of exports
Quality competitive
Price competitive
What is export led growth been narrowly focused on?
How to best increase competitiveness of UK exports to achieve sustained economic growth
What are the two issues with consumption led growth
- Demand for imports causing a current account deficit
2, unsustainable and volatile
Main way to achieve export led growth
Investment-led growth
Diagram for reverse J curve
What are the 3 pickiest of reflation to decrease a budget surplus
-reflating demand via expansionary monetary policy or fiscal policy, increases a country’s demand for imports
-trade can be liberalised by removing import controls
-there have been calls on countries with larger payments surpluses (China) to revalue to reduce global payment imbalances
What are the two reason a large budget surplus is not desirable?
- Other Countries will have to run deficits to even out(has to balance) and have the negatives of a deficit
- Leads to Demand pull inflation
What is primary income balance?
Balance between income received on UK’s overseas investments and income paid to overseas investments on UK investments
Which country runs the largest current account deficit
USA
What policy protected a country’s own industry for others overseas (think USA)
Protectionism
Why would a Courtney run a current account deficit on purpose
Encourage a depreciation of its exchange rate
