Ch.72 Gov. Policy, Balance Of Payments And Exchange Rates

Question 1

4 parts of current account?

Answer 1

• trade in goods
• trade in services
• income balance
• current transfers

Question 2

What is the capital and financial account and what does it include?

Answer 2

Transactions associated with changes of ownership of the UKs foreign financial assets and liabilities.

Includes: hot money, FDI, investments in bonds and shares

Question 3

5 reasons for UK deficit on trade in goods?

Answer 3

• high value of sterling
• economic growth due to rise in incomes
• low UK worker productivity tf higher avg. costs
• ‘Chindia Effect’ -> inflow cheap imports into the UK
• relocation of manufacturing to cheaper countries

Question 4

Define exchange rate?

Answer 4

The price of one currency in terms of another.

Question 5

Causes of changes in exchange rate?

Answer 5

Relative inflation rates
Relative interest rates
State of economy
Political stability
Speculation

Question 6

Explain how relative inflation rates affect the exchange rate?

Answer 6

If domestic inflation rate is higher relatively, the domestic currency will fall in value

Question 7

Explain how relative interest rates affect the exchange rate?

Answer 7

If domestic interest rates are higher relatively, foreigners will put their money into UK banks, thus increasing demand for £ leading to a rise in the £ value

Question 8

Explain how the state of the economy affects the exchange rate?

Answer 8

Good performance -> investment -> higher demand for £ -> increase in value of £

Question 9

Explain how political stability affects the exchange rate?

Answer 9

If an economy is politically unstable, there will be a loss in confidence in the economy leading to less investment etc. therefore the value of the currency will fall.

Question 10

Explain how speculation affects the exchange rate?

Answer 10

If an economy is expected to have a boost in economic growth, people will invest/put money in UK banks leading to a higher value of the £.

Question 11

Define de/revaluation?

Answer 11

A fall or rise in the value of the currency when the currency is pegged against other countries (done by gov.).

Question 12

Explain 3 possible effects of a devaluing currency?

Answer 12

A) ->fall in export prices -> inc. in export volume

B) ->inc. import prices -> (if elastic) less import volume

C) ->inc. import prices -> (if inelastic) inc. import volume

Question 13

Define Marshall-Lerner condition?

Answer 13

Devaluation will lead to an improvement in the current account so long as the combined price elasticities of exports and imports are greater than 1.

If it is less than 1 revaluation is required.

Question 14

Balance of payments equilibrium = ?

Answer 14

No tendency for it to change

Question 15

2 problems with devaluation?

Answer 15

J curve effect = in the short run a devaluation is likely to lead to a deterioration in the current account position before it starts to move.

Cost push inflation: devaluation -> imported inflation -> CAN lead to an inflationary spiral

Question 16

Explain another effect of devaluation?

Answer 16

It results in expenditure switching.

Expenditure switching = government policies to switch production currently being sold domestically, to exports.

Question 17

5 ways to better the current account without de/revaluation?

Answer 17

Deflation
Interest rates
Protectionism
Currency controls
Supply side policies

Question 18

Explain how deflation might better the CA and EV point?

Answer 18

It’s an ERP.

Gov. raise interest rates -> fall in spending on imports and domestic goods.
Therefore imports fall and domestic firms start selling their goods abroad (increase exports).

EV: initially speculators will buy sterling to invest in banks, so short term effect is worsening of CA.

Question 19

Define expenditure reducing policy?

Answer 19

Government policies to reduce level of AD in order to reduce imports and boost exports.

Question 20

Explain how protectionism might better the CA and 3 EV?

Answer 20

Tariffs and quotas -> less imports -> better CA

1) difficult to do if part of trading bloc
2) can lead to retaliation
3) can lead to inefficiency

Question 21

Explain how currency controls might lead to bettering of CA and EV?

Answer 21

Governments can limit purchase of foreign currency. This results in less imports therefore better CA.

EV: UK can no longer do this due to EU membership.

Question 22

Explain how supply side policy can lead to better CA and EV?

Answer 22

Can reduce labour costs, increase efficiency, innovate quality and design of products etc.

This lead to higher exports and lower imports.

EV: long term solution, not short term.