4.1.7 Balance of Payments Flashcards
What balances are the current account made of?
(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)
What does the trade balance of goods involve?
o Manufactured goods, components, raw materials
o Energy products, capital technology
What does the trade balance of services involve?
o Banking, Insurance, Consultancy
o Tourism, Transport, Logistics
o Shipping, Education, Health,
o Research, Arts
What counts as Net Primary Income from Overseas Assets?
o Profits, interest and dividends from investments in other countries
o Net remittance flows from migrant workers living and working overseas
What counts as net secondary income?
o Overseas aid / debt relief transfers
o Military grants
o UK Payments to the European Union (prior to the UK’s Brexit)
What are items included in the capital account?
- 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)
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?
(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
What is FDI?
- 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
Inward investment is a positive for the UK accounts, give some examples
- 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
How does outward investment affect the balance of payments?
Outward investment is a negative for the UK financial account of the balance of payments
Explain portfolio investment?
- 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)
What are current account deficits?
- 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
What are the key causes of a current account deficit?
- 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
Explain how poor price/non price competitiveness causes a deficit
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
Explain how a strong pound causes a deficit
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
Explain how price volatility causes a deficit
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
Explain how strong economic growth causes a deficit
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)
What is a current account surplus?
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.
What are the structural causes of a current account deficit?
(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
What are consequences of a current account deficit?
- 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 - 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
- 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 - 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
What are expenditure switching policies designed to do and give examples?
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)
Measures to reduce a country’s imbalance on the current account
- Expenditure switching policies
- Expenditure reducing policies
Explain what each expenditure switching policy does on a table with evaluation
