Balance of payments

Question 1

Define the balance of payments

Answer 1

A record of the UK’s economic transactions with the rest of the world, both trade flows and flows of savings and investment

Question 2

What are the 3 different sections of the balance of payments

Answer 2

• Current account
• Capital account
• Financial account

Question 3

What does the current account record

Answer 3

The effect of international trade on the UK’s AD, where:
- Exports increase the UK’s income so are recorded as a credit (+)
- Imports reduce UK income so are recorded as a debit (-)

Question 4

What are the 4 elements of the current account

Answer 4

a) net trade in goods
b) net trade in services
c) net primary income
d) net secondary income

Question 5

What are examples of goods, services, primary income and secondary income

Answer 5

goods: manufactured goods, raw materials and components

services: banking, tourism, transport, education

primary income: profit, interest and dividends from investments in other countries + remittance flows from migrant workers

secondary income: overseas aid and contributions to the EU

Question 6

What is in the capital account

Answer 6

Net income from things like patents and royalties (quite negligible in the balance of payments)

Question 7

What are the elements of the financial account

Answer 7

1. Net balance of FDI
2. Net balance of portfolio investment flows
3. Net balance of banking flow (hot money)

Question 8

Why is the balance of payments 0

Answer 8

The current account deficit balances a financial account surplus (and vice versa)

This is because countries with a CA surplus have excess cash to invest in foreign countries assets and provide FDI (causing an FA deficit) and countries with CA deficit need investment from foreign countries (causing an FA surplus)

Question 9

What is a BoP equilibrium vs diseqilibrium

Answer 9

equilibrium is where BoP = 0
disequilibrium is substantial and persistent current account deficit

Question 10

What are the drawbacks of a current account deficit

Answer 10

1. X-M is negative so bad for AD and economic growth
2. If FA surplus is very high, the country has to pay high interest rates and dividends to the country which is buying assets from them. - –
   - However, this is part of CA so CA deficit increases.
   - This might cause foreign investors to lose confidence in the countries ability to pay the debt, meaning they pull out of investment
   - leads to less money supply, leading to credit crunch, leading to bankruptcy

Question 11

Describe the UK’s current account position

Answer 11

• Trade deficit in goods
• Trade surplus in services (mainly finance)
• Net primary income deficit
• Net secondary income deficit

Overall, small persistent deficit (2-3% of GDP), which has been growing in recent years

Question 12

When can a current account deficit be alright?

Answer 12

1. If the deficit is small e.g. 1% of GDP would be healthy
2. The deficit is short term i.e. in a boom marginal propensity to import rises
3. The deficit is being used to import capital, which helps with long run growth
4. The deficit is continuously being financed by large FA inflows i.e. the UK and US1

Question 13

Explain the benefits of a current account surplus

Answer 13

1. X-M is positive so AD increase
2. Country can invest and lend to others, meaning they can build overseas wealth and helping their businesses grow (i.e. China, through FDI, moved businesses to Africa for their natural resources)
3. Means the country has a strong supply-side as they have world beating businesses

Question 14

Explain the disadvantages of a current account surplus

Answer 14

1. Demand pull inflation
2. Not importing to max capacity including goods that aren’t produced in their country so worse standard of living and too high savings ratio

This is why BoP equilibrium = 0

Question 15

Why do some countries have a current account deficit

Answer 15

1. Country’s supply side isn’t good enough to create world-beating businesses that produce high quality goods and services with international demand
2. Overvalued exchange rate due to high fixed exchange rate or high financial account inflows i.e. hot money. Leads to less competitive exports and cheaper imports. Impact of this depends on PED.
3. If the country is growing faster than the ones it trades with, imports will increase and exports will fall

Question 16

What are the 2 policies for reducing a current account deficit

Answer 16

1. Expenditure-reducing policies
2. Expenditure-switching policies

Question 17

Explain the aim, condition, drawback and benefit of expenditure-reducing policies

Answer 17

Aim:
Deflating AD using monetary and fiscal policy to reduce imports

Condition:
Income elasticity of demand for imports needs to be high so that a small drop in GDP leads to a large drop in imports

Drawback:
Compromise other important macroeconomic objectives like growth, unemployment and cause undershooting of inflation target

Benefit:
If the deficit was caused by over-heating of the economy in a boom, deflating AD doesn’t have much macroeconomic opportunity cost

Question 18

Explain the aim and ways it can be done for expenditure switching policies

Answer 18

Aim:
Make UK products more attractive so both UK and foreign consumers switch their spending to the UK

How can it be done:
1. improve supply side
2. Bring inflation rate below competitors
3. Devaluation of currency
4. Protectionism i.e. tariffs against imports

Question 19

What are the drawbacks of expenditure switching policies

Answer 19

• Supply-side improvements take a long time
• Bringing inflation down only helps if PED for imports and exports is high and may not be possible without deflation
• Devaluation can be difficult and unpopular with other countries
• Protectionism can cause trade wars and the collapse of global free trade

This is why the best way to solve BoP disequilibrium is action from surplus countries