4.1.7 Balance of Payments

Question 1

What balances are the current account made of?

Answer 1

(1) Net balance of trade in goods
(2) Net balance of trade in services
(3) Net primary income (includes interest, profits, dividends and migrant remittances)
(4) Net secondary income (includes transfers i.e. contributions to EU, military aid, overseas aid)

Question 2

What does the trade balance of goods involve?

Answer 2

o Manufactured goods, components, raw materials
o Energy products, capital technology

Question 3

What does the trade balance of services involve?

Answer 3

o Banking, Insurance, Consultancy
o Tourism, Transport, Logistics
o Shipping, Education, Health,
o Research, Arts

Question 4

What counts as Net Primary Income from Overseas Assets?

Answer 4

o Profits, interest and dividends from investments in other countries
o Net remittance flows from migrant workers living and working overseas

Question 5

What counts as net secondary income?

Answer 5

o Overseas aid / debt relief transfers
o Military grants
o UK Payments to the European Union (prior to the UK’s Brexit)

Question 6

What are items included in the capital account?

Answer 6

• Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts (example would be
  international buying and selling of land by businesses)
• Debt forgiveness/cancellation (forgiving debt is counted as a negative in this account)
• Capital transfers of ownership of fixed assets (i.e. international death duties)

Question 7

What is the financial account?

Answer 7

includes transactions that result in a change of ownership of financial assets and liabilities
between UK residents and non-residents

Question 8

What does the financial account include?

Answer 8

(1) Net balance of foreign direct investment flows (FDI)
(2) Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity)
(3) Balance of banking flows (e.g. hot money flowing in/out of banking system)
(4) Changes to the value of reserves of gold and foreign currency

Question 9

What is FDI?

Answer 9

• FDI is investment from one country into another (normally by companies rather than governments) that
  involves establishing operations or acquiring tangible assets, including stakes in other businesses

Question 10

Inward investment is a positive for the UK accounts, give some examples

Answer 10

• E.g. an overseas business decides to build a manufacturing factory in the UK
• A foreign retail firm invests to open new stores in the UK

Question 11

How does outward investment affect the balance of payments?

Answer 11

Outward investment is a negative for the UK financial account of the balance of payments

Question 12

Explain portfolio investment?

Answer 12

• Portfolio investment happens when people / businesses from one country buy shares or other securities such
  as bonds in other nations.
• For example:
  o A UK investor buys some shares in Google (this is a portfolio investment outflow for the UK accounts)
  o A German investment bank might buy some of the sovereign debt issued by the UK government
  (this counts as a portfolio investment inflow for the UK)

Question 13

What are current account deficits?

Answer 13

• It involves a net outflow of income from the economy’s circular flow
• Deficit countries need to run a financial account surplus to achieve balance on their external accounts
• This might be achieved for example by attracting inflows of financial capital (e.g. FDI) from other countries
• Current account deficit nations are debtor countries

Question 14

What are the key causes of a current account deficit?

Answer 14

• Poor price and non-price competitiveness
• Strong exchange rate affecting demand for exports and imports
• Recession in one or more major trade partner countries
  o Recession cuts value of exports to these countries
• Volatile global prices (e.g. soft and hard commodities)
• Strong domestic economic growth

Question 15

Explain how poor price/non price competitiveness causes a deficit

Answer 15

o Higher inflation than trading partners over a lengthy period of time
o Low levels of capital investment and research and development spending
o Weaknesses in design, branding and product performance – affecting non-price competitiveness

Question 16

Explain how a strong pound causes a deficit

Answer 16

o A high currency value increases the overseas prices of exports - leading to a fall in demand
o Appreciating currency also makes imports cheaper – leading to rising import demand from
consumers

Question 17

Explain how price volatility causes a deficit

Answer 17

o Exporters of primary commodities might be hit by a fall in global prices and a therefore direct fall in
the value of their export earnings
o Importing nations could be hit by higher world prices for oil and gas, raw materials
o If demand for imports is price inelastic (i.e. Ped< 1), then increased world prices will cause higher
spending on imports

Question 18

Explain how strong economic growth causes a deficit

Answer 18

o Rising demand for imported raw materials and component parts used by domestic industries
o Increased demand for and spending on imported capital equipment / new technologies
o Rising demand for luxury imported goods (i.e. products with a positive income elasticity of demand)

Question 19

What is a current account surplus?

Answer 19

A current account surplus means that there is a net injection of income into a country’s circular flow. Surplus nations
are also known as creditor countries and – other things being the same – a surplus will lead to an accumulation of
foreign exchange e.g. from rising export sales or an increase in net primary and secondary income.

Question 20

What are the structural causes of a current account deficit?

Answer 20

(1) Relatively low productivity / high unit labour costs
(2) Insufficient investment in capital which limits a nation’s export capacity
(3) Low levels of national saving
(4) Long term declines in the real prices of a country’s major exports

Question 21

What are consequences of a current account deficit?

Answer 21

1. A loss of aggregate demand if there is a trade deficit (M>X) causes weaker real GDP growth and might lead
   to reduced living standards and rising unemployment
2. Big current account deficits will usually cause the currency to depreciate, leading to higher cost-push inflation and a deterioration in the terms of trade
3. Some countries running current account deficits may choose to borrow to achieve a financial account surplus
   but this increase in external debt carries risks especially if interest rates rise
4. Unsustainable current account deficits can ultimately lead to a loss of investor consequence, leading to capital flight and a possible currency / balance of payments crisis

Question 22

What are expenditure switching policies designed to do and give examples?

Answer 22

These are policies designed to change the relative prices of exports and imports
Examples include:
* Depreciation of the Exchange rate
* Import tariffs
* Low rate of inflation (perhaps deflation)

Question 23

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

Answer 23

• Expenditure switching policies
• Expenditure reducing policies

Question 24

Explain what each expenditure switching policy does on a table with evaluation

Answer 24

Question 25

What do expenditure reducing policies do and give examples?

Answer 25

These are policies designed to lower real incomes and AD and thereby cut demand for imports
Examples include:
* Increase in income taxes
* Cuts in real level of G

Question 26

Explain what each expenditure reducing policy does on a table with evaluation

Answer 26

Question 27

Explain the J-Curve effect.

Answer 27

• In the short term, a currency depreciation may not improve the current account of the Balance of Payments
• This is because the price elasticities of demand for exports & imports are likely to be inelastic in the short term
• Initially the quantity of imports bought will remain steady in part because contracts for imported goods are
  already signed. Export demand will be inelastic in response to the exchange rate change as it takes time for
  export businesses to increase their sales following a fall in prices.
• Earnings from selling more exports may be insufficient to compensate for higher total spending on imports.
• The balance of trade may therefore initially worsen.

Question 28

What does the J Curve look like?

Answer 28

Question 29

What is the Marshall Lerner Condition?

Answer 29

Marshall Lerner condition states 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.

Question 30

What are global trade imbalances?

Answer 30

Persistent current account surpluses for some countries contrasted with deficits in other nations.

Question 31

How trade imbalances self correct in a freely-floating exchange rate system?

Answer 31

This is 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. However, imbalances often tend to persist, because a) not every country operates a freely-floating exchange rate and b) there may be structural reasons why some countries run persistent trade deficits or surpluses.

Question 32

What is the situation in deficit countries?

Answer 32

o Run up large external debts and are reliant on foreign capital
o May decide to switch towards using protectionist policies
o Deficits can lead to a fall in relative living standards over time if economic growth slows down

Question 33

What is the situation in surplus countries?

Answer 33

o Are saving more than they spend, thereby depressing global economic demand and growth
o May be adopting a policy to keep their currency deliberately under-valued
o 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