Balance Of layments And currecnt Account

Question 0

Trade deficit

Answer 0

Economy’s expenditure on imports exceeds that on exports

Question 1

Balance of trade

Answer 1

Total value of an economy’s exports subtract total value of imports

Question 2

Investment income

Answer 2

Interest, profits + dividends earned on overseas assets

Question 3

Net investment income

Answer 3

Total investment income received by UK from its foreign assets subtract total investment income paid to foreigners for assets they own in UK

Question 4

Transfers

Answer 4

Financial payments without good/ service offered in return

Question 5

Current account surplus

Answer 5

Total inflows/ injections received by economy for exports , investment income and transfers exceeds total outflows paid by economy to parties overseas

Question 6

Current account deficit

Answer 6

Total outflows withdrawals paid by an economy to parties overseas for exports , investment income and transfers exceeds the total inflows received by economy

Question 7

Capital inflows/ outflows

Answer 7

International movements of finance - currency speculation, changes in ownership of shares , foreign direct investment

Question 8

Hot money

Answer 8

International flows of finance that aim to earn short term gain on international interest rate differences (through saving) and predicted changes in exchange rates

Question 9

Import substitution

Answer 9

Country increasing production of goods & services that they would have otherwise imported - reduces leakage & increases economic growth

Question 10

Price elasticity of demand for imports

Answer 10

Responsiveness of demand for imports when there is a change in price. Imports tend to have price elastic demand - changes in import prices ( as a direct result of exchange rates changes and tariffs) can have more than a proportional impact in demand for imports

Question 11

Income elasticity of demand for imports

Answer 11

Responsiveness of demand for imports when there is a change in income

Question 12

Balance of Payments Account

Answer 12

Records all financial transactions that are made between consumers, firms and gov in UK and other international economies
Divided into two separate accounts -
CURRENT ACCOUNT- compromises balance of trade on goods and services , net investment income from assets overseas and net transfers
CAPITAL AND FINANCIAL ACCOUNT- net change in ownership of foreign assets - comprises flows of money associated with saving, loans, investment, speculation and currency stabilisation

Question 13

Causes of UK current account deficit (4)

Answer 13

1) ECONOMIC GROWTH-as incomes increase imports increase as imports have high positive income elasticity of demand - e.g. Fruits from warmer countries
2) RELATIVELY LOW IMPORT PRICES FOR FIRMS- most imports = raw materials for production- cheaper costs in developing economies make imported components competitive and UK firms import as a result + long term decline in manufacturing caused many UK firms to outsource low skilled production to developing economies , these are then sent back to UK for consumption ( significant debit on trade in goods) but profits errant are sent back to UK - credit
3) Commodity prices - world commodity prices tend to rise over time and this results in worsening of balance of trade HOWEVER : effect is dependent on price elasticity of demand for commodities
4) EXCHANGE RATES - high exchange rate ( strong pound) contributes strongly to current account deficit
5) HIGH RATES OF INFLATION
6) HIGH UNIT LABOUR COSTS
7) LACK OF NON -PRICE COMPETITIVENESS
8) PROTECTIONISM

Question 14

CURRENT ACCOUNT SURPLUS (5)

Answer 14

1) Export orientated growth- some countries have set out to increase capacity of their export industries as a growth strategy
2) Foreign direct investment
3) Undervalued exchange rate - may be achieved by currency intervention by a nation’s central bank ( selling their own currency and accumulating reserves of another)
4) Closed economy - range of tariffs & non- tariffs
5) Strong investment income from overseas investments

Question 15

Cures for current account deficit - DEVALUATION

Answer 15

Deliberate lowering of value of pound in terms of foreign currency so that UK exports become cheaper and imports become more expensive
MARSHALL-LERNER CONDITION :’ devaluation will improve the current account of the balance of payments only if sum of price elasticities of demand for imports and exports is greater than one’
J CURVE EFFECT- in short term price elasticities of demand for exports & imports are likely to be price inelastic because: trade contracts negotiated long time in advance, people take long time to realise and react, people may be loyal to existing sources of supply ( reliable, quality)

Question 16

Evaluation of devaluation

Answer 16

Effects depend on Marshall -Lerner condition
Short run effects may worsen situation - J curve
May not work of economy is close to capacity as the country cannot increase export production without suffering inflation which will erode any competitive advantage from failing currency
If large proportion of firm’s costs are imported then the higher import costs from the depreciation will worsen their price competitiveness and offset any benefit from the depreciation on export prices
Depends on scale if devaluation
Depends on other factors remaining constant - other govs do not manipulate their currency to offset your devaluation
Depends on firms passing in the depreciation- they may not do

Question 17

CURES FOR CURRENT ACCOUNT DEFICIT -DEFLATION

Answer 17

Either fiscal or monetary tightening to reduce aggregate demand and slow down rate of growth of domestic economy

1) by reducing disposable incomes and slowing growth causes imports to fall
2) reducing the rate of inflation may make country more price competitive

Question 18

Evaluation of deflation as cure for current account deficit

Answer 18

1) will also reduce domestic consumption and slow down earl incomes and could cause recession , deepening on original size of output gap
WILL WORSEN SITUATION IN SHORT RUN
2) will only work if gov is pursuing this policy faster than its trading partners

Question 19

Protectionism as a cure for current account deficit

Eval

Answer 19

Tariffs and quotas raise import prices and restrict volumes of imports

1) if demand is prices inelastic then values of imports might actually rise despite falling volumes
2) will be short sighted if other nations simply retaliate & put tariffs or other protectionist barriers against protectionist’s nations exports
3) WTO outlaws such protectionism measures except for certain countries under certain emergency conditions and is likely to lead to costly protracted WTO legal disputes with trading partners

Question 20

Supply side policies as a cure for current account deficit

Answer 20

Boosting productivity:
Better competition policy to encourage firms to be more competitive and efficient
Breaking up union power
Reducing red tape gov regulations which raise firms costs and reduce flexibility of working hours
Lowering income taxes to encourage work incentives
Encouraging training through subsidies & apprenticeships programmes
Improving quality of health , education + infrastructure
Encouraging investment

BOOSTING INVESTMENT
Lowering corporation tax
Subsidies to reduce cost of capital
Tax relief for investment projects
Improving access to credit
Maintaining political / economic stability

Question 21

Evaluation of supply side policies as cures for current account deficit

Answer 21

Question is what is the correct policy
Take long time to work
Cost a lot of money

Question 22

Why is current account deficit a problem?

Answer 22

1) has to be financed by corresponding inflow of foreign currency on the financial and capital account
2) is a net withdrawal - will decrease AD- v. bad if there is large native output gap
3) may be symptom of weakness
4) loss of assets to foreign nations
5) depends on size + duration of problem

Question 23

Why is current account deficit not a problem?

Answer 23

1) if current account deficit is financed by long term investment inflows it is perfectly manageable & not cause for concern
2) raises welfare
3) can be symptom of strength - if deficit is product of chocoholic growth and high marginal propensity to import then it is actually good for living standards etc
4) can be useful deflationary pressure valve - if economy sn a close to capacity with small negative output gap or with positive output gap demand pull inflation can be a problem - then exploitation of trade deficits will meet some of the excessive demand through imports and thus reduce inflation rate

Question 24

Free floating XR

Answer 24

Value of currency is determined purely through price mechanism ; the interaction of currency supply and demand
No XR target set by gov
No direct intervention in currency markets

Question 25

Managed floating XR

Answer 25

Value of currency determined through price mechanism , but some intervention may occur if XR becomes too volatile or for reasons to do with aggregate demand management

Question 26

Semi fixed XR

Answer 26

Specific target range is set for XR - currency can fluctuate between permitted bands but direct intervention in FOREX and constant interest rate fluctuations required in order to maintain fixed rate system

Question 27

Fully fixed XR

Answer 27

Currency is pegged to another or the economy joins single currency system
No fluctuations permitted
Central bank must have enough currency reserves to maintain pegged rate at all costs

Question 28

Case for floating XR

Answer 28

1) reduced need for currency reserves
2) useful instrument for economic adjustment - natural currency depreciation through a floating XR can provide boost to exports and thus stimulate growth during recession and when there is risk of deflation
3) trade deficit automatic stabiliser - floating XR can help when economy accumulates large current account deficit ; economies with a large current account deficit are experiencing high demand for imports and low demand for exports and in long run this puts downwards pressure on XR allowing system to autocorrect HOWEVER this can take long time and much depends on price elasticity of demand of exports & imports
4) less opportunity for currency speculation
5) freedom of domestic monetary policy - absence of XR target allows interest rates to be set to meet domestic objectives such as controlling inflation or stabilising economic cycle

Question 29

Case for fixed XR

Answer 29

1) Trade and investment - currency stability can promote trade and foreign direct investment as it reduces risk of or investors + easier for domestic firms to plan ahead - more likely to invest
2) some flexibility permitted - occasional devaluation / revaluation possible
3) reductions in costs of currency hedging - businesses have to spend less on currency hedging of Huey know that the currency will hold its value in foreign exchange markets - reduces opportunity cost associated with currency hedging in terms of reduced investment & productivity
4) discipline on domestic producers : at able currency acts as discipline on producers to keep their costs and prices down ; firms cannot just rely on floating exchange rate that just happens to make them competitive - may encourage attempts to raise productivity and focus on research & innovation
5) reinforcing gains in comparative advantage : if one economy’s currency is pegged to another , differences in labour costs will be reflected in the rate of growth of exports and I objects