2.5 Balance of Payments Flashcards
What are the components of the balance of payments? ( record of transactions conducted between residents of a country and the rest of the world)
Current account
Capital account
Financial account
Net errors and omissions
Explain balance of payments
A record of the transactions between residents of a country and the rest of the world
When money flows into the balance of payments it is known as a credit item
If it flows out it is known as a debit item.
How does the balance of payments affect economic performance?
Balance of payments should always balance eg UK has a current account deficit however it has a financial account surplus which counteracts it. The more integrated a country is in the global market, the greater impact the global transactions become on economic activity and performance.
What are the components of the current account ?( transactions in goods and services between residents of a country and rest of world)
Trade in goods = exports and imports of physical/ visible goods
Trade in services = exports and imports of invisible/ non tangible goods
Primary income = net income from investments abroad eg people working abroad or companies investing abroad
Secondary income = net transfers between governments and bilateral aid/ transfers to an international institution eg UK payments to EU and remittances and govt transfers of social security payments.
What does the capital account do?
Records all transfers and is the smallest of the three accounts in the UK’s balance of payments. Transfer of assets of migrants recorded here.
What does the financial account consist of?
Foreign direct investment= money flowing into the economy from investment from foreign firms. In the UK this is a positive net inflow.
Portfolio investment= inflow of money into equity markets or the purchase of property or other assets
Other investment = currency flows from banking. This is where hot money flows are recorded.
What is the policy objective of a sustainable balance of payments position?
As a country becomes more developed and standards of living rise it is not uncommon for a country’s current count to be in deficit. This is fine if there is a sufficient income flowing into the balance of payments.
Economists often measure a current account in % of GDP to better understand the sustainability of the payments position. This can then be used to indicate external imbalances and lack of international competitiveness
Current account deficits may need to be financed through borrowing from another country ( sometimes countries reluctant to finance deficit if a % of GDP.
Could be a rise in unemployment due to a lack of total factor productivity and relatively high factor input costs.
What imbalances on the balance of payments can occur?
UK has experienced an imbalance of payments for years because:
Loss of manufacturing due to a change to a services based economy. The no longer have a comparative manufacturing advantage and can’t compete with lower factor input costs in developing countries therefore leading to reduced demand for UK goods and a continued rise of deficit in the trade in goods.
High exchange rate has reduced the competitiveness of UK exports and discouraged UK consumers from purchasing domestic goods instead preferring cheaper imports
Strong domestic demand has led to a rise in demand for imported goods which has resulted in a greater deficit in the trade in goods.
What are the causes of imbalances on the balance of payment?
Changes in economic activity at home and abroad alter the trade in goods and services
Exchange rate influences the value of goods and services. The depreciation of exchange rate will cause the price of exports to rise and the price of imports to fall.
Economic shocks and rate of economic growth influences demand and supply of goods and services
Inflation affects the price competitiveness of domestically produced goods which influences international demand for exports and domestic demand for cheaper imports
International competitiveness - - rising labour costs can erode the competitiveness of domestically produced goods on the international market
What are the consequences of imbalance on the balance of payments?
Unemployment could rise - comparative advantage lost could lead to structural unemployment and if labour is immobile, long term unemployment or hysteresis effect could occur.
Aggregate demand will fall as international dimension of the aggregate demand function is diminished
In the short run, it may be possible to finance the trade deficit by selling UK financial assets overseas or borrowing from abroad
However:
Risk of British assets being lost due to;
How reliant country is on international trade
How flexible are domestic industries to be able to respond to an economic shock
The J curve effect suggests that a reduction in the value of a country’s currency will initially increase a current account deficit before reducing it
Marshall- Lerner conditions state that a devaluation or depreciation in the currency will only improve a current account position if the combined price elasticity of demand for exports and imports is greater than 1.
How can imbalance on the balance of payments be corrected?
Internal devaluation= expenditure reducing policy aiming to correct external imbalances by reducing the level of aggregate demand the price level and nominal wages. Usually done by raising taxes and interest rates and limiting govt expenditure.
Nominal wages may be reduced in the public sector which has little effect on the competitiveness of the tradable goods sector.
Large costs in terms of lower GDP and higher unemployment
Exchange rate devaluation may be better as it avoids costs by restoring competitiveness through lower export prices and higher import prices ( expenditure switching)
What are the problems with exchange rate devaluation compared to internal devaluation?
The PED of exports and imports is price inelastic.
J curve effect in short run
Marshall-Lerner condition not satisfied
External imbalances caused by a lack of non-price competition
Reduction in FDI
No impact on the root cause of external imbalances
