4.1.7 - balance of payments

Question 1

What is the balance of payments?

Answer 1

A record of all a country’s financial dealings with the rest of the world over the course of a year.

Question 2

What are the four parts of the BOP?

Answer 2

-current account
-capital account
-financial account
-international investment position

Question 3

What is the current account?

Answer 3

The CA records the transactions related to a country’s trade in goods and services, primary and secondary income.

Question 4

What are the three parts of the current account?

Answer 4

-balance of trade
-income
-current transfers

Question 5

What is the balance of trade (current account)?

Answer 5

The difference between the value of goods and services exported and the value of goods and services imported. Exports appear as a positive entry and imports are a negative entry.

Question 6

What is the income part (current account)?

Answer 6

Comprises income earned by domestic citizens who own assets overseas minus income earned by foreign citizens who own assets in the country, eg. profits, dividends and interest.

Question 7

What are current transfers (current account)?

Answer 7

Usually money transfers between central governments who lend and borrow money from each other or grants.

Question 8

What is a current account deficit?

Answer 8

Value of money leaving the country exceeds the value of money entering the country.

Question 9

What is a current account surplus?

Answer 9

The value of money entering the country exceeds the value of money leaving the country.

Question 10

What is the capital account?

Answer 10

Refers to transactions in fixed assets and is relatively small.

Question 11

What is the financial account?

Answer 11

Comprises transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities.

Question 12

What parts are included in the financial account?

Answer 12

-direct investment
-portfolio investment
-financial derivatives
-reserve assets

Question 13

What is direct investment (financial account)?

Answer 13

This relates to capital provided to or received from an enterprise, by an investor in another country, eg. FDI

Question 14

What is portfolio investment (financial account)?

Answer 14

This relates to any investments in equities and debt securities, eg. gilts, bonds, stocks, shares

Question 15

What are financial derivatives (financial account)?

Answer 15

These include any financial instrument where the price of which is based on the value of an underlying asset. This includes options (on currencies, interest rates, commodities, indices), traded financial futures, warrants and currency and interest swaps.

Question 16

What are reserve assets (financial account)?

Answer 16

These refer to foreign financial assets that are available to, and controlled by the monetary authorities eg. Bank of England, for financing or regulating payment imbalances. This includes monetary gold, Special Drawing Rights, reserve position in the IMF and foreign exchange held by the bank.

Question 17

What is the international investment position?

Answer 17

The balance sheet of the stock of external assets and liabilities.

Question 18

What are some causes of a current account deficit?

Answer 18

-low productivity
-high value of the country’s currency = appreciation
-high rate of inflation
-rapid economic growth resulting in increased imports
-non price factors eg. poor quality and design
-lack of research and innovation
-low capital investment
-fall in the value of imports

Question 19

What are some causes of a current account surplus?

Answer 19

-high productivity levels
-low value of the country’s currency = depreciation
-low rate of inflation
-slow economic growth/downturn resulting in decreased imports
-non price factors eg. high quality and design
-high research and innovation from domestic economy
-high capital investment
-rise in the value of imports

Question 20

What measures can be used to reduce a deficit on the current account?

Answer 20

-expenditure reducing
-expenditure switching
-supply side policies

Question 21

What is expenditure reducing?

Answer 21

Measures designed to lower incomes and reduce aggregate demand so that consumers spend less on imports

Question 22

What are some methods of expenditure reducing?

Answer 22

-higher direct taxes
-cuts in real government spending on welfare and public services
-increased interest rates to lower demand for credit and increase saving
-deflationary fiscal and monetary policies

Question 23

What is expenditure switching?

Answer 23

Use of protectionist measures to change the relative prices of exports and imports to encourage people to buy domestic goods rather than imports.

Question 24

What are some methods of expenditure switching?

Answer 24

-depreciation of the exchange rate = improved price competitiveness of exports and more expensive imports
-tariff on imports to make them more expensive than domestic g/s
-lower relative inflation = more price competitive imports

Question 25

What are the possible negative impacts of expenditure reducing/switching?

Answer 25

Expenditure reducing may lead to a decrease in spending on domestic goods, causing unemployment and reduced economic growth.
Expenditure switching may lead to retaliation, causing a fall in exports.

Question 26

How can supply side policies be used to reduce the current account deficit?

Answer 26

-spending on education and training = improved export quality
-infrastructure improvements eg. improved transport, telecoms, to increase supply-side capacity and productive efficiency
-incentive to promote enterprise and start-ups
-privatisation/deregulation = increased productivity and efficiency
-investment in education to improve human capital
-protected property rights to drive a faster rate of innovation
-tax incentives to attract FDI from companies who export goods and services

Question 27

Evaluation of supply side policies to reduce the current account deficit

Answer 27

They can incur an opportunity cost however they contribute positively to economic growth and can be anti-inflationary in the long run.

Question 28

Why can large and persistent deficits be a problem?

Answer 28

-there is need to finance increasing expenditure on imports, usually through foreign loans
-reduced AD due to negative net trade, fall in real output and slower GDP growth, leads to weaker investment and jobs, negative multiplier effect, depreciating exchange rate
-imbalances may lead to large currency fluctuations which have a destabilising impact on world trade

Question 29

Why can a large and persistent surplus be a problem?

Answer 29

-Resources are focused on producing to meet export demand rather than domestic demand, consumer choice and living standards may be low

Question 30

BOP disequilibrium in the context of the overall state of the economy

Answer 30

-There may be a large deficit in trade of goods but this is outweighed by a surplus in services. This may be a problem because the dependence on visible imports may have major effects on the future of manufacturing activity and employment in some regions.
-There may be a large deficit in trade in goods but this is normal when experiencing an economic boom. If a deficit exists during a recession this is more concerning as there shouldn’t be considerable purchases of imports
-The absolute level of a deficit is of less importance than its value in relationship to the overall level of national income - larger deficit to GDP ratio is more concerning
-If there is a large trade deficit, it is important to know what is imported. If they are raw materials, they are used for economic growth but finished consumer goods indicate weakness in manufacturing industries.
-A nation may have some finite resources giving it the ability to reach a current account surplus. Once this asset runs out, trading position may be very weak.
-A current account deficit may be covered by drawing on reserves or borrowing. Borrowing may require a high interest rate and reserves will eventually run out.