5.1 The Current Account of the Balance of Payments Flashcards
What is the Balance of Payments?
The Balance of Payments is a record of all international transactions between one country and the rest of the world.
What does the Current Account measure?
The Current Account measures the total value of export revenues and import expenditures of trade in goods and services, investment income, and current transfers.
What is one demand side cause of a Current Account deficit?
Strong domestic growth (higher incomes at home),
One demand side cause of a Current Account deficit is strong domestic growth (higher incomes at home). When real disposable incomes are high at home, the marginal propensity to import increases. This leads to a greater ‘sucking in’ of imports effect, increasing the demand and expenditure on imports. Ceteris paribus, this worsens the trade balance of the current account, causing a Current Account deficit.
What is another demand side cause of a Current Account deficit?
2) Recession abroad (low Incomes abroad).
Another demand side cause of a Current Account deficit is a recession abroad (low incomes abroad). When real disposable incomes fall abroad in the economies of major trading partners, such as during a recession, the demand for domestic exports decreases. This results in a fall in the revenue generated from exports, which, ceteris paribus, worsens the trade balance of the current account, causing a Current Account deficit.
How can a strong exchange rate contribute to a Current Account deficit?
3) A strong exchange rate
A strong exchange rate can contribute to a Current Account deficit. When the exchange rate is strong, it makes exports dearer and imports cheaper. Economic theory suggests that the demand for imports and, consequently, the expenditure on imports will rise, while the demand for exports and, therefore, the revenue generated by exports will decrease. Both effects worsen the trade balance of the current account, leading to a Current Account deficit.
Q: How does low labor productivity contribute to a current account deficit?
A: Low labour productivity. Low labour productivity means output per hour worked is low relative to competitor countries around the world. This increases unit labour costs, a major cost of production for firms who will reflect such costs in higher prices charged, reducing the price competitiveness of a country’s exports. This will reduce the demand and thus revenue generated from exports, worsening the trade balance of the current account causing a current account deficit.
Q: How can high minimum wages impact the current account balance?
A: High minimum wages relative to competitor countries, who either do not have minimum wages or whose minimum wage is much lower, will increase unit labour costs; a major cost of production for firms, who will reflect such costs in higher prices charged reducing the price competitiveness of a country’s exports. This will reduce the demand and thus revenue generated from exports, worsening the trade balance of the current account causing a current account deficit.
Q: How does poor investment contribute to a current account deficit?
A: Poor investment implies that capital machinery is outdated, depreciating, inefficient, and costly to maintain. This means that costs of production are relatively higher than competitor countries whose capital machinery is more productive, with firms reflecting higher costs in higher prices charged reducing the price competitiveness of a country’s exports. Once more, non-price competitiveness of exports will fall as the final quality of goods produced is likely to be lower. These two factors will reduce the demand and thus revenue generated from exports, worsening the trade balance of the current account causing a current account deficit.
Q: What is the impact of higher relative inflation on the current account?
A: If a country has higher inflation rates relative to competitor countries, the price competitiveness of exports will be lower. This will reduce the demand and thus revenue generated from exports, worsening the trade balance of the current account causing a current account deficit.
Q: How do government restrictions on free trade affect the current account balance?
A: If foreign governments increase or impose new trade barriers on domestic exports, such as tariffs, quotas, and non-tariff barriers, it will be harder to access international markets. This will reduce the revenue generated by a country’s exports worsening the trade balance of the current account causing a current account deficit.
Q: What happens when a country loses its comparative advantage?
A: If one country loses their comparative advantage, perhaps due to skills improvements, lower wages, or better access to raw materials in another country, industries will go into decline where large export revenues were previously being generated. Losing this export revenue will worsen the trade balance of the current account causing a current account deficit.
Q: How does resource depletion contribute to a current account deficit, especially in developing countries?
A: This is a strong argument in the case of developing countries in particular where extraction/mining laws and regulations do not exist or are not enforced. Self-interested, profit-maximizing firms will ignore the long-term repercussions of their actions and continue to exploit natural resources eventually leading to depletion of the resource. Primary commodity export revenue is the major source of export revenue for these countries; therefore, depleting such resources will drastically reduce export revenue worsening the trade balance of the current account causing a current account deficit.
