2.+4. Trade (X, M, and BoP) Flashcards
What accounts comprise the balance of payments (BoP)?
- Current Account
2.a. Capital Account
2.b. Financial Account
(The capital and financial accounts are often considered together)
What does the current account include?
All economic transactions between countries e.g. trade in goods and services (X+M), income and current transfers
What are income transfers?
Net earnings on foreign investment as well as net cash transfers e.g. salaries and dividends
What does the capital account include?
Transfers of the ownership of fixed assets
What does the financial account include?
Investment e.g. direct investment, portfolio investment, and reserve assets
Why might a government wish to achieve a stable balance of payments?
- Financing a current account deficit can be difficult in the long run
- To high a current account deficit increase reliance on other countries’ economic performance
- An imbalance may indicate economic weaknesses or structural issues
What might cause a current account deficit such as that seen in the UK?
- Appreciation of the currency
- Economic growth
- Weak international competitiveness
- Deindustrialisation
What influences the capital and financial account balance?
Attractiveness to foreign investors
Name some consequences of imbalances in the balance of payments
- Imported raw materials may become expensive causing cost-push inflation domestically
- International trade causes interdependency
- Surpluses and deficits may lead to limited long-term growth as growth is tied to the economic performance of other countries
- It may be difficult to attract sufficient financial flows to finance a current account deficit in the long-run
Give an example of a fiscal policy measure to reduce a current account deficit
- Raise income taxes = reduce RDI = lower M
- Raise import VAT and customs duty
Give an example of a monetary policy measure to reduce the current account deficit
Lowering interest rates = depreciation (hot money flows out) = WPIDEC = lower M + higher X
Give an example of a supply-side policy measure to reduce the current account deficit
- Increased spending on education and training = more internationally competitive = higher X
- Deregulation or privatisation = lower costs for firms = high output = higher X
- Subsidies for domestic firms
What is a drawback of correcting a current account deficit using fiscal policy?
Fiscal policy is effective in the short term, but less effective in the long term - households are likely to revert back to imports when policy measures end
What is a drawback of correcting a current account deficit using monetary policy?
It is hard to accurately change the supply of money or know in advance the effect of changing interest rates. There is also a significant time lag
What is a drawback of correcting a current account deficit using supply-side policy?
Policies to aid domestic firms may incur retaliation from countries who see it as unfair protectionism. Deregulation may lead to monopolisation and reduced efficiency
What is international trade?
The exchange of goods and services across international borders
What is comparative advantage?
When one country can produce a given good or service at a lower opportunity cost than another country
What is absolute advantage?
When one country can produce more of a given good or service than another country with the same given resources
What does the theory of competitive advantage assume about the market?
That the market is perfectly competitive
What does comparative advantage not consider?
The exchange rate when considering the cost of production in both countries
What is a drawback of applying comparative advantage theory to the modern world economy?
The theory only considers two countries in isolation and the modern network of global trade is far more complex than this
What are the advantages of international trade?
- Greater world output = greater consumption = higher economic welfare
- Higher quality products - focus on what nations are best at producing
- Greater variety of goods and services
- Greater competition = lower average costs
- More opportunities for economies of scale
What are the disadvantages of international trade?
- Unsustainable exploitation of scarce non-renewable resources
- Primary product dependency, or dependency on a single export
- Structural unemployment
- Some nations may become stuck in the production of a few goods restricting development
What is the nominal exchange rate?
The weight of one currency relative to another
What is the real exchange rate?
The weight of one currency relative to another taking into account inflation
What are the three types of exchange rate system?
- Floating
- Hybrid
- Fixed
What is a floating exchange rate?
An currency system where the value of the exchange rate is determined by the market forces of supply of and demand for that currency
What is a hybrid exchange rate system?
A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values
What is a fixed exchange rate?
A currency system where the value of the exchange rate is pre-determined by the government or central bank
What are the 4 measures of exchange rates?
- Bilateral
- Effective
- Real
- Nominal
What is a bilateral exchange rate?
A market exchange rate between two currencies is bilateral - the value of one currency expressed in another currency
What is an effective exchange rate?
An index measure of the relative strength of a nation’s currency in comparison with all those of the nations it trades with
What is the difference between ‘depreciation and appreciation’ and ‘devaluation and revaluation’?
Depreciation and appreciation occur when the value of a currency falls or rises in a floating exchange system. Devaluation and revaluation occur when the value of a currency is officially lowered or raised to a baseline in a fixed exchange system
What might cause a change in a free-floating exchange rate?
- Inflation
- Interest rates
- International competitiveness
- Government finances
- Government intervention
- Speculation
- Balance of payments
What is the Marshall-Lerner condition?
The Marshall-Lerner condition states that a depreciation only improves a current account deficit if the absolute sum of long run export and import demand elasticities is greater than or equal to 1
|PEDX| + |PEDM| ≥ 1
What does a J-curve show?
When a currency first depreciates, the current account actually worsens as imports become more expensive. In the long run, exporting is cheaper and so the volume of exports rises. Consumers also have more time to switch from imports to domestic goods, both improving the deficit
Give an advantage and disadvantage of a free-floating exchange rate system
:) Automatically adjusts to economic shocks
:) Gives monetary policy more freedom to focus on other macroeconomic objectives
:( Fluctuations in price are unpredictable making investment harder to plan
:( Can adversely affect exports and imports causing unemployment
:( More vulnerable to speculation
Give an advantage and disadvantage of a fixed exchange rate system
:) Allows firms to plan investment
:) Gives monetary policy a focused target
:( Government failure
:( Balance of payments does not automatically adjust to economic shocks
:( Can be costly and difficult to maintain. Requires large foreign currency reserves
Give an advantage and disadvantage of a hybrid exchange rate system
:) Makes fluctuations in the currency more predictable
:) Combines the benefits of fixed and free-floating
:( Makes monetary policy inflexible
What is Purchasing Power Parity (PPP) Theory?
The idea that goods in one country will cost the same in another country, once their exchange rate is applied. It estimates how much the exchange rate must be adjusted to make exchange equivalent
What is the equation for a real exchange rate?
real exchange rate = (nominal exchange rate x domestic price) / foreign price.
