Balance of payments

Question 1

Define balance of payments

Answer 1

Is the record of a country’s transactions (trade and movement of money) with the rest of the world.

Question 2

What are the 3 components of BoP ?

Answer 2

1.The current account
2.The capital account
3.The financial account

Question 3

What is a deficit and a surplus ?

Answer 3

A deficit is when outflows are greater than inflows and a surplus is when inflows are greater than outflows.

Question 4

Define the current account

Answer 4

Measures all the currency flows into and out of a country in a particular time period in terms of payment for exports and imports of goods and services, together with primary and secondary incomes.

Question 5

What are the 4 components of the current account ?

Answer 5

1. The balance of trade in goods
   2.The balance of trade in services
   3.The balance of primary incomes
   4.The balance of secondary incomes

where each of these items show individual surpluses or deficits and combined they show whether the current account is in a surplus of deficit.

Question 6

What are the 3 factors that influence a country’s current account balance ?

Answer 6

1. Productivity - when it is high workers are able to produce more and better quality products than other countries will have a competitive advantage.

2.Exchange rates - when exchange rate falls they should see exports sales rising and imports falling due to them getting more expensive. ( yet this is subjected to the elasticity of the demand curve )

3.Inflation - if lower relative to other countries will gain a price competitive edge as its products become cheaper relative to other countries.

Question 7

What is the balance of primary income ?

Answer 7

It shows the net investment income. This the difference between inward and outward flows of investment income. ( which is the income that UK citizens receive from foreign investments )

Investments can be split to short term - shares - dividends and long term (FDI) - factories - profit

Another part is also remittances - sending money back home

Question 8

What is the balance of secondary income ?

Answer 8

This looks at transfer payments made between countries without anything of economic value received in return e.g foreign aid and contributions to the EU. Therefore more developed countries tend to have a deficit in their secondary income.

Question 9

Define capital account

Answer 9

It was used to describe inflows and outflows of capital i.e domestic purchase of foreign assets. But most items have moved to the financial account so the capital account is not very significant anymore.

Question 10

What is the link between the financial account and the current account ?

Answer 10

The link is that the financial account is the expenditure on foreign investments but current account is the income from them.

Therefore if someone buys shares in the UK the financial account will experience a surplus where the current account will experience a deficit as dividends will be an outflow.

e.g Capital outflow (ie. UK residents buying up assets overseas) (-ve on financial account) should generate investment income over a longer-term. +ve on Current account (balance of primary income)

Question 11

Define the financial account

Answer 11

describes outflows and inflows of capital (ie. domestic purchase of foreign
assets and foreign purchase of domestic assets).

Question 12

what are the 3 components of the financial account ?

Answer 12

1.long-term direct capital flows,
2.long-term portfolio capital flows and
3.short-term ‘hot money’ capital flows.

Question 13

What are long term direct capital flows ?

Answer 13

It is FDI which is long term investment is real productive capital assets such as factories, mining facilities, airports, taker overs or mergers in a country.

Question 14

What factors might influence FDI flows between countries ?

Answer 14

1. Exchange rates
   2.Competitive and comparative advantage
   3.Easier movement of capital
   4.Profit potential
   5.Tax credits/government subsidies
   6.Production costs
   7.Inflation

Question 15

What is portfolio capital flows ?

Answer 15

Purchase of one country’s securities e.g bonds and shares by residents or financial institutions of another country. - FINANCIAL ASSETS

Question 16

What are some examples of capital flows ?

Answer 16

1.A UK investor buys some shares in Google (this is a portfolio investment outflow for the UK accounts)

2.A German investment bank might buy some of the sovereign debt issued by the UK government (this counts as a portfolio investment inflow for the UK)

Question 17

Define short term “hot money” capital flows ?

Answer 17

movement in capital made in order to make profits from changes in exchange ratesand interest rates by moving money between currencies - this is short term

Exchange their pounds for
dollars believing/hoping that the dollar is about to get stronger. If it does, they could then turn those dollars back into pounds
and make a profit.

Question 18

What are the dangers of self fulfilling prophecies and destabilising effects of hot money ?

Answer 18

1. Self fulfilling prophecies : Where exchange rates float freely, an excess of demand causes the exchange rate (the price of that currency) to rise.

So a mass move by investors to buy a currency in anticipation of a
rate rise will actually cause a rate rise!

2. Destabilising: Large movements of ‘hot money’ out of or into a given currency,
   affects exchange rates and as a result, trade and therefore the current account, and therefore the economy as a whole.

Governments have little or no control over the behaviour of
investors, and limited means with which to defend their currencies from investors speculative transactions. E.g UK Exchange Rate Mechanism Crisis 1992

Question 19

What are the 3 policies for tackling A balance of payment deficit ?

Answer 19

1.Deflation - expenditure reducing
2.Direct controls - expenditure switching
3.Currency devaluation

Question 20

What is deflation and what are the possible policy conflict ?

Answer 20

These are policies that reduce AD. The effect on imports will depend on the marginal propensity to import - the higher the MPM the greater impact this policy will have.
e,g mpm = 0.55 if demand fell by 10bn then imports will fall by 5.5bn

possible policy conflicts: is that delation will depress economic activity impacting incomes, employment and growth. Therefore governments need to choose wisely when to use deflationary policies

Examples of policies include contractionary fiscal and monetary policies

Question 21

How can deflation act as expenditure switching policies ?

Answer 21

Deflation can act as an expenditure switching policy - lower inflation compared to other countries makes exports more competitive

Question 22

What are direct controls and policy conflict ?

Answer 22

Involves placing all protectionist policies . Yet this is limited by the fact many countries are in trade treaties.

policy conflicts - reduces welfare for consumers, do not deal with reasons why domestic products can’t compete.

Question 23

What is currency devaluation and what does it depend on ?

Answer 23

This is the fall in the value of the currency which makes imports more expensive and exports enjoy a price competitive advantage.

How effective devaluation would be relies on the demand elasticates of imports and exports:
1) Imports - elastic - policy very effective

2) Imports - inelastic while exports - elastic then according to Lerner if the absolute sum of long termdemand elasticites export and import is greater than 1 then devaluation will reduce a deficit.
Note: in addition to meeting this condition there must be spare capacity in the economy to meet increased demand for exports.

Question 24

What is the J curve ?

Answer 24

It is a diagram that plots the balance of payments against time after a currency devaluation

Question 25

What are the 3 policies used to tackle a surplus ?

Answer 25

1. Reflation
   2.Removal of controls
   3.Revlaution

Note: Lerner’s condition still applies and the J curve is the same but upside down instead

Question 26

What is the limitation to all the 3D and 3R policies ?

Answer 26

Is that they are only helpful in the short term. For governments to sustain fall in imports and rise in exports they will have to use long term supply side policies that will make exports more competitive in terms of quality as well as price

Question 27

What 3 economic implications will always be evaluating with gov measures to directly influence current account ?

Answer 27

1. Inflation
   2.Economic growth
   3.Unemployment

Question 28

What are the positives and negatives for the current account surplus ?

Answer 28

Surpluses are associated with national economic success - as long as it is measuring the competitiveness of exporting industries.

Large surpluses overtime are undesirable:

1. One’s country surplus is another country’s deficit as the BoP must balance for the whole world. This would mean that some countries will be left with persisting deficit and so will introduce direct controls - all suffering.

2.A surplus is an injection to AD which can be inflationary, this is good if there is unemployment but bad when the economy is close to full capacity.

Question 29

What are the positives and negatives of current account deficit ?

Answer 29

1.Short term is not serious as it may mean that the countries resedients benefit from increases standards of living due to cheap imports.

2.Long run it is more serious as it means that the countries industries are incompetitive which can lead to domestic unemployment and this can also deter forgein investment as the potential of profit would be low !