Balance of payments pt3

Question 1

Devaluation in a free floating currency

Answer 1

This only applies to systems in which exchange rates are set by the government, but can also refer to the depreciation or downward float of the value of a currency in a free floating rate system. Sterling (£) is a free floating currency so government has limited power to influence exchange rates.

Question 2

Policy conflict/side effects

Answer 2

Deflationary policies deliberately depress economic activity which, although it should have an impact on the BOP deficit, will also have a much more direct impact incomes, employment, output and growth. Governments need to be wary. If the economy is overheating, deflationary policies make sense but not if the economy is struggling.

Question 3

The J Curve

Answer 3

The J Curve effect refers to the shape of a graph the plots BOP against time after a currency devaluation

Question 4

The J curve explained

Answer 4

The first part of the graph shows the deficit we want to eliminate. Devaluation then takes place and immediately after, the BOP gets worse due to time lag. Once the effect of devaluation kicks in, the BOP improves and the deficit reduces and even turns into a surplus.

Question 5

J curve in the long and short run

Answer 5

Price elasticities are greater in the LR. In the SR, firms are tied into contracts, and consumers do not immediately change habits. This time lag causes the deficit to get wider before it starts closing. Also in the LR the low exchange rate means imports are costlier which can lead to greater inflation, decreasing the countries export competitiveness again and cutting into the BOP surplus.

Question 6

Supply side policies and the current account

Answer 6

A lack of competitiveness leading to a BOP deficit can only be tackled in the LR through supply side measures. SSP’s should aim to allow the economy to become more productive and improve the quality of domestic production. Government can directly do this by funding research and innovation, or indirectly by supporting firms that engage in such activities

Question 7

Policies to tackle a BOP surplus

Answer 7

Reflation-Expansionary monetary or fiscal policy with the aim of increasing AD
Removal of controls-Removal or trade tariffs, quotas and regulations
Revaluation-High exchange rates to make exports less attractive and imports cheaper