Ch.72 Gov. Policy, Balance Of Payments And Exchange Rates Flashcards
4 parts of current account?
- trade in goods
- trade in services
- income balance
- current transfers
What is the capital and financial account and what does it include?
Transactions associated with changes of ownership of the UKs foreign financial assets and liabilities.
Includes: hot money, FDI, investments in bonds and shares
5 reasons for UK deficit on trade in goods?
- 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
Define exchange rate?
The price of one currency in terms of another.
Causes of changes in exchange rate?
Relative inflation rates Relative interest rates State of economy Political stability Speculation
Explain how relative inflation rates affect the exchange rate?
If domestic inflation rate is higher relatively, the domestic currency will fall in value
Explain how relative interest rates affect the exchange rate?
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
Explain how the state of the economy affects the exchange rate?
Good performance -> investment -> higher demand for £ -> increase in value of £
Explain how political stability affects the exchange rate?
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.
Explain how speculation affects the exchange rate?
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 £.
Define de/revaluation?
A fall or rise in the value of the currency when the currency is pegged against other countries (done by gov.).
Explain 3 possible effects of a devaluing currency?
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
Define Marshall-Lerner condition?
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.
Balance of payments equilibrium = ?
No tendency for it to change
2 problems with devaluation?
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
Explain another effect of devaluation?
It results in expenditure switching.
Expenditure switching = government policies to switch production currently being sold domestically, to exports.
5 ways to better the current account without de/revaluation?
Deflation Interest rates Protectionism Currency controls Supply side policies
Explain how deflation might better the CA and EV point?
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.
Define expenditure reducing policy?
Government policies to reduce level of AD in order to reduce imports and boost exports.
Explain how protectionism might better the CA and 3 EV?
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
Explain how currency controls might lead to bettering of CA and EV?
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.
Explain how supply side policy can lead to better CA and EV?
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.
