4.1.7 Balance of Payments Flashcards
The current account of a nation’s balance of payments is made up of 4 separate balances
What are they
- Net balance of trade in goods
- Net balance of trade in services
- Net Primary income
- Net Secondary Income
What is included in the trade balance in goods
Manufactured goods/Components/raw materials
Energy products/Capital Technology
What is included in the trade balance of services
Banking, Insurance, Consultancy
Tourism, transport, logistics
Shipping, Education, Health
Research, Arts
What is included in the Net Primary Income
Profits, interest and dividends from investments in other countries
Net remittance flows from migrant workers and working overseas
What is included in Net Secondary Income
Overseas aid/debt relief transfers
Military grants
UK payments to EU (prior to Brexit lol)
The Capital account of the balance of payments is a small element or it
What are the main items included
- Sale/transfer of patents, copyrights, franchises (or internationally buying/selling land)
- Debt cancellations (counted as a negative)
- Capital transfers of ownership of fixed assets
What is the Financial Account
includes transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-residents
What does the financial account include
- Net balance of FDI flows
- Net balance of portfolio investment flows (assets that is purchased in the expectation that it will earn a return or grow in value)
- Balances of banking flows (hot money)
- Changes to values of reserves of gold + foreign currency
What is Foreign direct investment
is investment from one country into another
Could involve establishing operations/acquiring tangible assets/stakes in other businesses
Explain a portfolio investment flow
happens when businesses from one country buy shares or other securities such as bonds in other nations
A UK investor buys some shares in Google - this is a portfolio investment outflow for the UK accounts
What was the current account deficit as of 2018
What was this as a % of GDP
£82 Billion
3.9% of GDP
What is a current account deficit
How would a country with a deficit achieve balance on their external accounts
It involves a net outflow from the economy’s circular flow
Deficit countries need to run a financial account surplus to achieve balance on their external payments
They are debtor countries
Briefly list the reasons for a current account deficit
- Poor price and non-price competitiveness
- Strong exchange rate affecting demand for exports and imports
- Reccession in one or more or major trade partner country
- Volatile global prices
- Strong domestic economic growth
Explain how poor price and non-price competitiveness can lead to a current account deficit
- Higher inflation than trading partners over an extended period of time
- Low levels of capital investment and research and development spending
- Weakness in design, branding and product performance
Explain how a strong exchange rate affecting demand for imports can cause a current account deficit
A high currency value increases the overseas prices of export - fall in demand
Appreciating currency also makes imports cheaper - increased import demand
Explain why a recession in one or more major trading partners countries would lead to a current account deficit
recession cuts value of exports to these countries
Explain why volatile global prices can lead to a current account deficit
- Exporters of primary commodities might be hit by a fall in global prices and a therefore direct fall in the value of their expert earnings
- Importing nations could be hit by higher would prices for oil/gas/raw materials
- if demand for imports is price inelastic, then increased world prices will cause higher spending on imports
Explain why a strong domestic economic growth can also be a cause of a widening current account deficit
- Rising demand for imported raw materials and component parts used by domestic industries
- Increased demand for and spending on imported capital equipment/new technology
- Rising demand for luxury imported goods (positive YED)
Would could be some structural causes of a current account deficit
- Relatively low productivity/high unit labour costs
- Insufficient investment in capital which limits a nation’s export capacity
- Low levels of national savings
- Long term declines in real prices of a country’s major exports
What could be 4 possible consequences for a current account deficit
- loss of aggregate demand if there is a trade deficit (M>X) causing weaker real GDP growth and might lead to reduced living standards/rising unemployment
- cause the currency to depreciate, leading to higher cost-push inflation and a deterioration in the terms of trade
- Some countries running current account deficits may borrow to achieve a financial account surplus but this increase in external debt carries risks if interest rates rise
- lead to a loss of investment, leading to capital flight and a possible currency/balance of payments crisis
What is a current account surplus
means that there is a net injection of income into a country’s circular flow
These nations are creditor countries
What are the main causes of a current account surplus
- Large propensity to save and invest
- Large gap between export/import values, when the net income balance and net transfers are small
- Export surplus due to high world prices like oil/gas
- Deficit on financial account - FDI coming from revenue from exports
- Strong exchange rate as a result
What are expenditure switching policies
Policies designed to change the relative prices of exports and imports
Like import tariff - cause consumers to switch to domestic consumers
What are expenditure reducing policies
These are policies designed to lower real income and AD and thereby cut demand for imports
E.g. higher direct taxes, cuts in gov spending
List 3 types of expenditure switching policies
- Depreciation of the exchnage rate
- Import tariffs
- Low rate of inflation (perhaps deflation)
Explain depreciation of the exchange rate as an Expenditure switching policy
However, highlight a problem with it
Reduces relative price of exports and makes imports more expensive
However, risk of cost-push inflation - erodes competitive boost + fall in real income
Explain import tariff, as an Expenditure switching policy
However, also explain the problems with it
Increases the price of imports and makes domestic output more price competitive
However, risk of retaliation from other countries
Explain low rate of inflation, as an Expenditure switching policy
Keeps general price level under control and makes exports more competitive
However, risks from deflation as a way of achieving internal devaluation
List 2 types of expenditure reducing policy
- Increase in income taxes
- Cuts in real level of government spending
Explain increasing income taxes, as an expenditure reducing policy
However, explain the problems with this
reduces real disposable income causing falling demand for imports
however, cut in living standards and risk of damage to work incentives in labour market
Explain cuts in real level of government spending, as a form of Expenditure reducing policy
However, explain the problems with this
Lowers aggregate demand, firms may look to export their spare capacity
However, damage to short term economic growth, risk that austerity hits investment
What other methods could the Government use to increase price competitiveness and exports
Supply-side policies
These can increase output and reduce domestic price levels
Can lead to more innovation, making exports more desirable
What is the J Curve Effect
shows the possible time lags between a falling currency and an improved trade balance
Explain the shape of the J-Curve
- In short term - currency depreciation may not improve current account BoP
- This is because the price elasticities of demand for export/imports is likely to be inelastic in short term
- Initially, quantity bought will remain steady in part because contracts for imported goods are already signed. Exporting businesses will take time to increase sales following price drop
- Earings from selling more imports may not be equal to higher total spending on imports
- Balance of trade hence will worsen
What does the Marshall Lerner Condition state
that a depreciation/devaluation of the exchange rate will lead to a net improvement
in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1 (elastic)
What are global trade imbalances
Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations
imbalances often tend to persist, because:
a) not every country operates a freely-floating exchange rate
b) there may be structural reasons why some countries run persistent trade deficits or surpluses.
How could floating exchange rates be self correcting
It suggests that in a floating exchange, trade imbalances rate system will self-correct because if,
say, a country has a trade deficit, then demand for exports will be low which in turn causes reduced demand for the currency.
This leads to a depreciation of the currency, thus making exports more price competitive and stimulating demand for them.
Why might a trade deficit be a problem
- Run up large external debts and are reliant on foreign capital
- May decide to switch towards using protectionist policies
- Deficits can lead to a fall in relative living standards over time if economic growth slows down
Why might trade surpluses be a problem
- Are saving more than they spend, thereby depressing global economic demand and growth
- May be adopting a policy to keep their currency deliberately under-valued
- Might be under-consuming (thus affecting living standards) and allocating domestic scarce resources to exporting overseas rather than allowing higher levels of domestic consumer spending
