Lecture set 1

Question 1

T/F: It is known that trade flows are larger than capital flows

Answer 1

False, Capital flows are larger than trade flows. These are though only estimates.

Question 2

How are capital flows defined?

Answer 2

Investment money associated to buying/selling of assets globally.

Question 3

What is the Balance of Payments (BOP) for a country?

Answer 3

An annual income statement for a country.

Question 4

What has to balance in the BOP?

Answer 4

Income and expenditure

Question 5

How does a country generate income over time?

Answer 5

By selling goods, services and/or assets to foreigners.

Question 6

In the country generates an income, what happens to the BOP?

Answer 6

The BOP goes up.

Question 7

What actors prepare the annual BOP?

Answer 7

National governments, large international organisations like the IMF

Question 8

Why is it so difficult to prepare the BOP?

Answer 8

Because only tangible goods have physical evidence of, not services and assets traded.

Question 9

What can BOP statements influence?

Answer 9

• Investment decisions
• Government policy decisions
• Interest rates
• Exchange rates
• Business practices

Question 10

Which are the two main accounts in the BOP statement?

Answer 10

Currenct account and the capital financial account

Question 11

What kind of transactions get recorded in the current account?

Answer 11

The buy and sell of goods and services

Question 12

What kind of transactions get recorded in the capital account

Answer 12

The buy and sell of various assets

Question 13

If a country has a trade balance described as X-M>0 then it must be

Answer 13

Running a trade surplus in the current account thus becoming a net seller.

Question 14

If a country has a trade balance described as X-M<0 then it must be

Answer 14

running a trade deficit in the current account thus becoming a net buyer.

Question 15

The gross national product (GNP) measures the value of produced goods and services, but what does it not include?

Answer 15

It does not include intermediate goods i.e. “half finished goods” only produced and sold goods.

Question 16

Savings can be mathematically shown as

Answer 16

S=Y-C-G

Question 17

If S>I then what does that mean for X and M?

Answer 17

X>M and we do have a trade surplus

Question 18

If a policy change does not have any effect on S or I will it have any effect on the trade balance?

Answer 18

No

Question 19

Can a government budget deficit have effect on the trade balance?

Answer 19

Yes, Because of the deficit, it means that Savings go down thus depreciation in I too, but if I is held fix, there is going to be a pressure on X-M to go down too. Resulting in a trade deficit, the country is a net buyer, thus trade deficit in the current account.

Question 20

Are current account surpluses desirable?

Answer 20

It depends, conventional wisdom says yes, but Economic theory and empirical evidence suggest otherwise.

Question 21

Say a country has a large X, why do they have that, name 5 possibilities.

Answer 21

1. Exporting country charge low price for high quality
2. The country is abundant in natural resources, i.e. oil.
3. Industry is successful because of low wages.
4. Government policy make it easy because they construct policy from mercantilist ideas.
5. Devalue the currency to obtain a current account surplus so that the goods are being cheaper to foreigners and jack up the exports.

Question 22

There are two main ways to explain large X in terms of trade flows and capital flows.

Answer 22

Trade flows: Import spending is normal but the country is a massive exporter, or import is very small.
Capital flows: Large S, domestic savings are high, i.e. capital flight. Small I, means that the country is in a recession.

Question 23

Say a country has a Small M, why do they have that, name 3 possibilities.

Answer 23

1. Consumers are highly nationalistic, they prefer domestically produced goods, there is a HOME BIAS. High price is necessary to maintain home bias which is bad for consumer welfare.
2. Government policy is designed to reduce import spending. This through import tariffs and import quotas. To block M and protect domestic industry.
3. Marketing

Question 24

Large Say a country has a large S, why do they have that, name 3 possibilities.

Answer 24

1. Large S indicates low consumption spending which means lower standard of living. Domestic firms must export everything they produce because nobody at home is being-weak economy.
2. Welfare system is bad, you need savings for unpredicted circumstances.
3. Government policy, by increasing savings rate

Question 25

Say a country has a Small I, why do they have that, name 2 possibilities.

Answer 25

A small I indicate that there is no investment activity. If there’s a lack of investment activity, productivity goes down and thus income decrease, wealth decrease which give a long term economic decline. Low investmentspending and low consiumptionspending-aggregate demand goes down.

1. Poor investment climate-nobody whats to invest in a recession. Maybe there is no protection for investors or risk is very high due to unstable economy.
2. Government policy is hostile towards foreign investors.

Question 26

Why might a current account surplus persist?

Answer 26

Capital leaving the country, domestic country is a risky place.

Question 27

Why might a current account deficit persist?

Answer 27

A safe harbor for capital investments, think Turkey.

Question 28

Is a current account deficit sustainable?

Answer 28

It depends on the average return and cost of capital.
_If there is no average return, but still cost on capital-unsustainable
_If average cost=average return-can go on forever
_If average return exceeds average cost-real wealth increase means trade deficit.

Question 29

Why do many developing countries experience persistent current account deficits?

Answer 29

Because there are high returns and relatively low risk.

Question 30

*Possible exam question: To understand trade imbalances you must first….?

Answer 30

Understand why capital leaves some countries and enters others

Question 31

*Possible exam question: explain why countries with extremely high rates of savings often experience trade surpluses whereas countries with high rates on investments often experience trade deficits.

Answer 31

Explain through S-I=X-M.
High rates-investment opportunities
High savings means that the country is a massive exporter but have low consumption spending.