4.1 - Balance of payments Flashcards
theme 4
What is the balance of payments?
A set of accounts recording all transactions conducted between residents of that country and residents of all other countries.
> anything that gives rise to the flow of money across international boundaries is recorded in the balance of payments.
Transactions between residents of different countries involve activities such as…
- importing and exporting goods
- investments in financial assets
> eg: stocks, bonds, buying properties - investments in multinational corporations
- sending or receiving gifts
How are transactions recorded?
- Inflows of money from residents abroad are recorded as credits (+)
- Outflows of money to residents abroad are recorded as debits (-)
What do credits and debits represent in the UK?
- Credits
> inflows of money from abroad can only be made if foreigners buy pound sterlings (£)
> so, credits represent a foreign demand for £s - Debits
> outflows of money from the UK to foreigners can only be made if sell £s
> so, debits represent a selling of £s to buy foreign currency
What are the components of the balance of payments ?
1) Current account
2) Capital and financial accounts
What is the current account?
- Current account is where payments for the purchase of goods and services are recorded.
> inflows minus outflows in money terms
What does the current account record?
1) Visible balance of trade
= Exports (of country’s goods) - Imports (of country’s goods)
2) Invisible balance of trade
= Exports (of country’s services) - Imports (of country’s services)
3) Net primary income (investment)
= Inflows (of wages, rents, interest, profits from abroad) - Outflows (of wages, rents, interest, profits)
4) Net secondary income (tranfer)
= Inflows (such as gifts, foreign aid) into the country - Outflows (such as gifts, foreign aid) sent out of the country.
What are the capital and financial accounts ?
Where flows of money associated with saving, investment, speculation, currency stabilisation are recorded.
What is recorded in the capital account ?
1) Capital transfers
= Inflow (of debt forgiveness, investment grants) - Outflow (of debt forgiveness, investment grants)
2) Transfers of non-produced, non-financial assets
= Inflow (of natural resources that have not been produced, eg: land, mineral rights, forestry rights, water, fishing rights) - Outflow (of natural resources that have not been produced)
3) transfers recorded are those of immigrants and emigrants
> bringing financial capital into UK or taking it abroad
What does the financial account record ?
1) Foreign direct investment
= investments in physical capital (usually undertaken by multinational firms)
2) Portfolio investment
= includes flows of money to purchase foreign shares were this is less than 10% of the company
> shows investment in financial assets (savings, shares and bonds, derivatives)
3) Reserve assets
= Foreign currency reserves that the central bank can buy or sell to influence the value of the country’s currency in a fixed exchange rate system.
Countries can expect surpluses and deficits to occur in the short run because the current account is made up of millions of different transactions.
In the long term countries can be split into 3 groups…
1) Countries where the current account broadly is in balance
> France and Chile
2) Countries which run persistent current account surpluses
> Norway, China, Germany, Switzerland
3) Countries which run persistent current account deficits
> UK, US, Turkey, Poland, Australia
What are the causes of current account surpluses / deficits ?
1) productivity
2) value of countries currency/exchange rates
3) Inflation
4) economic growth
5) non price factors such as quality/design
6) natural resources
How do natural resources lead to current account surpluses?
- Some countries are abundant in natural resources relative to the size of their population
- This tends to cause current account surpluses because there is little pressure to use the money from their exported goods (eg: oil in Saudi Arabia) to fund imports.
How does poor reputation lead to current account deficit ?
- country develops a reputation for poor quality and design,
- its exports fall as foreign buyers look for better substitutes elsewhere
- Domestic buyers who are able to shop abroad also choose to buy better quality products elsewhere and the level of imports rise
- A fall in exports and a rise in imports worsens the balance on the current account
how does low productivity lead to a current account deficit
- Low productivity raises costs
- Exporting firms with low productivity may find themselves at a price and cost disadvantage in overseas markets which will decrease competitiveness and the level of exports
- With higher domestic prices, consumers may also buy abroad thus increasing the imports
- Falling exports and rising
imports creates a deficit
How does high inflation lead to a current account deficit
- A relatively high rate of inflation makes a country’s exports more expensive than other nations
- Foreign buyers look for substitute products which are priced lower
- Exports fall and the balance on the current account worsens
- Similarly, high inflation may mean that goods/services are cheaper in other countries
- Domestic consumers may switch demand to foreign goods and as imports rise, the balance on the current account worsens
How does a relatively low value of a countries currency lead a current account surplus?
- Currency depreciation makes a country’s exports cheaper relative to other nations making them more attractive
- Foreign buyers increase their demand for these exports
- Exports rise
- Similarly, currency depreciation makes imports more expensive
- Domestic consumers will demand less foreign goods and so imports decrease
- the balance on the current account worsens - surplus
How does rapid economic growth lead to a current account deficit?
- Rapid economic growth raises household income
- Households respond by purchasing goods/services with a high-income elasticity of demand (income elastic)
- Many of these goods are imported and as imports rise, the balance on the current account worsens - deficit
What are some measures to reduce a country’s imbalance on the current account?
- demand side policies
- supply side policies
- do nothing
- expenditure switching policies
Explain how demand side policies can reduce a country’s imbalance/deficit on the current account
- Contractionary monetary or fiscal policy can be used to reduce AD.
- This reduces discretionary income so reduces demand for imports.
- It should be effective since there is high income elasticity for
imports.
What is a cost of using contractionary demand side policies to balance out a current account deficit?
they are only short term and limit output of the economy, causing a reduction in
living standards and growth and employment
Explain how supply side policy’s can reduce a deficit on the current account…
- Improves the quality of product and lower the costs of production. Both of these factors help the level of exports to increase thus reducing the deficit
What is a cost of using supply side policies to balance out a deficit on the current account?
- These policies tend to be long term policies so the benefits may not be seen for some time.
- They usually involve government spending in the form of subsidies and this always carries an opportunity cost
- This will be politically unpopular
and will cause job losses in the short term. - because they focus resources on industries where there is a real comparative
advantage, accepting some industries should close.
What are examples of expenditure switching policies to reduce deficit on current account?
- protectionist policies
> Tariffs or quotas will reduce the attractiveness of imports. - devaluation/depreciation of the currency
> lowering value of domestic currency will make exports cheaper for foreign buyers and imports more expensive for domestic consumers
