4.1.7. Balance of Payments

Question 1

What is the Balance of Payments?

Answer 1

For a country it is a record of all the financial transactions that occur between it and the rest of the world

Question 2

What are the two main sections of the Balance of Payments?

Answer 2

1. Current Account
2. Financial and Capital Account

Question 3

What is the current account?

Answer 3

All transactions related to the goods/ services along with payments related to transfer of income. (Money coming in and going out)

Question 4

What section of the balance of payments is seen as the most important? Why?

Answer 4

The current account as it records the net income that an economy gains from international transactions

Question 5

What is the capital account?

Answer 5

Records small capital flows between countries and is relatively inconsequential

Question 6

What is the financial account?

Answer 6

Records the flow of all transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities.
It includes:
-FDI
-Portfolio Investment
-Financial derivatives
-Reserve Assets

Question 7

What are assets and liabilities?

Answer 7

Assets- Any resource/good that can provide future economics benefits e.g. property, shares, paintings etc..

Liabilities- A debt that has to be repaid

Question 8

What is Foreign Direct Investment (FDI)?

Answer 8

Flows of money to purchase a controlling interest (10% or more) in a foreign firm

Question 9

What is portfolio investment?

Answer 9

Flows of money to purchase foreign company shares and debt securities (gov bonds)

Question 10

What are financial Derivatives?

Answer 10

Sophisticated financial instruments which investors use to speculate and return a profit

Question 11

What are reserve assets?

Answer 11

Assets controlled by the Central Bank and available for use in achieving the goals of monetary policy

Question 12

What is monetary policy?

Answer 12

Adjustment of interest rates and the money supply so as to influence AD and meet the inflation target

Question 13

Why is BofP called the BALANCE of payments?

Answer 13

This is because the current account should balance with the capital and financial account and be equal to zero

Question 14

If there is a BofP and the Current Account balance is positive what would the financial/ capital count balance be?

Answer 14

Negative

Question 15

What does it mean if there is a current account deficit?

Answer 15

Must be a surplus in the capital and financial account. Imports> Exports

Question 16

What does it mean if there is a current account surplus?

Answer 16

Must be a deficit in the capital and financial account. Exports> Imports

Question 17

What are causes of current account deficits?

Answer 17

1. Relatively low productivity- Low productivity raises costs and so with higher domestic prices more consumers buy abroad increasing imports
   2.High value of country’s currency- Currency appreciation makes exports more expensive relative to other nations and so foreign buyers look for substitute products price lower. Also makes imports cheaper
2. Rapid economic growth- Raises household income and purchase income elastic products which many are imported
3. Poor quality and design- exports fall if reputation for poor quality and design. Buyers look for better substitutes elsewhere
4. High rate of inflation-Makes exports more expensive and they look for substitutes lower priced

Question 18

What are ways to reduce imbalances in the current account?

Answer 18

-Do nothing and leave to market forces to self-correct the deficit
-Expenditure switching policies
-Expenditure reducing policies
-Supply-side policies

Question 19

What are the costs and benefits of doing nothing to tackle current account deficit?

Answer 19

Costs:
-External factors can prevent currency from depreciating
-May take long time for self-correction which can cause many domestic industries to go out of business
-Longer it takes to self-correct the more firms will delay investment in the economy

Benefits:
-Floating exchange rates act as self-correcting mechanism

Question 20

What are expenditure switching policies?

Answer 20

Involves the use of protectionism or a devaluation of the currency under a fixed exchange rate mechanism. (Gov actions to get people to buy fewer imports and buy more domestic goods instead) (“switching” spending from foreign goods to local goods)

Question 21

What are the costs and benefits of expenditure switching policies to tackle current account deficit?

Answer 21

Costs:
-Protectionist policies can lead to retaliation by trading partners

Benefits:
-Often successful in changing buying habits of consumers

Question 22

What are expenditure reducing policies?

Answer 22

Measures designed to reduce AD such as deflationary fiscal policy. (Gov actions to make people spend less overall as they will buy fewer imports and help fix current account deficit)

Question 23

What are the costs and benefits of expenditure reducing policies to tackle current account deficit?

Answer 23

Costs:
-Deflationary fiscal policy also dampens domestic demand which can cause output to fall
-When output falls GDP growth slows and unemployment may increase

Benefits:
-Deflationary fiscal policy reduces discretionary income which leads to fall in demand for imported goods

Question 24

What is Deflationary fiscal policy?

Answer 24

Occurs when the government raises taxes, decreases gov spending or both

Question 25

What is discretionary income?

Answer 25

Income that remains after taxes and necessity purchases are account for

Question 26

How is discretionary income different to disposable income?

Answer 26

Disposable income= Money you have left after taxes. You use it to pay rent/ mortage, buy food, cover bills Discretionary income= What's left after taxes and basic living expenses (rent, food, bills etcc..). You use it for going out to eat, vacations, hobbies, entertainment and non-essential stuff

Question 27

What are supply-side policies?

Answer 27

Policies aimed to improve the quantity/quality of the factors of production thereby raising the potential output. (Gov actions aimed at making it easier and cheaper to produce goods to help economy produce more. Boost supply of economic= more jobs, lower prices and faster growth)

Question 28

What are the costs and benefits of supply-side policies to tackle current account deficit?

Answer 28

Costs: -Tend to be long-term policies so benefits may not be for some time -Usually involve gov spending in form of subsidies which carries and opportunity cost (focusing on something else and sacrificing another thing) Benefits: -Improves quality of products and lowers costs of production

Question 29

Are persistent current account deficits a good or bad thing?

Answer 29

Bad, because it means finance from abroad (loans or FDI) is required in order to fund continued imports. This may mean the country is gradually selling its assets and owing money to foreign entities can create vulnerabilities.

Question 30

Are persistent current account surpluses a good or bad thing?

Answer 30

Bad, Means the focus of the allocation of a nation's resources is on meeting foreign demand as opposed to meeting domestic demand. This can limit availability in local economy of goods/services.