balance of payments 4.1

Question 1

current account of a nation’s balance of payments is made up of four separate balances:

Answer 1

(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)

Question 2

Trade Balance in Goods (X-M)

Answer 2

o Manufactured goods, components, raw materials
o Energy products, capital technology

Question 3

Trade Balance in Services (X-M)

Answer 3

o Banking, Insurance, Consultancy
o Tourism, Transport, Logistics
o Shipping, Education, Health,
o Research, Arts

Question 4

Net Primary Income from Overseas Assets

Answer 4

o Profits, interest and dividends from investments in other countries
o Net remittance flows from migrant workers living and working overseas

Question 5

Net Secondary Income

Answer 5

o Overseas aid / debt relief transfers
o Military grants
o UK net payments to the European Union budget (prior to the UK’s Brexit)

Question 6

Capital Account

Answer 6

• 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).

Question 7

Financial Account

Answer 7

(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.

Question 8

Key Causes of a Current Account Deficit

Answer 8

• Poor price and non-price competitiveness
• strong exchange rate
• recession
• volatile global prices
• strong domestic economic growth

Question 9

Structural (supply-side) causes

Answer 9

(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.

Question 10

Consequences from a current account deficit

Answer 10

• a loss of AD as trade deficit
• big current account deficits
• Unsustainable current account deficits can ultimately lead to a loss of investor confidence

Question 11

Measures to reduce a country’s imbalance on the current account

Answer 11

• expenditure switching policies
• expenditure reducing policies

Question 12

The J Curve Effect

Answer 12

• 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.

Question 13

j curve effect

Answer 13

shows possible time lags between a falling currency and an improved trade balance

Question 14

The Marshall Lerner condition states that

Answer 14

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

Question 15

The J-curve effect and application of the Marshall-Lerner condition are effective ways to evaluate

Answer 15

impact of exchange rate changes

Question 16

What are global trade imbalances?

Answer 16

Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations.

Question 17

Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations.

Answer 17

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

Question 18

Surplus countries:

Answer 18

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.

Question 19

short term causes of deficits and surpluses

Answer 19

• consumer demand and household spending - income
• marginal propensity to import
• exchange rate
• relative inflation rate

Question 20

medium term causes of surpluses and deficits

Answer 20

• as country loses its comparative advantage, consumers switch to other countries

Question 21

long term causes of surpluses and deficits

Answer 21

• lack of capital investment
• deindustrialisation
• natural resources
• competitiveness
• corruption levels

Question 22

two main causes of deficit

Answer 22

demand side
supply side

Question 23

demand side policies to reduce imbalance

Answer 23

• Contractionary monetary or fiscal policy to reduce AD =lower demand for imports
• effective as high MPM
• but reduction in QoL and econ growth

Question 24

supply side policies to reduce imbalance

Answer 24

• 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

Question 25

Expenditure switching policies:

Answer 25

• use of tariffs
• control inflation
• devalue/ depreciate pound

Question 26

use of tariffs

Answer 26

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.

Question 27

control inflation

Answer 27

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.