Balance Of Payments

Question 1

What is the balance of payments?

Answer 1

The balance of payments is a record of all the transactions between the UK and the rest of the world (into and out).

Question 2

What is the balance of payments split into?

Answer 2

1) The current account

2) The capital account

Question 3

Explain the current account?

Answer 3

This shows visibles (goods) and invisibles (services) with the rest of the world.

Question 4

What is the difference between our imports and exports of goods called? And how does it differ from the current account?

Answer 4

The balance of trade. It does not include services.

Question 5

Explain the capital account?

Answer 5

This refers to a record of all the large investment flows of money between the UK and the rest of the world.

Question 6

What are the 3 transactions usually found in the capital account?

Answer 6

1 - All the money foreigners are investing in our banks and all the money we are investing overseas (due to higher interesf rates)

2 - All the money foreign businesses are investing in UK and all the businesses investing abroad

3 - UK consumers buying property abroad and foreign consumers buying property in the UK e.g. Holiday homes

Question 7

What does it mean if we’re in a current account deficit?

Answer 7

Imports > Exports

Question 8

What does it mean if we’re in a surplus in the current account

Answer 8

Exports > Imports

Question 9

List The Causes of a current account deficit

Answer 9

1. Overvalued exchange rate - exports become too expensive to buy but imports will be cheaper
2. Economic growth (boom) - if there’s an increase in real wages, people in the Uk have more disposable income, firms will be under less pressure to sell exports as they can sell them in the UK (which is cheaper + less risky). BUT if the domestic demand cannot be met it will lead to an increase in imported goods.
3. If Inflation is too high - our goods will be in short demand as UK consumers will prefer buying cheaper imports
4. Goods are not competitive enough - could be caused by: low productivity, higher wages, low investment on research & development
5. Economies we sell exports too are doing poorly - ppl in those counrties will be less likely to buy our exports as they might not be able to afford it
6. Increase in prices of raw materials - demand is price inelastic meaning if prices increase so will firms costs

Question 10

What will the balance of payments always be

Answer 10

Equal to 0

The deficit of either the current or capital account will always equal the surplus of the current or captial account

Question 11

Policies to reduce a balance of payments deficit

Answer 11

1. Devaluation- reducing value of exchange rate to decrease imports (more expensive) & increase exports (cheaper)
2. Protectionism - putting tariffs on imports to make them more expensive & increase spending on UK goods
3. Deflationary policies to reduce consumer spending - gov could pursue tight monetary (increase interest rates) and fiscal policies (increase taxes)
4. Supply side policies - policies aimed at increasing producticity and competitivness in the economy such as: increase spending on training & education

Question 12

What does devalutation depend upon?

Answer 12

• Marshall Leaner Condition - PED for imports and exports needs to be price elastic (>1) in order for a reduction to be able to decrease deficit
• UK Firms response to the increase in demand of exports. Since the closer the economy is to FE the harder it is to increase output. (Only if the economy has spare capacity will deficit decrease)
• what exporters do - if exchange rate falls firms might not want to sell more but just make a profit by keeping price at same level as before which is effectively the same price as other countries therefore increasing profit but exports stay at same rate
• J curve effect

Question 13

What is the J curve effect

Answer 13

Even if demand is price elastic & firms can increase their output it is unlikely to happen straight away. Since the current account deficit is likely to get worse before it gets better.

When the currency falls firms will likely make a loss until output increase etc..x which then leads to an increase in exports

Question 14

Effects of a current account deficit

Answer 14

1. The size of the deficit relative to that countries GDP. Generally, anything above 3% would be a problem
2. Whether the deficit persists over time - It keeps happening year after year

Both of those factors tend to be true in the UK.

Question 15

Why might the current account deficit cause problems?

Answer 15

1) We are spending more money than we are earning from other countries. This means we are getting into debt with the rest of the world. Eventually that money needs to be paid back, and in the future when this happens, people may have to accept a lower standard of living. (Higher taxes, less spending etc.)
2) Because we have this deficits, the government may have to increase interest rates to persuade foreigners to lend them money.
3) If we have a current account deficit, i.e. spending too much abroad it can reduce the value of the exchange rate. In the long run this could make us even less competitive.