4.14.3 - The Balance of Payments

Question 1

What is the balance of payments?

Answer 1

A record of all the currency flows into and out of a country in a particular time period.

Question 2

What is the current account?

Answer 2

Measures all the currency flows into and out of a country in a particular time period in payment for exports and imports of goods and services, together with primary and secondary income flows.

Question 3

What is the financial account?

Answer 3

The part of the BoP that records capital flows into and out of the economy.

Question 4

What is the balance of primary income?

Answer 4

Inward primary income flows comprising both inward-income flowing into the economy in the current year generated by UK-owned capital assets located overseas, and outward primary income flows comprising income flowing out of the economy in the current year generated by overseas-owned capital assets located in the UK.

Question 5

What is the balance of seconary income?

Answer 5

Current transfers, international aid and transfers between the UK and EU, flowing into or out of the UK economy in a particular year.

Question 6

What is the current account deficit and surplus?

Answer 6

Currency outflows in the current account exceed currency inflows and vice versa, respectively.

Question 7

Why does the UK run a trade deficit?

Answer 7

They consistently import more than they export.

Question 8

Why may the current account deficit cause an issue in the future?

Answer 8

If the UK is unable to finance their current account deficit due to investors losing confidence in the UK, then there will be a dramatic fall in living standards.

Question 9

What is the balance of trade in goods?

Answer 9

The section of the current account that measures payments for exports and imports of goods.

Question 10

What is the balance of trade in services?

Answer 10

Part of the current account which measures the difference between the payments for the exports of services and the payments for the imports of services.

Question 11

Where does the UK have a competitive advantage over many other countries?

Answer 11

Service-sector industries.

(Financial, insurance, ICT services etc.)

Question 12

What are primary income flows mostly made up of?

Answer 12

Investment income generated from profits, dividends and interest payments flowing between countries.

Question 13

How does profit income return to the UK?

Answer 13

Income generated from overseas investment flows back to the parent company and its UK shareholders.

The investment itself is an outward capital flow, but the income it generates is current income.

Question 14

Why does the UK have a negative secondary income balance?

Answer 14

• Net contributions to the EU budget
• Overseas aid
• Cost of maintaining armed forces (Afghanistan, Ukraine etc.)

Question 15

How do you make inward investment income?

Answer 15

Through outward capital flows.

Question 16

What does direct overseas investment mean?

Answer 16

The acquisition of real productive assets.

i.e. factories, oil refineries etc.

Question 17

What is foreign direct investment?

Answer 17

Investment in capital assets in a foreign country by a business with HQ in another country.

Question 18

What is portfolio investment?

Answer 18

The purchase of one country’s securities by the residents or financial institutions of another country.

Question 19

Why did portfolio investment fall after the credit crunch in 2007?

Answer 19

Many financial assets are known as ‘toxic assets’ and a potential purchaser of a package of financial assets could not know in advance whether assets were of high risk or not.

Question 20

How does ‘hot money’ move?

Answer 20

If the owners of funds believe the value of a currency to fall or rise, they can move money into that currency expecting short-term speculative gains.

Question 21

Why is ‘hot money’ an issue?

Answer 21

The large scale flows of money destabilises exchange rates as there is excess supply and demand between currencies which means the exchange rates are shifting to eliminate the excesses.

Question 22

Explain what happens when the graph moves from AD₁ to AD₂?

Answer 22

At point X, the economy is in deep recession.

Increasing AD causes real output to rise to Y₂ although at the cost of some inflation as the price level rises to P₂.

Question 23

Explain what happens when the graph moves beyond Y₃?

Answer 23

As you reach the LRAS curve, export demand becomes inflationary rather than reflationary and the price level will rise drastically.

Question 24

Why is the LRAS likely to shift right in the case of exports increasing?

Answer 24

If the foreign demand for exports was due to favourable supply-side conditions in the domestic economy, which means the LRAS curve will shift right as the productive capacity of the economy would have increased.

Question 25

What is export-led growth?

Answer 25

Short-run economic growth due to an increase in exports.

Question 26

Do current account deficits pose problems?

Answer 26

In the short-run, no.

In the long-run, it may suggest a fundamental disequilibrium in the economy which can lead to the decline of the country’s industries in the face of international competition.

Question 27

Do current account surpluses pose problems?

Answer 27

They can do.

• One country’s surplus is another’s deficit
• Surplus can be inflationary

Question 28

How does one country’s surplus being another’s deficit pose a problem?

Answer 28

On a global scale, the BoP is 0.

Unless countries with large surpluses reduce their surpluses, deficit countries cannot reduce their deficits. Those countries with deficits may then take protectionary measures from all countries. In an extreme scenario, a world recession could be triggered by the resulting collapse of world trade.

Question 29

How can a balance of payments surplus be inflationary?

Answer 29

As the balance of payments surplus is an injection of AD into the circular flow of income, the equilibrium level of nominal or money national income rises.

If the economy is already close to full capacity, demand-pull inflation results.

Question 30

What are the three factors that influnce the current account balance of a country?

Answer 30

• Productivity
• Inflation
• Exchange Rate

Question 31

How does inflation influence the current account balance of a country?

Answer 31

If the rate of inflation of a country relative to their trading partners is less, then exports become more price competitive and imports become more price competitive.

Question 32

What are the main policies to reduce a BoP deficit (in the short-run)?

Answer 32

• Deflation
• Direct Controls
• Devaluation

Question 33

How does deflation reduce the BoP deficit?

Answer 33

To achieve deflation, contractionary fiscal or monetary policy can be implemented, reducing the AD in an economy. As a result, the spending on imports is reduced.

Question 34

How do direct controls reduce the BoP deficit?

Answer 34

The imposition of quotas or embargoes on imports which directly cut or prevent expenditure on imports and, as a result, reduce the BoP deficit as people are forced to spend on domestic goods.

Question 35

How does devalutation reduce the BoP deficit?

Answer 35

Reducing the external value of the currency makes the prices of imports less price competitive so people are more likely to invest in domestic goods.

Question 36

Why are direct controls weakened in the world economy?

Answer 36

The WTO and other free trade organisations reduce the freedom of individual countries to impose import controls unilaterally to improve their current accounts.

Question 37

Why do price elasticities of demand for exports and imports have an effect on the effectiveness of a fall in the exchange rate?

Answer 37

If demand for both exports and imports are highly price elastic, a fall in the exchange rate is likely to reduce a current account deficit.

Following devaluation, the domestic price of imports will rise, while the overseas price of exports falls. As a result, UK residents spend less on imported goods due to the increase in their prices and overseas residents spend more on the UK’s exports.

Question 38

What is the Marshall-Lerner condition?

Answer 38

If the sum of the export and import price elasticities are greater than unity, then a fall in the exchange rate can reduce a deficit and a rise in the exchange rate can reduce a surplus.

PED_X +PED_M > 1

PED_X = Price Elasticity of Demand of Exports
PED_M = Price Elasticity of Demand of Imports

Question 39

Why does the Marshall-Lerner condition hold?

Answer 39

During currency depreciation, if the PED_X is inelastic and the price of exports are falling, so total revenue will fall and therefore total export revenue will fall. Alongside this, if the PED_M is inelastic and the price of imports are rising, therefore total import expenditure will rise.

If net exports are inelastic, then as prices fall, total revenue will also fall. This will worsen the current account deficit.

If the PED_X-M is inelastic, then the current account deficit will increase.

Question 40

What happens to the Marshall-Lerner condition in the short-run?

Answer 40

Demands tend to be inelastic in the short-run for both imports and exports as it takes time for consumers to adjust.

For this reason, the balance of payments will worsen before economic agents adjust their behaviours.

Question 41

What is the only way to improve a BoP in the long-run?

Answer 41

Appropriate and successful supply-side policies and supply-side improvements undertaken by firms within the economy.

Question 42

How can the UK ensure they increase their exports?

Answer 42

Improving:
* Price competitiveness
* Quality competitiveness

Question 43

What are the main issues with consumption-led growth?

Answer 43

• Much of consumer spending is on goods and services from other countries, so imports increase
• Unsustainable way to grow as speculative bubbles lead to collapses in AD and economic growth declines

Question 44

How can the government reduce a BoP surplus?

Answer 44

• Reflation
• Removal of import controls
• Revaluation