balance of payments 4.1 Flashcards
current account of a nation’s balance of payments is made up of four separate balances:
(1) Net balance of trade in goods
(2) Net balance of trade in services
(3) Net primary income (includes interest, profits, dividends and migrant remittances)
(4) Net secondary income (includes transfers i.e. contributions to EU, military aid, overseas aid)
Trade Balance in Goods (X-M)
o Manufactured goods, components, raw materials
o Energy products, capital technology
Trade Balance in Services (X-M)
o Banking, Insurance, Consultancy
o Tourism, Transport, Logistics
o Shipping, Education, Health,
o Research, Arts
Net Primary Income from Overseas Assets
o Profits, interest and dividends from investments in other countries
o Net remittance flows from migrant workers living and working overseas
Net Secondary Income
o Overseas aid / debt relief transfers
o Military grants
o UK net payments to the European Union budget (prior to the UK’s Brexit)
Capital Account
- Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts (example would be international buying and selling of land by businesses).
- Debt forgiveness/cancellation (forgiving debt is counted as a negative in this account).
- Capital transfers of ownership of fixed assets (i.e. international death duties).
Financial Account
(1) Net balance of foreign direct investment flows (FDI).
(2) Net balance of portfolio investment flows (e.g. inflows/outflows of debt and equity).
(3) Balance of banking flows (e.g. hot money flowing in/out of banking system).
(4) Changes to the value of reserves of gold and foreign currency.
Key Causes of a Current Account Deficit
- Poor price and non-price competitiveness
- strong exchange rate
- recession
- volatile global prices
- strong domestic economic growth
Structural (supply-side) causes
(1) Relatively low labour productivity / high unit labour costs.
(2) Insufficient investment in capital which limits a nation’s export capacity.
(3) Low levels of national saving.
(4) Long term declines in the real prices of a country’s major exports.
Consequences from a current account deficit
- a loss of AD as trade deficit
- big current account deficits
- Unsustainable current account deficits can ultimately lead to a loss of investor confidence
Measures to reduce a country’s imbalance on the current account
- expenditure switching policies
- expenditure reducing policies
The J Curve Effect
- This is because the price elasticities of demand for exports & imports are likely to be inelastic in the short term.
- Initially the quantity of imports bought will remain steady in part because contracts for imported goods are already signed. Export demand inelastic in response to exchange rate change as it takes time for export businesses to increase their sales following a fall in prices.
- Earnings from selling more exports may be insufficient to compensate for higher total spending on imports.
- The balance of trade may therefore initially worsen. This is known as the ‘J-Curve’ effect.
- Providing that PED for imports exports greater one, then trade balance improve overtime.
- known as Marshall-Lerner condition.
j curve effect
shows possible time lags between a falling currency and an improved trade balance
The Marshall Lerner condition states that
depreciation / devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1
The J-curve effect and application of the Marshall-Lerner condition are effective ways to evaluate
impact of exchange rate changes
What are global trade imbalances?
Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations.
Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations.
o Run up large external debts and are increasingly reliant on foreign capital.
o May decide to switch towards using protectionist policies such as tariffs and quotas.
o Deficits can lead to a fall in relative living standards over time if economic growth slows down
Surplus countries:
o Are saving more than they spend, thereby depressing global demand and growth.
o May be adopting a policy to keep their currency deliberately under-valued against other countries.
o Might be under-consuming (thus affecting living standards) and allocating domestic scarce resources to exporting overseas rather than allowing higher levels of domestic consumer spending.
short term causes of deficits and surpluses
- consumer demand and household spending - income
- marginal propensity to import
- exchange rate
- relative inflation rate
medium term causes of surpluses and deficits
- as country loses its comparative advantage, consumers switch to other countries
long term causes of surpluses and deficits
- lack of capital investment
- deindustrialisation
- natural resources
- competitiveness
- corruption levels
two main causes of deficit
demand side
supply side
demand side policies to reduce imbalance
- Contractionary monetary or fiscal policy to reduce AD =lower demand for imports
- effective as high MPM
- but reduction in QoL and econ growth
supply side policies to reduce imbalance
- improve productivity and efficiency or quality through comp. policy or infrastructure improve
- encourage industries to exploit opportunities in export market overseas and focus resources on industries where the UK has a real CA
- but forces some industries to close - politically unpopular
Expenditure switching policies:
- use of tariffs
- control inflation
- devalue/ depreciate pound
use of tariffs
Tariffs or quotas will reduce the attractiveness of imports. However, they are likely to cause trade wars as other countries implement protectionist policies and so therefore may even worsen the deficit. These are almost impossible to implement, given trading blocs and the laws of the WTO.
control inflation
the price of British goods rises slower than those in other countries, meaning that they become more competitive over time. The problem is that it will lead to a fall in demand for domestic goods and so therefore could cause unemployment and a fall in growth.
