2.+4. Trade (X, M, and BoP)

Question 1

What accounts comprise the balance of payments (BoP)?

Answer 1

1. Current Account
   2.a. Capital Account
   2.b. Financial Account

(The capital and financial accounts are often considered together)

Question 2

What does the current account include?

Answer 2

All economic transactions between countries e.g. trade in goods and services (X+M), income and current transfers

Question 3

What are income transfers?

Answer 3

Net earnings on foreign investment as well as net cash transfers e.g. salaries and dividends

Question 4

What does the capital account include?

Answer 4

Transfers of the ownership of fixed assets

Question 5

What does the financial account include?

Answer 5

Investment e.g. direct investment, portfolio investment, and reserve assets

Question 6

Why might a government wish to achieve a stable balance of payments?

Answer 6

1. Financing a current account deficit can be difficult in the long run
2. To high a current account deficit increase reliance on other countries’ economic performance
3. An imbalance may indicate economic weaknesses or structural issues

Question 7

What might cause a current account deficit such as that seen in the UK?

Answer 7

1. Appreciation of the currency
2. Economic growth
3. Weak international competitiveness
4. Deindustrialisation

Question 8

What influences the capital and financial account balance?

Answer 8

Attractiveness to foreign investors

Question 9

Name some consequences of imbalances in the balance of payments

Answer 9

• 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

Question 10

Give an example of a fiscal policy measure to reduce a current account deficit

Answer 10

• Raise income taxes = reduce RDI = lower M
• Raise import VAT and customs duty

Question 11

Give an example of a monetary policy measure to reduce the current account deficit

Answer 11

Lowering interest rates = depreciation (hot money flows out) = WPIDEC = lower M + higher X

Question 12

Give an example of a supply-side policy measure to reduce the current account deficit

Answer 12

• 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

Question 13

What is a drawback of correcting a current account deficit using fiscal policy?

Answer 13

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

Question 14

What is a drawback of correcting a current account deficit using monetary policy?

Answer 14

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

Question 15

What is a drawback of correcting a current account deficit using supply-side policy?

Answer 15

Policies to aid domestic firms may incur retaliation from countries who see it as unfair protectionism. Deregulation may lead to monopolisation and reduced efficiency

Question 16

What is international trade?

Answer 16

The exchange of goods and services across international borders

Question 17

What is comparative advantage?

Answer 17

When one country can produce a given good or service at a lower opportunity cost than another country

Question 18

What is absolute advantage?

Answer 18

When one country can produce more of a given good or service than another country with the same given resources

Question 19

What does the theory of competitive advantage assume about the market?

Answer 19

That the market is perfectly competitive

Question 20

What does comparative advantage not consider?

Answer 20

The exchange rate when considering the cost of production in both countries

Question 21

What is a drawback of applying comparative advantage theory to the modern world economy?

Answer 21

The theory only considers two countries in isolation and the modern network of global trade is far more complex than this

Question 22

What are the advantages of international trade?

Answer 22

• 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

Question 23

What are the disadvantages of international trade?

Answer 23

• 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

Question 24

What is the nominal exchange rate?

Answer 24

The weight of one currency relative to another

Question 25

What is the real exchange rate?

Answer 25

The weight of one currency relative to another taking into account inflation

Question 26

What are the three types of exchange rate system?

Answer 26

1. Floating
2. Hybrid
3. Fixed

Question 27

What is a floating exchange rate?

Answer 27

An currency system where the value of the exchange rate is determined by the market forces of supply of and demand for that currency

Question 28

What is a hybrid exchange rate system?

Answer 28

A currency system that fixes an exchange rate around a certain value, but still allows fluctuations, usually within certain values

Question 29

What is a fixed exchange rate?

Answer 29

A currency system where the value of the exchange rate is pre-determined by the government or central bank

Question 30

What are the 4 measures of exchange rates?

Answer 30

1. Bilateral
2. Effective
3. Real
4. Nominal

Question 31

What is a bilateral exchange rate?

Answer 31

A market exchange rate between two currencies is bilateral - the value of one currency expressed in another currency

Question 32

What is an effective exchange rate?

Answer 32

An index measure of the relative strength of a nation’s currency in comparison with all those of the nations it trades with

Question 33

What is the difference between ‘depreciation and appreciation’ and ‘devaluation and revaluation’?

Answer 33

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

Question 34

What might cause a change in a free-floating exchange rate?

Answer 34

1. Inflation
2. Interest rates
3. International competitiveness
4. Government finances
5. Government intervention
6. Speculation
7. Balance of payments

Question 35

What is the Marshall-Lerner condition?

Answer 35

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

Question 36

What does a J-curve show?

Answer 36

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

Question 37

Give an advantage and disadvantage of a free-floating exchange rate system

Answer 37

:) 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

Question 38

Give an advantage and disadvantage of a fixed exchange rate system

Answer 38

:) 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

Question 39

Give an advantage and disadvantage of a hybrid exchange rate system

Answer 39

:) Makes fluctuations in the currency more predictable
:) Combines the benefits of fixed and free-floating

:( Makes monetary policy inflexible

Question 40

What is Purchasing Power Parity (PPP) Theory?

Answer 40

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

Question 41

What is the equation for a real exchange rate?

Answer 41

real exchange rate = (nominal exchange rate x domestic price) / foreign price.