4.1.7 Balance Of Payments

Question 1

Components of the balance of payments

Answer 1

1) Current account
2) Capital account
3) Financial account

Question 2

Balance of payments

Answer 2

A country who participates in foreign trade will be sending and receiving money from other countries and they keep track of these transactions in a balance sheet, called the balance of payments.
- The balance of payments shows all flows into and out of the country and since total inflows must equal total outflows, the balance of payments must balance.
- If there is a recorded deficit or surplus, this is a balancing item, all the transactions that fail to be recorded by the statisticians.

Question 3

The current account

Answer 3

The current account itself is split into different parts: trade in goods, trade in services and income and current transfers.

Question 4

The Capital and Financial accounts

Answer 4

• The capital account is relatively unimportant as it mainly records transfers of immigrants and emigrants taking money abroad or bringing to the UK, or government transfers such as debt forgiveness to Third World countries.
• The financial account is more important and is split into three main parts: foreign direct investment (FDI), portfolio investment and other investments.
• Foreign direct investment is the flow of money to purchase part of a foreign firm (10% of more of the ordinary shares) e.g. BT buying a 15% share in a telecommunications company in Brazil.
• Portfolio investments are the same thing but where they buy less than 10% of the company. Other investments include loans, purchasing of currency and bank deposits.

Question 5

Causes of deficits and surpluses examples

Answer 5

There can be deficits and surpluses on particular part of the accounts; a country can run a deficit on the current account if they are able to have a surplus on the capital account.
France and Chile tend to have a current account balance, China and Germany tend to have a current account surplus and Britain and the USA tend to have a current account

Question 6

Short-term causes of deficits/surpluses on the current account

Answer 6

• It can be caused by high levels of consumer demand. If real household spending grows more quickly than the supply side of the economy can deliver, the only way of meeting this demand is by importing those goods and services. High incomes in a country lead to high imports but have no effect on the level of exports.
• Moreover, it can be caused by a strong exchange rate which reduces the UK price of imports and leads to an expenditure-switching effect away from domestically produced output. The high value of the pound improves the terms of trade between the UK and other countries, allowing us to buy and consume more imports with each pound. It increases the price of exports and so leads to a fall in the value of exports. This assumes that PED is inelastic.
• A high level of relative inflation will decrease exports since it will increase their price compared to goods produced by other countries.

Question 7

Medium-term causes of deficits/surpluses on the current account

Answer 7

• As a country loses its comparative advantage, people will transfer their purchases to other countries and the UK will need to switch resources to production of other things.
• Similarly, the growth of cheap imports from countries like China has caused a substitution effect.

Question 8

Long-term causes of deficits/surpluses on current account

Answer 8

Much of the UK’s trade deficit is due to structural rather than cyclical factors, due to supply side deficiencies.
- A lack of capital investment means firms use older and more out of date technology. This contributes to a lack of productivity. Germany has 35% higher productivity per hour worked than the UK. In the UK, productivity is only growing at 1%.
- Deindustrialisation in the UK has led to a decrease in the relative importance of industry and manufacturing in the economy. This makes it more difficult to export, since services are harder to export.
- Countries with a large amount of natural resources tend to export more, and if they also have a small population (e.g. Saudi Arabia) then they tend to have a current account surplus.
- Some countries are more competitive than others, for example high labour productivity or a reputation for high quality.
- Countries with corruption and where it is difficult to set up a business tend to find it difficult to export

Question 9

Main current account issues for UK

Answer 9

In the context of the UK, the main issues are low levels of investment, the impact of the banking crisis on preventing borrowing, low innovation, skills shortages, inefficient monopolies and underperforming businesses and poor infrastructure.

Question 10

Measures to reduce a country’s imbalance on the current account

Answer 10

There are two main causes of deficit: demand side issues and supply side issues. This means there are two main ways to fix it: demand and supply side policies.
- These are much longer-term solutions but will solve the balance of payment issues in the long term rather than temporarily as with aggregate demand.
Expenditure-switching policies can also be used.

Question 11

Demand-side policies

Answer 11

Monetary or fiscal policy can be used to reduce AD. This reduces income so reduces demand for imports. It should be effective since there is high income elasticity for imports.
- However, they are only short term and limit output of the economy, causing a reduction in living standards and growth.

Question 12

Monetary policy

Answer 12

Monetary policy is used by the government to control the money flow of the economy. This is done with interest rates and quantitative easing. This is conducted by the Bank of England, which is independent from the government.
- Interest rates
- Quantitative Easing QE

Question 13

Fiscal policy

Answer 13

Fiscal policy uses government spending and revenues from taxation to influence AD. This is conducted by the government.
- Government spending
- Taxation

Question 14

Supply-side policies

Answer 14

• They could also use a range of measures to improve productivity and efficiency or improve quality. This could include competition policy, improving labour or improving infrastructure.
• They can seek and encourage industries to exploit opportunities in export market overseas and focus resources on industries where the UK has a real comparative advantage, accepting some industries should close. This will be politically unpopular and will cause job losses in the short term.

Question 15

Expenditure switching policies

Answer 15

Cannot solve long-term causes of a deficit
- Tariffs or quotas
- Controlling inflation
- Value the pound

Question 16

Tariffs or quotas

Answer 16

Tariffs or quotas will reduce the attractiveness of imports. However, they are likely to cause trade wars as other countries implement protectionist policies and so therefore may even worsen the deficit. These are almost impossible to implement, given trading blocs and the laws of the WTO.

Question 17

Controlling inflation

Answer 17

They could attempt to control inflation which will mean that the price of British goods rises slower than those in other countries, meaning that they become more competitive over time. The problem is that it will lead to a fall in demand for domestic goods and so therefore could cause unemployment and a fall in growth.

Question 18

Value of pound

Answer 18

They could also devalue/depreciate the pound as this will makes exports cheaper and imports dearer. However, this will not always work. (Marshall-Lerner and J-Curve). It is not feasible for many countries as they have a floating exchange rate and so central banks intervening in the market will only nudge the exchange rate for a short period of time. The best way to affect the value of the currency is by changing the interest rate, but this has effects on AD and so may not have the intended effect.

Question 19

Significance of global trade imbalances

Answer 19

• Could argue a current account imbalance is not much of a problem as long as the capital and financial account is in surplus. However, the financial crisis of 2008 dramatically reduced the amount of capital flowing around the global economy and showed how quickly the position of the capital account can change. The uncertainty around Brexit increased the concern about the balance of payments due to fears over the response of the financial markets.
• Since the late 1990s, there have been concerns about global imbalances which can be measured in two ways: imbalances on the current account and imbalances in assets owned abroad or borrowing owned abroad. The two are linked since if a country has a constant surplus, then it will tend to build up a stock of assets abroad whilst if they have a constant deficit, they will owe more and more to foreign creditors. This may become an issue if imbalances are large.
• Today, deficits are less of a concern to countries: the US and UK have no problem financing their deficits and borrowing has not built up unsustainable debts.