Balance of Payments

Question 1

What is Balance of Payments (BOP)?

Answer 1

The Balance of Payments (BOP) of a country is a statement of all the international transactions of a country with the rest of the world over a period of time, usually a year. IN other words, the balance of payments records the international inflows and outflows of a country’s currency

Question 2

What are the major components of Singapore’s BOP?

Answer 2

i) Current Account
ii) Capital & Financial Account

Question 3

How can you determine whether a country is in a stable or self-sustaining position?

Answer 3

i) The BOP account remains in balance over reasonable periods of time
ii) Any imbalance in the current account is matched by long term capital flow.

Question 4

What is a BOP equilibrium?

Answer 4

A BOP equilibrium is usually taken to mean that the trade and capital flows into and out of the country balances over a number of years

Question 5

What is BOP disequilibrium?

Answer 5

A BOP disequilibrium will exist if there is a persistent tendency for the trade and capital outflows to be more or less than the corresponding inflows

Question 6

What causes persistent deficit in the BOP account?

Answer 6

i) a deficit on the current account not matched by inflows in the capital and financial account
ii) a net inflow on the capital and financial account not matched by a surplus in the current account

A persistent deficit must then be accommodated by a reduction in gold and foreign reserves or by borrowing in the official reserves account of the BOP

Question 7

What causes a persistent surplus in the BOP account?

Answer 7

i) a surplus on the current account not matched by outflows from the capital and financial account
ii) a net outflow on the capital and financial account not matched by a deficit from the current account

A persistent surplus would result in an accumulation of gold and foreign reserves, hence it does not pose payment difficulties to a country as a BOP deficit would

Question 8

What are the Price Factors that creates trade imbalances?

Answer 8

i) Rate of domestic inflation relative to other countries
ii) Changes in exchange rate
iii) Changes in domestic supply conditions

Question 9

What is the Marshall Lerner condition?

Answer 9

where, (PEDx + PEDm >1)

Question 10

What are the reasons for a fall in a country’s export supplies?

Answer 10

i) Loss in comparative advantage
ii) Relative rise in COP
iii) Falling domestic productivity

Question 11

What are the non-price factors that create trade imbalances?

Answer 11

i) Changes in interest rates
ii) Changes in the global demand conditions
iii) establishing institutional changes
iv) Imbalances in a country’s capital and financial account

Question 12

How does a loss in comparative advantage result in a fall in export supply?

Answer 12

A loss in comparative advantage due to higher costs may reduce supply of exports. This may be due to rising input prices like wage increases, which increases the cost of production in the country.

Note:
Changes in comparative advantage due to higher domestic cost would be a price factor. However, if loss of comparative advantage due to other countries gaining comparative advantage due to use of better technology, it may be a non- price factor.

Question 13

How does a relative rise in cost of production result in a fall in export supply?

Answer 13

During an oil crisis, energy prices would have soared and lead to an increase in cost of production. This will reduce the supply of exports.

Increase in wages in Singapore due to government policy to reduce inflow of low-cost foreign labour, and levies imposed on the employment of low-cost foreign labour.

Question 14

How does falling domestic productivity result in fall in export supply

Answer 14

Falling health conditions have caused a fall in productivity of workers in many african countries. As a result, the supply for many of these countries’ export falls.

Question 15

How does an imbalance in a country’s capital and financial account lead to trade imbalances?

Answer 15

Insufficient savings/government revenue -> borrow from abroad/sell assets to foreigners to finance spending -> inflate the demand and value of country’s currency -> country’s exchange rate being overvalued -> reduce trade competitiveness

Question 16

What are the causes of Capital and Financial account Disequilibrium?

Answer 16

a) Changes in Interest Rates
b Expected changes in Exchange Rates
c) Changes in political and social factors

Question 17

How does changes in Interest Rates result in Account Disequilibrium?

Answer 17

Expansionary monetary policy -> increased money supply, lowered interest rates -> outflow of Hot Money -> BOP deteriorates

Question 18

How does expected change in exchange rates result in account Disequilibrium?

Answer 18

Expectation of Depreciation:
- high outflow of short term investments
- prospective foreign investors might defer his investments for some time (long-term capital flow)
- worsening BOP

Expectation of Appreciation:
- more investment will be made
- improve BOP position

Question 19

How does a BOT deficit affect the Government?

Answer 19

(For managed float systems) Foreign reserves depleted decreases the scope of monetary policy -> less attractive to FDI as BOP deficit could be due to the loss of exports price and non-price competitiveness

Question 20

How does BOT deficit affect Consumers?

Answer 20

Developing country: if BOP deficit is due to the import of capital goods -> translate into more consumer goods in the future -> increasing material SOL in the future

Question 21

How does BOT deficit affect Producers?

Answer 21

BOP deficit -> depreciation -> more competitive export prices -> export revenue increases

Question 22

Why must a persistent deficit be corrected? (affecting government)

Answer 22

BOT deficits will have to be corrected because there is a limit on the ability of the government to sustain such chronic deficits. Its finite resources will run out as a deficit must be accommodated by a reduction in gold and foreign reserves or by borrowing in the official reserves account of the BOP.

Question 23

How does a developing country correct persistent BOT to improve material SOL of its people?

Answer 23

Current account deficit due to purchasing of imported capital goods rather than consumption goods -> increased productive capacity -> allow country to export more in the future -> correct initial account deficit -> wealth created will increase material SOL of people

Question 25

What are the consequences of persistent deficit? (affecting government)

Answer 25

-persistent loss of gold/foreign reserves or to borrow short term -> shows that country is unable to finance desired import goods and services with exports or long term capital flows.
-need to incur large external debts (from overseas) to cover deficit -> constrained by foreign perception of credit-worthiness -> lower country’s competitiveness in attracting FDI -> affecting long term growth prospect
-if it borrows too much, agencies which lend it money such as IMF will impose conditions for future borrowing -> government loses ability to run economy it sees fit
-persistent trade deficit -> reflect poor economic management -> result in loss of confidence of in economy -> capital flight may ensue -> worsen country’s BOP -> may lead to depreciation of exchange rate

Question 26

What can a persistent trade deficit with low exports indicate of the economy?

Answer 26

The economy is not competitive in terms of:
- Export price competitiveness and/or
- Export price non-competitiveness (quality)

Question 27

What is the effect of BOT deficit on a free float exchange rate regime?

Answer 27

BOT deficit -> Currency depreciates -> Px lower in foreign currency, Pm higher in local currency -> Qx rises and Qm falls -> X-M increases, assuming MLC holds -> trade deficit is reduced

Question 28

What are the effects of BOP deficit in a fixed/managed float exchange rate regime?

Answer 28

BOP deficit -> Currency should depreciate but is now overvalued -> Govt. purchases more domestic currency -> Official reserves decreases -> Currency depreciates when official reserves run out

Question 29

What are the Macroeconomic policies to correct BOT Imbalances?

Answer 29

i) Expenditure Reducing (income effect)
ii) Expenditure switching (substitution effect)

Question 30

What is Expenditure Reducing?

Answer 30

These are measures which aim to rectify the deficit by cutting expenditure, including expenditure on imports.

Eg. Contractionary Fiscal and Monetary policy

Question 31

What is Expenditure Switching?

Answer 31

These are measures which are designed to switch expenditure from imports to domestically produced goods.

Eg. Supply side policies, Exchange rate policy, and Trade policies

Question 32

Note: When correcting BOT deficit, Contractionary Fiscal Policy/Monetary policy works best if it leads to expenditure switching behaviour instead of expenditure reducing. This is because it will solve the trade deficit without exacerbating employment and income problems.

Question 33

Note: Contractionary Fiscal Policy and Contractionary monetary policy will involve severe domestic costs; output and employment levels tend to fall. For a country that is faced with both trade deficit and demand deficit unemployment (below full employment level), such policies will worsen the unemployment problem and economic growth. Hence not viable when economy is in a recession or slowdown

Question 34

Note: The use of Contractionary Fiscal Policy/Monetary Policy to correct a trade deficit is more appropriate if it is mainly caused by an increase in import expenditure, and if the economy is also suffering from demand-pull inflation.

Question 35

Note: For the purpose of discussion in examinations, assess the advantages
and disadvantage for each policy specific to the given context of the question.
Make an overall evaluation that is a reasoned stand relevant to the question.

Question 36

Note: If the root cause of the current account deficit is due to a loss inn export competitiveness, then a contractionary monetary policy/fiscal policy targeting import expenditure would not address the lack of export revenue

Question 37

Why is a fall in government expenditure through contractionary fiscal policy politically unacceptable?

Answer 37

This is because it could mean a cut in spending in areas such as education and healthcare, resulting in worsened non-material SOL.

Question 38

When are such polices (contractionary fiscal/monetary policy) typically used?

Answer 38

These policies are more likely used to address trade deficit in the short-term and should be complemented with more long term measures. eg. supply-side policies that improve export competitiveness in the long term.

Question 39

Note: to correct BOT surplus, pursue expansionary fiscal/monetary policy

Question 40

Note: to correct BOT deficit, pursue contractionary fiscal/monetary policy

Question 41

Why is BOT surplus often tolerated in SOEs?

Answer 41

eg. Singapore, as it is the main source of actual economic growth. Hence, small and open economies with BOT surplus often leave the adjustment to the deficit nations, choosing instead to deal with the inflation rather than the BOT surplus

Question 42

Note: in fixed/managed float exchange rate, devaluation or depreciation can help to correct a trade deficit.

Question 43

Note: in free-floating exchange rate, any BOP disequilibrium will be auto-corrected

Question 44

What is the J-Curve effect?

Answer 44

Depreciation of exchange rate can cause a deterioration of the current account in the short term (because demand is inelastic). However in the long term, demand becomes more price elastic, and therefore the current account begins to improve

Question 46

Why would the government implement Supply-side policies to correct BOT deficit?

Answer 46

To improve price and product competitiveness of domestic product to increase demand for domestic goods internationally. This has an expenditure switching effect

Question 47

note: Supply side policies can improve long term export competitiveness

Answer 47

The main focus of supply side policies in correcting a BOP deficit due to current account is to make the country more productive and to increase its exports

Question 48

What are the possible supply-side policies to correct BOT deficit?

Answer 48

a) Training and retraining to increase labour productivity
b) Provision of monetary incentives for firms to increase R&D investments

Question 49

How does training and retraining to increase labour productivity correct BOT deficit?

Answer 49

Investing in education and encouraging investments -> improve quality of FOP -> improve COP and quality of exports

Assuming export prices are lower relative to other economies and PEDx >1, this would lead to a more than proportionate increase in Qd for exports and a rise in export revenue. Assuming import expenditure remains the same, the trade and BOP deficit would be reduced

Question 50

How does provision of monetary incentives for firms to increase R&D investments correct BOT deficit?

Answer 50

1. Firms may carry out PROCESS INNOVATION to improve efficiency of production to reduce unit COP to increase export price competitiveness.
2. Firms may carry out PRODUCT INNOVATION to improve quality of product to increase demand and reduce substitutability (reduce PED/XED) of domestic goods.

Elaborations:
1. If export prices are lower relative to other economies and PEDx >1, this would lead to a more than proportionate rise in quantity demanded for exports and a rise in export revenue. Assuming import
expenditure remains the same, the trade deficit would be reduced.
2. This would lead to an increase in demand for the country’s exports and consequently a rise in export revenue. Assuming import expenditure remains the same, the trade deficit would be reduced.

Question 51

Summary table on page 28 onwards