4.1.7 Balance of Payments

Question 1

What is the balance of payments?

Answer 1

BoP is a record of transactions between one country and the world. It contains the current account and capital and financial account.

Bop must always add up to 0, so a current account deficit will mean a capital and financial account surplus and vice versa

Question 2

What is the current account made up of?

Answer 2

• Trade in goods and services (the trade balance): measures inflow and outflow of money exchanged for goods and services
• Primary income (investment income e.g. dividends, rent): income received by UK investors from abroad is positive, income leaving UK is negative
• Secondary income (net transfers e.g. workers remittances or foreign aid): Transferring money to families back home - no goods exchanged

Question 3

UK 2018 Current account deficit?

Answer 3

-£81 billion, 4% of GDP

Question 4

What is the financial account made up of?

Answer 4

• FDI (e.g. Tata-Jaguar): buying of UK firms is a positive on financial account
• Portfolio investment: this is the value of purchased shares, not the dividend income. Not full ownership of companies
• Other investments (hot money flows): depositing money in banks with highest interest

Question 5

5 causes of deficits and surpluses on CA?

Answer 5

1) exchange rates - strong currency - exports expensive - CA deficit
2) relative inflation - high inflation - exports more expensive relatively - CA deficit if exchange rate doesn’t fall
3) competitiveness - higher productivity, lower costs - higher quality (Germany, Forbes) - CA surplus
4) economic growth - higher employment and incomes - more demand for imports (normal good) - CA deficit or surplus
5) protectionism - trade barries reduce imports - CA surplus

Question 6

Measures to reduce trade imbalance

Answer 6

1) Expenditure-reducing policies/contractionary policies - reduce AD - fiscal/monetary - less spending, fewer imports
2) Expenditure switching (Trade barriers or devaluing currency) - consumers switch from imports to domestic goods
3) Supply-side policies - low corporation tax - encourages investment and R+D - more innovation - better quality goods - more demand for exports
4) Currency controls - restricting purchase of foreign currency - limited imports - CA improves

Question 7

Impact of trade imbalances?

Answer 7

AD:
- (X-M) negative, AD falls, GDP falls - unemployment and poor living standards
+ Not significant if deficit is small % of GDP, UK only 4% of GDP
+ No effect on GDP if economy is near full capacity

Exchange rates:
- Depreciation - supply of currency increases as exports increase. Demand for currency falls if exports are low. S shifts right, D shift left. Price of currency falls

CA surplus effect on AD:
+ (X-M) increases, AD increases, GDP increases, employment and living standards improve