BOP Flashcards
Financial account
Transaction in financial assets, investment flows and central government transactions in foreign exchange reserves, gold, bonds etc. Importantly, it includes investment in foreign companies abroad (FDI)
Capital account
Relatively small. It includes physical capital transfers. When a migrant becomes a resident of the UK, then an assets owned by that person are transferred to being British owned.
It also includes royalties (income from owning an asset like a book or music. Also includes incoming and outgoing capital for FDI
Current account
Trade in goods: net goods exported
Trade in services: net services exported.
Profits and income payments: inward flows from the profits of British companies, outward flows of foreign companies’ profits operating in the UK. Transfers of wages/income such as British people working abroad and sending money back home and vice versa (remittances).
Transfer payments: smallest portion - money transferred between governments.
If a foreign firms purchases physical capital in order to set up in the UK…
then the initial inflow of FDI is entered as an inflow on the capital account. The resulting profits which are made by the foreign firms, will be record as an outflow on the profits and income section of the current account.
Reasons for a trade surplus
Low valued exchange rate: This would make exports more price (ceteris paribus). China has been accused of under valuing its exchange rate to enhance competitiveness.
Competitiveness: Low unit labour costs (total cost of labour divided by units produced) from high productivity means lower price relative to other countries. Dynamic efficiency would mean higher quality, innovative products.
High domestic saving ratio: increased savings of people will mean less demand imports. Whereas US and UK have high MPMs (marginal propensity to import) resulting in high levels of imports…if the MPM was low then a current account surplus is more likely.
Protectionism: policies such as tariffs, quotas and regulations may reduce the level of imports. However, retaliation could than restrict the level of export.
FDI: Foreign companies invest in a country and then export to the rest of the world. This would also be an inflow on the financial account. However, profits being sent back to country of origin would be an outflow of the current account.
Is a deficit always bad?
Type of imports: Where imported goods are raw materials or machinery they may lead in the long run to a more competitive economy and cause export revenue to increase. Raw material can be turned into exports.
Size of the deficit: The current account deficit can be measured as % of GDP, some economists believe a deficit is sustainable as long as it doesn’t exceed 5% of GDP.
Inflation: A deficit may also imply high levels of imports, under such circumstances an increased demand for imports reduces inflationary pressures due its dampening effect on AD.
If the exchange rate is weak: A current account deficit, in theory, can self-correct itself into a surplus…if the deficit is caused by an increase in imports, the supply of pounds will increase. (UK residents will need to supply pounds to receive foreign currency to pay for the imports) and the value of the exchange rate will fall. This in turn will lead to an increase in exports (as they are cheaper) therefore self-correcting the current account deficit into a surplus.
Policies to correct a deficit
Using supply side policies to increase international competitiveness.
What are the causes of a current account deficit?
The root cause of the current account deficit is usually either related to excess AD (too much spending on imports) or because of supply side weakness (a lack of international competitiveness due to low levels of investment in R&D, weakness in design/labour productivity, higher relative inflation then trading partners over several years).
In any policy question focus on the underlying cause.
What do expenditure reducing policies do?
Policies which aim to reduce the real spending of consumers (therefore reduce imports).
Fiscal policy can be used (e.g. a rise in income tax that reduces disposable income).
Higher interest rates would dampen consumer spending which is the largest component of AD, hence slowing down the rate of economic growth. Although imports may reduce, (X-M) is the smallest component of AD.
What do expenditure switching policies do?
Policies that encourage consumers to switch their spending away from imports towards the output of domestic firms. Expenditure occurs if relative price of imports can be raised, or if the relative price of UK exports can be lowered.
Measures include:
Tariffs or other import controls can occasionally be used but could result in retaliation.
Policies that reduce the rate of inflation below that of other international competitors leading to an improvement in price competitiveness.
A depreciation/devaluation of the exchange rate which increases the price of imports and reduces the foreign price of exported goods and service. For a depreciation to work, your PED of your exports plus the PED of imports must = 1. If you devalue the currency, people will buy imports regardless of changes in value of currency. Similarly, the revenue generated from imports will fall as the change in price is proportionally greater than the change in quantity demand. This in turn reduces (X-M), worsening the current account deficit.
What is a short term issue of depreciating the exchange rate?
(EVAL)
Devaluation of the currency cause the current account balance to become worse. Supplier won’t initially respond due to hedging and the view that this could be temporary fall. Hedging means that importers are likely to be bound contracts and so cannot switch quickly. Hedging agrees and exchange rate between firms and supplier which usually take 6-18 months.
Providing that the sum of PED (X) and PED (M) is greater than one, the the trade balance will improve overtime.
What is the Marshall-Lerner condition?
The condition that states that devaluation (of the currency) will have a positive effect on the current account only if PED (X) + PED (M) is greater than one.
Why may a country do nothing about a current-account deficit?
In theory, a current account deficit will self-correct, as a deficit on the current account will lead to fall in the value of the currency. If the deficit is caused by an increase in imports, the supply of pound will increase and the value of the exchange rate will fall. Equally. when the current account deficit is caused by a fall in exports - the demand for currency falls. Theoretically therefore, a deficit eventually leads to a weakening of the exchange rate and makes exports cheaper (so increased exports) - self-correcting itself over time. Nevertheless, this depends on the Marshall-Lenner condition.
Why may a deficit not be used negatively?
When it is caused by importing raw material and capital, which can be used to improve the macroeconomy and used to make high-value imports exports (Application: Zambia import copper ore and export copper).
If the economy is experiencing high inflation, then a reduction in AD (m part (X-M)) will help counteract the situation - dampening demand-pull inflation.
Could imply that the country has high FDI and that companies are simply sending profits back. FDI invest in physical infrastructure and create employment (may be significant in areas with structural employment and a low occupational mobility).
