4.1.7 BoP class PP Flashcards
What is balance of payments?
It summarises all transactions between residents of a nation and non-residents during a period. It includes the value of trade flows, investment incomes and other financial transactions across national borders.
What are the 3 elements of the BoP?
- The current account
- the capital account
- The financial account
What is the current account?
It records payments for trade in goods and services + net flows of primary and secondary income.
Its the sum of;
- net balance of trade in goods
- net balance of trade in services
- net primary income
- net secondary income
What is primary income?
It measures the monetary flows generated from the owning of cross-border financial assets, known as investment income.
It represents the yields from UK investments abroad and that of foreign-owned investment in the UK. Primary income also includes pay for cross-border workers such as migrants.
Which income flows appear in primary income?
- Income on direct investment, includes profits, dividends and interest earned by residents from their direct investments in foreign companies and vice versa.
- Income on portfolio investment, income e.g. dividends + interest earned by residents from portfolio investments in foreign securities.
- Compensation of employees, wages, salaries and other compensation earned by foreign workers employed in a country by residents working aboard.
- Taxes on income and wealth, includes taxes on income and wealth paid to foreign governments and taxes paid by foreign residents to the domestic government.
What is secondary income?
In the context of BoP, it is current transfers between residents and non residents. e.g. foreign aid and contributions to international organisations e.g. the UN and the EU- which the UK has now left.
What money flows appear in secondary income?
- Remittances, money sent by foreign workers back to home countries
- Foreign aid, grants, concessional loans, and other forms of assistance provided by one country to another for developmental, humanitarian or other purposes.
- Diaspora contributions, contributions made by a country’s diaspora to support projects or family members in their home country.
- Payments made to international institutions, when the UK was a member of the EU, the UK was a net contributor to the EU budget. These payments were treated as a negative on the secondary income account.
What are remittances?
They are typically categorized as a credit item in the current account, contributing positively to the current account balance.
In many lower-income countries, remittances can offset trade deficits or other current account deficits, helping to achieve or maintain a current account surplus.
What is the financial account?
- includes transactions that result in a change of ownership of financial assets and liabilities between a country’s residents and non-residents.
What does the financial account include?
- Net balance of FDI
- Net balance of portfolio investment flows
- Balance of banking flows e.g. hot money inflows
- Changes in the value of a country’s reserves of gold and foreign currency.
Give some examples of flows on the financial account.
- An overseas company announces an inward investment project into the UK renewable energy industry.
- Expectations of higher monetary policy interest rates lead to an inflow of hot money into a country’s banking system.
- Overseas investors bid to buy new issues of gov debt.
- A domestic UK company sells one of their foreign subsidiaries and raises several blns of £s as a result which flows back to the UK.
What is the capital account?
Capital transfers; It involves the transfer of assets without any exchange of economic value, e.g. debt forgiveness, gifts and inheritance. These transfers can be between gov, institutions or individuals.
Non-produced, non-financial assets; This includes sales and purchase of non-financial assets like patents, copyrights and licences as well as the transfer of natural resources and land ownership between countries.
What are net errors and omissions?
They reflect the imbalances resulting from imperfections in the source data and compilation of the balance of payments accounts. They are needed to ensure that accounts in the country’s balance of payments statement always sum to 0.
What is a current account deficit?
The value of a country’s exports of G+S, investment incomes and transfer inflows are lower than spending on imported G+S, investment income outflow and outward transfers.
- net outflow of income from a country’s circular flow.
- it is a sign of economic weakness as it means that the country is relying on borrowing from abroad to finance it’s consumption
- not always a bad thing, it can be a sign of strong economic growth or investment in importing new capital goods.
How is a current account deficit financed?
- A current account deficit is an external deficit and means that the UK is the net borrower within the rest of the world.
- The uk e.g. needs to attract net financial inflows on the financial account.
- This might be achieved when the UK stock market is rising and/or when property prices are increasing, attracts portfolio inflows.
- Might happen when relatively high interest rates attract inflows of hot money into the commercial banking system.
- Might happen when UK businesses sell some of their overseas assets and return the money raised over home to UK shareholders.
- Or it can be financed when overseas investors have an appetite to purchase new issues of UK gov. debt in the bond market.
What are the cyclical macro causes of a current account deficit?
When an economy is experiencing a boom, rising real incomes and consumer spending and falling saving ratios can lead to a surge in import demand which can cause an increase in the size of a trade deficit.
What are the structural causes of a current account deficit?
They focus on supply side weaknesses in an economy such as relatively low capital investment, low productivity and research and businesses not operating at the cutting edge of innovation.
What are the SR causes of a current account deficit?
- A fall in the value of exports, perhaps caused by a decline in the world price of a nation’s major export, especially for primary producers.
- A boom in consumer spending and a fall in saving which leads to increased consumer demand for imported goods and services.
- A strengthening exchange rate which might make a country’s export sector less price competitive in overseas markets.
- A broadly-based economic boom, leading to rising import demand.
What are the LR causes of a current account deficit?
- Low rates of capital investment which limits the overall productive capacity and cost competitiveness of key export industries
- Relatively high cost and price inflation contrasted with trade partners.
- Weakness in non-price competition such as branding and innovation.
- Long-term decline of previously dominant export sectors such as deindustrialisation in manufacturing and decline in extractive sectors.
How can an economic boom cause an external deficit?
- Economic boom occurs when demand, real incomes and national output are all rising at above trend rates.
- One effect of this is often a strong rise in consumer spending for goods and services which have high income elasticity of demand.
- A large percentage of consumer durables such as new cars and household appliances tend to be imported.
- Thus a rise in consumer spending and a reduction in household saving can cause the volume of imports to rise at a fast pace.
- If the domestic economy is booming, there might be limited spare capacity in general and in export industries in particular.
- Thus, higher imports and a slowdown in exports might then lead to a widening of a country’s trade deficit on the current account.
How can a strong currency cause an external deficit?
- When a currency appreciates, the foreign price of a country’s export increases.
- This can lead to exports becoming less price competitive overseas causing a substitution effect, leading to weaker demand.
- A fall in the value of exports can then lead to a higher trade deficit, since net trade = X-M
- A stronger currency also leads to cheaper prices for imported products such as finished manufactured products.
- This might cause domestic consumers to switch demand and spending towards good and services produced overseas.
- A rise in spending on imports will lead to a higher trade deficit especially if demand for imports has a high coefficient of PED.
How can low productivity cause an external deficit?
- Labour productivity measures the output per person hour worked or the value of output per person employed.
- Relatively low productivity means that efficiency in the UK is below that of other major trading competitor nations.
- If labour productivity is low, then- for a given level of wages- the unit labour cost of production will be higher.
- As a result, exporting firms with low productivity may find themselves at a price and cost disadvantage in the overseas market.
- This might cause a slowdown in exports as foreign consumers look for relatively cheaper substitutes.
- And it might also cause a rise in import penetration into a domestic economy as consumers prefer to buy cheaper goods/ services.
What are the main causes of a current account deficit?
Poor price and non-price competitiveness on the supply side.
- Higher relative inflation than trading partners over several years.
- Low levels of investment and research and development spending
- Weakness in design, branding, and low labour productivity.
Strong exchange rate affecting exports and imports.
- High currency value which increases the prices of exports.
- Appreciating currency makes substitute imports cheaper.
Volatile global prices of key exports and imports.
- Exporters of commodities might be hit by a fall in global prices.
- commodity importing nations could be hit by higher world prices.
High propensity to consume imports on behalf of consumers.
What are the macro effects of a current account deficit?
- Fall in AD since X-M is negative, leading to slower GDP growth.
- Drag on GDP growth might then lead to weaker investment and jobs
- Large external deficit is likely to lead to a depreciating exchange rate
- High external deficit may reflect weaknesses on the supply side.
- Deficit must be financed by attracting a net flow on the financial account by allowing overseas buyers to acquire a nation’s assets.
Give examples of policies that can be used to improve the trade balance.
Both macroeconomic policies and more targeted interventions can be used.
Macroeconomic;
- Adjusting interest rates, changing the exchange rate or altering fiscal policy.
Targeted;
- Subsidies to exporters, tariffs on imports and even direct gov. intervention in industries.
e.g. a gov. could use export subsidies to make its goods more competitive abroad, or it could impose tariffs on imports to make them more expensive, thus discouraging consumers from buying them and encouraging them to buy domestic products instead.
What are expenditure switching policies?
These are policies designed to change the relative prices of exports and imports. e.g. an exchange rate depreciation can improve the price competitiveness of exports and make imports more expensive when priced in a domestic currency.
Give examples of expenditure-switching policies.
- Central bank intervention to lower the external value of a currency
- Gov. subsidies to domestic producers
- Import tariffs designed to increase the price of imported products
- Period of internal devaluation (falling domestic price level) to improve price and cost competitiveness of domestic businesses.
Evaluate the expenditure switching policy to improve the trade balance, Depreciation of the exchange rate.
It reduces relative price of exports and makes imports more expensive. It has a risk of cost-push inflation which erodes competitive boost + fall in real incomes/ standard of living.
Evaluate the expenditure switching policy to improve the trade balance, Import tariffs.
It will increase the price of imports and makes domestic output more price competitive. However there is risk of retaliation from other countries if import tariffs are used.
Evaluate the expenditure switching policy to improve the trade balance, Low rate of inflation.
It keeps general price level under control and makes exports more competitive. However there are risks from deflation as a way of achieving internal devaluation, including lower investment rates.
What are expenditure reducing policies?
They are contractionary monetary and fiscal policies designed to lower real incomes and AD and thereby cut the demand for imports.
They may include higher direct taxes, cuts in real gov. spending or an increase in monetary policy interest rates to lower demand for credit and increase saving.
Give 3 examples of expenditure reducing policies.
- rise in burden of direct taxes such as higher income taxes
- Cuts in gov. spending on welfare.
- Cuts in gov. spending on public services.
Why are expenditure reducing policies also known as deflationary policies?
These are policies that are aimed at reducing the growth of AD and reducing inflation. There might be a conflict with other macroeconomic objectives such as maintaining low unemployment.
Evaluate the expenditure reducing policy to improve the trade balance, Increase in income taxes.
It reduces real disposable incomes, causing falling demand for imports.
It can cause a cut in living standards and risk of causing damage to work incentives in labour market.
Evaluate the expenditure reducing policy to improve the trade balance, Cuts in real level of gov. spending.
It lowers AD, firms may look to export to make fuller use of their spare capacity. However it may damage the ST economic growth, risks that austerity hits planned business investment which could worsen the balance of trade in the LR.
What supply-side policies might help to reduce and external deficit?
- Infrastructure projects in improving transportation networks, telecoms to increase supply-side capacity and productive efficiency.
- Incentives to promote enterprise/ start-ups/ new export businesses.
- Privatisation/ deregulation to increase productivity and efficiency.
- Investment in education to improve a country’s human capital
- Protecting property rights to drive a faster rate of innovation/ ideas
- Tax incentives to attract FDI from companies who subsequently will export G+S.
What isi the J Curve effect?
It shows the possible time lags between falling currency and an improved trade balance. Initially, a country’s external trade deficit might increase following a currency depreciation. In the short term, the volume of exports and imports may not respond quickly to the price changes.
As time passes and trade volumes adjust, the trade balance tends to improve, creating the bottom part of the J.
How can the J curve effect be explained?
In the short term, a currency depreciation may not necessarily improve the current account/ trade balance. This is because the price elasticities of demand for exports and imports are likely to be inelastic in the ST.
Initially the quantity of imports bought will remain steady because many contracts for imported goods are already signed.
It takes time for export businesses to increase their sales following a fall in prices.
Earnings from selling exports may be insufficient to compensate for higher total spending on imports. The balance of trade may therefore initially worsen.
What is the Marshall-Lerner condition?
It 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 PED for X and PED for M >1.
Give 3 reasons for the larger trade deficit in the UK between 2022-2023.
- Export growth has weakened- many UK businesses claim that exports to the EU are being hampered by non-tariff barriers after the UK left the EU single market in Jan 2020.
- Higher global prices for essential imports- world prices of many imported commodities including natural gas and crude oil surged in 2021-2022.
- Currency weakness- external value of the £ against the euro and $ fell sharply in the latter part of 2022. This increases price of imports whereas exports take time to respond- leading to a possible J curve effect on the trade balance.
Give 3 consequences for the UK of a large current account deficit.
- Currency weakness- can put pressure on the sterling to depreciate. As the currency weakens, imports become more expensive, which can then contribute to inflationary pressures and falling real incomes.
- Slower economic growth- A current account deficit represents a net outflow of income from the UK’s circular flow. This reduces AD and acts as a drag on SR GDP growth- made worse by higher cost-push inflation.
- Need to attract capital flows- A current account deficit requires net capital/ financial inflows to finance this deficit. This might require the central bank to raise IRs to attract hot money in the UK. It can be done by attracting inward FDI.
What are 3 reasons that many African countries run large current account deficits?
- Fall in world prices of a country’s key export- link to primary product dependency
- Rise in value of essential imports- perhaps because a country is importing technology- impact on their LRAS.
- Net outflow of interest, profits and dividends from stock of foreign investment- transnational companies remitting their profits to other countries.
What is meant by a current account surplus?
It means that there is a net injection of income into a country’s circular flow. Surplus nations are known as creditor countries and- other things being the same- a surplus will lead to an accumulation of foreign exchange from rising export sales or an increase in net primary and secondary income.
What are the main causes of a current account surplus?
An external surplus can result from a country building strong competitive advantage in a range of industries and markets leading to fast export growth.
- Results from a persistent surplus of saving over investment for households, firms and the gov. This means that demand for imports is weaker.
- An export surplus may be the result of high world prices for exports of commodities.
- Might result from strong net inflows of investment income from assets owned overseas or when inflows of remittances from people living and working in other countries is a high percentage of GDP.
What are some of the macro effects of a current account surplus?
- would allow a country to run deficit on the financial account of the BoP.
e.g. surplus foreign currency can be used to fund investment in assets located overseas.
Some current account surplus countries have large sovereign wealth funds. These funds can invest surpluses in assets at home or overseas.
Current account surplus countries with floating currencies nearly always have a stronger ER since high export sales leads to an increase in demand for a nation’s currency.
How can a current account surplus affect inflation rates?
- Increased AD: a current account surplus typically means that a country is exporting more G+S than it is importing. When AD rises significantly, it can lead to a positive output gap and cause demand pull inflation.
- Resource constraints: As domestic industries expand to meet the export demand, they may experience resource constraints, such as labour shortages or increased demand for raw materials. If these resources are limited in supply, their prices can rise, contributing to cost push inflation.
- Asset price inflation: A current account surplus causes an inflow of foreign currency into an economy including the banking system. Excess liquidity in the financial system can then lead to asset price inflation, where the prices of assets such as shares and property rise rapidly.
Give examples of countries with large current account surpluses in 2023
- Germany
- China
- Japan
- Netherlands
- Singapore
Give 2 advantages of a country running a large current account surplus.
- Increase in national savings, accumulation of foreign currency reserves, allows a country to reduce their external debt and invest overseas.
- Net inflow of demand into the circular flow. e.g. profits from overseas investments provide a flow of funds for corporate investment.
Give 2 risks/ drawbacks from a persistently large current account surplus.
- Appreciation of the currency- might make some domestic businesses less competitive in overseas markets
- Might evoke a protectionist response from countries running large trade/ external deficits- countries might get locked in a trade war.
Why is the balance of trade important?
- Economic stability: surpluses and deficits can lead to imbalances that can lead to inflation ect.
- ER stability: A deficit can put downwards pressure on a country’s currency, leading to depreciation.
- Sustainable growth: a surplus can lead to savings and investment, a deficit can indicate a country is borrowing heavily to finance consumption.
- Trade and export competitiveness: BoP reflects a country’s ability to compete in international markets.
- Foreign exchange reserves: A surplus in the BoP can lead to the accumulation of foreign exchange reserves, which can act as a buffer against external shocks.
- Poverty reduction: Many lower and middle income countries have used export led growth to drive higher real GDP per capita and achieve sizeable reductions in extreme poverty.
When do trade imbalances occur?
When some counties run persistent surpluses on their trade accounts, whereas others experience persistent and often large external deficits.
How can an increase in a country’s current account deficit cause a change in the external value of their currency?
- Current account of the BoP compromises the balance of trade in G+S plus net investment incomes from overseas assets and net transfers. A deficit is usually the result of an increasing net trade deficit where the value of imports exceeds the value of exports.
- As a result, there will be a net outflow of money from a country’s circular flow. Households and businesses pay for imports in their own currency, but this is eventually converted into the currency of the exporting nation. Hence, a rising current account deficit leads to an increased supply of a nation’s currency in the foreign exchange markets.
- Therefore, in the currency market, there will be an outwards shift of supply. This might lead to the external value of the currency falling. In a free-floating system, this is called a depreciation.
What is the significance of a large trade imbalance?
- Deficit countries run up large external debts and are reliant on foreign capital. This risks the political opposition to domestic assets being bought by overseas TNCs.
- Deficit countries may decide to switch towards using protectionist policies, promoting the rise of economic nationalism.
- Surplus countries are saving more than they spend, thereby depressing global AD and growth.
- Surplus nations might be under consuming and allocating domestic scarce resources to exporting overseas.
Give an overview of trade and the BoP
- Trade figures usually reflect the underlying competitiveness of a country in world markets
- Trade deficits have cyclical and structural causes
- Supply-side policies are important in the LR to help improve trade outcomes
- Era of hyper globalisation is under threat
- There has been a switch to regional trade agreements and a rise in non-tariff barriers.
