3. The International Economy - Balance of Payments

Question 1

What is the balance of payments (BoP)?

Answer 1

This is a record of all the financial transactions of a country with other countries - keeps a record of all flows of money in and out of a country.

Question 2

What is the BoP made up of?

Answer 2

Its made up of three parts;
The current account
The capital account
The financial account

Question 3

What is the current account made up of?

Answer 3

Its made up of four parts;
Visible Trade - goods (e.g. televisions)
Invisible Trade - services (e.g. banking)
Primary Net Income - investment and employment in/outflows (e.g. foreign business in UK deposits in foreign bank account)
Secondary Net Income - transfers (e.g. aid payments)

Question 4

How do you find the current account balance?

Answer 4

You simply add up all the inflows and outflows for the economy across all four sections, then subtract outflows from inflows.

Question 5

What exists when the current account balance is negative?

Answer 5

A trade deficit

Question 6

What exists when the current account balance is positive?

Answer 6

A trade surplus

Question 7

What is the capital account made up of?

Answer 7

Its made up of two parts;
Direct Investment Flows - physical investments (e.g. factories)
Portfolio Investment Flows - financial investments (e.g. stocks, shares etc.)

Question 8

Why must the current and capital accounts balance?

Answer 8

If a country runs a trade deficit on its current account it must run an equally large surplus on its capital account. An economy can’t sustainably spend more than it brings in so it must balance.

Question 9

What is the financial account made up of?

Answer 9

A record of all transactions for financial investment, it’s made up of three parts;
Direct investment. This is net investment from abroad.
Portfolio investment. These are financial flows, such as the purchase of bonds, gilts or saving in banks.
Short-term monetary flows known as “hot money flows” to take advantage of exchange rate changes, e.g. foreign investor saving money in a UK bank to take advantage of better interest rates.
The Capital account is a subdivision of the financial account and makes up the majority of the financial account.

Question 10

What factors influence a country’s current account?

Answer 10

1. Consumer Spending (depending on the MPI)
2. Productivity, effecting international competitiveness of products
3. The exchange rate - SPICED & WIDEC
4. Structure of the economy - deindustrialization of manufacturing may harm exports
5. Levels of investment - both at home and abroad
6. Government spending - domestic policies and foreign aid

Question 11

Is the BoP self-correcting?

Answer 11

When there is a trade deficit M>X everyone is buying imports, in order to do this people must be selling £s, in the FOREX market this causes the £ to depreciate, as the £ depreciates WIDEC comes into play causing imports to fall and exports to rise hereby fixing the BoP. However, trade isn’t the only thing driving the ER , speculation or hot money flows may prevent the £ weakening so the BoP can’t correct.

Question 12

What policies can be used to address a BoP deficit or surplus?

Answer 12

There are three types of policies used to deal with trade deficits/surpluses;
Expenditure Switching policies
Expenditure Reducing policies
Supply-side policies

Question 13

What are expenditure switching policies?

Answer 13

These are policies that change the relative prices of X & M to reduce deficits or surpluses.

1. Introduce protectionist policies - tariffs
2. Change the value of your currency
3. Change the level of your inflation

Question 14

What are expenditure reducing policies?

Answer 14

These are policies that control demand and limit spending on imports while encouraging saving in the private sector.

1. Increase Interest Rates
2. Fiscal Constraint

Question 15

What are supply-side policies?

Answer 15

These are policies that aim to boost international competitiveness of exports, they’re part of a long-term strategy.

1. Policies to encourage business start-ups – successful small businesses with export potential.
2. Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance, medicine.
3. Investment in modern critical infrastructure to support businesses and industries involved in international markets.

Question 16

What possible other consequences may policies to deal with budget deficits/surpluses have?

Answer 16

Expenditure Switching Policies - Protectionist Policies may lead to retaliation, reduced economic growth, reduced employment but also reduced inflation.
Expenditure Reducing Policies - Increased interest rates may lead to reduced economic growth, reduced employment and inflation.
Supply-side policies - education/training, this is likely to take a while to come into affect but when it does it will have positive implications for growth, employment, inflation and the BoP. This is the best strategy to use overall.

Question 17

What are the possible impacts of a budget deficit if left unaddressed?

Answer 17

A budget deficit means we’re importing more than we’re exporting, this is going to reduce AD. On a graph this will show;

1. Reduced Economic Growth
2. Reduced Employment
3. Reduced Inflation
4. A stronger balance of payments - only bc of MPI and inelastic imports will continue

Question 18

What are the global implications of an economy adopting corrective policies to deal with BoP deficits/surpluses?

Answer 18

If a major economy suffers from reduced AD and the associated issues after using a policy to deal with a budget deficit.
Nations they trade with will lose out as will those that receive aid from it, nations may gain from migration of skilled workers elsewhere but they may lose out as there inflation becomes relatively higher so there exports are less competitive - worsening there BoP.