Balance of Payments

Question 1

Define balance of payments

Answer 1

Record of all financial transactions between 1 country and other countries

• inflow recorded as ➕ item
• outflow recorded as ➖ item

Question 2

What are the main components of the balance of payments?

Answer 2

1) Current account
2) Capital account
3) Financial account

Question 3

What is the current account composed of?

Answer 3

1) Trade balance
2) Income balance (primary income)
3) Current transfers (secondary income)

Question 4

What is the trade balance?

Answer 4

(value of 🚘 and 🧹 exported) ➖ (value of 🚘 and 🧹 imported)

- may be separated into trade in 🚘 balance and trade in 🧹 balance

Question 5

What is the income balance (primary income)?

Answer 5

(income flowing into country from non-residents) ➖ (income flowing out of country from residents to non-residents)

Question 6

What are current transfers (secondary income)?

Answer 6

Income that has no corresponding output e.g. donations, tax payments, foreign aid and grants

Question 7

What comprises or influences the financial account?

Answer 7

1) FDI
2) Portfolio investment (in shares and bonds)
3) Changes in foreign exchange reserves
4) Short term capital flows (🔥 💵 flows)

Question 8

What comprises the capital account?

Answer 8

Transactions associated with changes of ownership of 🇬🇧’s financial assets and liabilities

Question 9

What are the causes of current account deficits?

Answer 9

1) ⬇️ productivity relative to other countries- … country’s 🚘 and services ✖️ competitive internationally
2) ⬆️ inflation relative to other countries- exports ⬆️ expensive- ⬇️ competitive
3) Dependency on ⬆️ priced imports e.g. raw materials- … large outflow of 💵
4) Relocation of manufacturing industries to ⬇️ wage countries … exports ⬇️
5) Protectionism by other countries- make country’s 🚘 and 🧹 ⬇️ competitive
6) Poor quality 🚘 relative to those produced by other countries- ⬇️ competitive
7) Overvalued exchange rate- imports cheaper and exports ⬆️ expensive

Question 10

What are the causes of current account surpluses?

Answer 10

1) ⬆️ productivity relative to other countries- … country’s 🚘 and services ⬆️ competitive internationally
2) ⬇️ inflation relative to other countries- exports cheaper- ⬆️ competitive
3) Abundance of raw materials- ⬆️ demand by other countries-> ⬆️ exports
4) Undervalued exchange rate- imports expensive and exports cheaper
5) Protectionism by domestic country- aimed to ⬇️ imports (made ⬆️ expensive)
6) ⬆️ quality 🚘 relative to those produced by other countries- ⬆️ competitive

Question 11

What has the 🇬🇧’s current account looked like in recent years?

Answer 11

Deficit on current account- trade in 🚘 balance deteriorated particularly

Question 12

What are the main causes for the 🇬🇧’s current account deficit?

Answer 12

1) ⬆️ value of sterling
2) Continuous economic growth (1992-2008)-> rising real incomes-> ⬆️ marginal propensity to import-> ⬆️ imports and … deficit on current account
3) ⬇️ productivity- since financial crisis-> ⬆️ average costs
4) Relocation of manufacturing to countries with ⬇️ labour costs e.g 🇨🇳
5) Slow growth in Eurozone-> ⬇️ demand for 🇬🇧’s exports
6) ⬆️ protectionism by 🇺🇸 (especially since financial crisis)

Question 13

State the ways in which a current account deficit can be reduced?

Answer 13

1) Supply side policies to ⬆️ productivity and competition
2) Expenditure-reducing policies
3) Expenditure-switching polices

Question 14

How can supply side policies, designed to increase productivity and competition, be used to ⬇️ a current account deficit?

Answer 14

Aim to ⬆️ competitiveness of 🚘 and 🧹- …-> ⬆️ exports and ⬇️ imports

Market based:

1) Privatisation- ⬆️ private owned industries than public owned … ⬆️ competition
2) Deregulation- ⬇️ government control in industries … ⬆️ competition (public sector reform)

Interventionist:

1) Education 📚 and training aimed to ⬆️ productivity of workforce- ⬆️ occupational mobility of labour (transferable skills)- ALSO determines level of human capital (knowledge and skills of workforce)-> ⬆️ productivity and competitiveness
2) Investment in infrastructure- ⬆️ efficiency e.g. travel costs 💵 and times ⏰-> cost savings-> ⬇️ production costs-> ⬇️ prices of 🚘 and 🧹-> ⬆️ competitiveness
3) Investment allowances and tax breaks- stimulate purchase of capital equipment (machines etc) AS WELL AS R and D (find new and ⬆️ efficient ways of production)-> ⬇️ costs-> ⬇️er prices-> ⬆️ competition

NOTE- LINKS TO INTERNATIONAL COMPETITIVENESS

Question 15

How can expenditure-reducing policies be used to ⬇️ a current account deficit?

Answer 15

1) Deflationary fiscal policy- ⬇️ AD by ⬆️ taxes and/or ⬇️ government expenditure
E.g. ⬆️ in direct taxes (income or corporation tax)-> ⬇️ disposable income-> ⬇️ consumption-> ⬇️ in imports demanded (… ⬇️ marginal propensity to import)-> improvement in balance of trade

2) Deflationary monetary policy- ⬇️ AD by ⬆️ interest rates
BUT EVALUATION- many countries e.g. 🇬🇧 have independent central 🏦 … ✖️ within governments power to ⬆️ interest rates to ⬇️ deficit

Question 16

How can expenditure-switching policies be used to ⬇️ a current account deficit?

Answer 16

1) Protectionist policies e.g. subsidies to domestic producers- spending switched from imports to domestic 🚘 etc
BUT EVALUATION- WTO rules or trading bloc membership may make impossible/illegal to employ these resources

2) Devaluation/depreciation ⬇️ of country’s 💴- exports ⬆️ internationally competitive as cheaper and imports ⬆️ expensive … spending switches to domestic 🚘
BUT EVALUATION- country with fixed exchange rate can devalue 💴 BUT under managed exchange rate depreciation ONLY possible via ⬇️ interest rates/QE or foreign currency transactions- ✖️ possible under floating exchange exchange rate and completely controlled by market forces e.g. 🇬🇧
BUT ✖️ possible for government if central 🏦 independent

Question 17

What is the significance of global trade imbalances?

Answer 17

IF deficits easily financed by inflows on financial account then ✖️ cause for concern ALSO under floating exchange rates- there should be an automatic adjustment where deficit-> ⬇️ exchange rate
BUT if deficits ✖️ able to be financed e.g. 🇺🇸 where 🇨🇳 financed deficits- ✖️ sustainable