Balance Of layments And currecnt Account Flashcards
Trade deficit
Economy’s expenditure on imports exceeds that on exports
Balance of trade
Total value of an economy’s exports subtract total value of imports
Investment income
Interest, profits + dividends earned on overseas assets
Net investment income
Total investment income received by UK from its foreign assets subtract total investment income paid to foreigners for assets they own in UK
Transfers
Financial payments without good/ service offered in return
Current account surplus
Total inflows/ injections received by economy for exports , investment income and transfers exceeds total outflows paid by economy to parties overseas
Current account deficit
Total outflows withdrawals paid by an economy to parties overseas for exports , investment income and transfers exceeds the total inflows received by economy
Capital inflows/ outflows
International movements of finance - currency speculation, changes in ownership of shares , foreign direct investment
Hot money
International flows of finance that aim to earn short term gain on international interest rate differences (through saving) and predicted changes in exchange rates
Import substitution
Country increasing production of goods & services that they would have otherwise imported - reduces leakage & increases economic growth
Price elasticity of demand for imports
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
Income elasticity of demand for imports
Responsiveness of demand for imports when there is a change in income
Balance of Payments Account
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
Causes of UK current account deficit (4)
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
CURRENT ACCOUNT SURPLUS (5)
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
Cures for current account deficit - DEVALUATION
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)
Evaluation of devaluation
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
CURES FOR CURRENT ACCOUNT DEFICIT -DEFLATION
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
Evaluation of deflation as cure for current account deficit
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
Protectionism as a cure for current account deficit
Eval
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
Supply side policies as a cure for current account deficit
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
Evaluation of supply side policies as cures for current account deficit
Question is what is the correct policy
Take long time to work
Cost a lot of money
Why is current account deficit a problem?
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
Why is current account deficit not a problem?
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
Free floating XR
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
Managed floating XR
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
Semi fixed XR
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
Fully fixed XR
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
Case for floating XR
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
Case for fixed XR
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
