LS7 + LS8 + LS9 - Balance Of Payments, Exchange Rates, International Competitiveness

Question 1

Accounts in BoP

Answer 1

Current account - trade of goods and services, income, transfers
Capital account - capital transfers, non financial asset transfers
Financial account - FDI flows, portfolio investment flows, banking flows, values of reserves of gold/foreign currency

Question 2

Advantages of international capital flows

Answer 2

Growth in world trade
Additional source of finance for firms - important for firms in developing countries
FDI can lead to transfer of technology and skills

Question 3

Disadvantages of international capital flows

Answer 3

Interconnected global financial system comes with stability risks
Can potentially undermine national security
Can lead to excessive borrowing

Question 4

Causes of CA deficit/surplus

Answer 4

Relative export competitiveness, exchange rates, states of the economy
Export competitiveness is determined by inflation, productivity, innovation, protectionism

If there is a current account deficit: must be a surplus in capital and financial account

If there is a current account surplus: there must be a deficit in the capital and financial account

CAUSES OF CURRENT ACCOUNT DEFICIT:

Relatively low productivity-
Low productivity raises costs

Exporting firms with low productivity may find themselves at a price & cost disadvantage in overseas markets which will decrease competitiveness & the level of exports

With higher domestic prices, consumers may also buy abroad thus increasing the imports

Falling exports & rising imports creates a deficit

RELATIVELY HIGH VALUE OF THE COUNTRYS CURRENCY:

Currency appreciation makes a country’s exports more expensive relative to other nations

Foreign buyers look for substitute products which are priced lower

Exports fall & the balance on the current account worsens

Similarly, currency appreciation makes imports cheaper

Domestic consumers may switch demand to foreign goods & as imports rise, the balance on the current account worsens

RELATIVELY HIGH RATE OF INFLATION:

A relatively high rate of inflation makes a country’s exports more expensive than other nations

Foreign buyers look for substitute products which are priced lower

Exports fall & the balance on the current account worsens

Similarly, high inflation may mean that goods/services are cheaper in other countries

Domestic consumers may switch demand to foreign goods & as imports rise, the balance on the current account worsens

RAPID ECON GROWTH RESULTING IN INCREASED IMPORTS:

Rapid economic growth raises household income

Households respond by purchasing goods/services with a high-income elasticity of demand (income elastic)

Many of these goods are imported & as imports rise, the balance on the current account worsens

Question 5

Problems of CA deficit

Answer 5

AD is reduced - but depending on size of deficit and its causes
Debt burden increases - but depending on how the deficit is corrected

Question 6

Problems of CA surplus

Answer 6

Heavy dependence on exports - but depending on size of surplus and also a good thing if a result of successful SSPs
Can be harmful to the economies of trade partners - depends on level of AD in trade partners economies

Question 7

Expenditure reducing policies

Answer 7

Contractionary monetary policy, contractionary fiscal policy
Fall in income -> fall in demand for imports -> rise in net exports -> fall in CA deficit -> position in CA improves
EV: could lead to recession, depends on MPM, business/consumer confidence and the level of output gap

Question 8

Expenditure switch policies - protectionism

Answer 8

Tariffs, quotas, embargoes, admin barriers, subsidies
Imports become more expensive -> exports are cheaper -> net exports rise and domestic output rises -> deficit falls
EV: retaliation, could break WTO rules, could be inflationary -> higher prices for domestic consumers, reduced comp so higher prices

Question 9

Expenditure switch policies - exchange rate weakening

Answer 9

Lower int rates, increase money supply, sell more domestic currency reserves
Export competitiveness rises, import competitiveness falls -> net exports rise -> deficit falls, better position on CA
EV: depends on ML condition is satisfied or not, could lead to inflation

Question 10

Expenditure switch policies SSPs

Answer 10

Spending on infrastructure, education/training, tax cuts, subsidies, etc
Higher output and productivity in long run -> boost domestic consumption -> net exports rise -> better position on CA

Question 11

Exchange rates

Answer 11

Value of one currency in relation to another
Floating - determined by market forces (S&D) cannot be set
Managed - value of currency is set by CB/govt against another currency/ies or gold
Fixed - market forces determine value, but is influenced by CB/govt - buying and selling currency, changing int rates, and currency control

Question 12

Marshall-Lerner condition

Answer 12

For a depreciation in currency to cause improvement in BoP, PED of imports + PED of exports have to be >1

Question 13

J-curve

Answer 13

Initially, a depreciation of currency will lead to a deterioration in the CA position before it starts to improve in long run
This occurs due to contracts preventing firms from immediately switching suppliers, and firms and consumer need time to adjust to changes in price

Question 14

Evaluation points to rectify a current account deficit

Answer 14

The cause of the current account deficit. GOV needs to know root cause and target policies - directly overcome the underlying problem. Expenditure reducing policies will only be useful if there is excessive import expenditure due to high incomes. Structural issues- supply side policies= long-term solution. Consequence of using wrong policies, macroeconomic objectives conflicts, burdens on future tax payers or worsened international relations.

Is the current account deficit really a problem?

§ A small deficit is unlikely to be difficult to finance especially if GDP growth rates are increasing faster than the current deficit- implies that a country can afford its borrowing to finance the C.A deficit without risk of panic fuelled currency crisis in the long term. GOVs looking to use expenditure reducing policies - worsen growth and U/E unnecessarily.

§ However, if the deficit balloons and grows at a faster rate than increases in real GDP, = unsustainable and indicative of debt dependency = negative consequences of running a C.A deficit more significant.

§ Once more if the deficit is caused by structural problems, it would be long term and persistent.

Question 15

Significance of global trade imbalances

Answer 15

Current account imbalance is not much of a problem as long as the capital and financial account is in surplus.- financial crisis of 2008 dramatically reduced the amount of capital flowing around the global economy and showed how quickly the position of the capital account can change. Pound fell 10% In Brexit. 25% in GFC

§ Exposed to macroeconomic shocks

§ Since the late 1990s, concerns about global imbalances which can be measured in two ways: imbalances on the C.A and imbalances in assets owned abroad or borrowing owned abroad. The two linked since if a country has a constant surplus, then it will tend to build up a stock of assets abroad whilst if they have a constant deficit, they will owe more and more to foreign creditors. This may become an issue if imbalances are large.

§ Problems arise if foreign investors refuse to lend to a ‘country’- but it is an individual or institution which takes the loan and not the country. If they refuse to lend to a bank or the GOV, this will have much larger impacts than if they refuse to lend to a firm or individual.

§ Today, deficits are less of a concern to countries: the US and UK have no problem financing their deficits and borrowing has not built-up unsustainable debts.

§ C.A imbalances become a problem when GOVs can’t repay their foreign currency debts.

§ Countries with large deficits are seen as having a problem, whilst those with large surpluses are seen as being successful but in reality, those with surplus cause just as much instability as those with deficits.

§ C.A surpluses cause losses for citizens in a country who don’t see the high living standards which they could
enjoy from consuming more

Question 16

Difference between reevaluation and appreciation

Answer 16

As with any market, if there is excess demand for the currency on the forex market, then prices rise (the currency is worth more)
In a floating exchange rate system this is called an appreciation

A revaluation occurs if the Central Bank decides to change the peg and increase the strength of its currency

Question 17

Difference between devaluation and depreciation

Answer 17

A devaluation occurs if the Central Bank decides to change the peg and decrease the strength of its currenc

If there is an excess supply of the currency on the forex market, then prices fall (the currency is worth less)
In a floating exchange rate system this is called a depreciation

Question 18

Factors affecting a floating exchange rate

Answer 18

What factors cause an appreciation- factors that shift demand for the pound to the right

1. Increases in income abroad. As incomes abroad increase, MP of foreigners to buy UK G&S increases. This increases demand for UK exports and thus demand for the pound from D1 to D2- APPRECIATE from P1 to P2
2. Relative rise in UK I/R- as UK rates increase and are relatively higher than the rest of the world, investors will put their money in UK banks. ‘hot money inflows= increase demand for the pound shifting the demand curve = appreciation
3. An increase in FDI in Britain. Higher demand for the pound as capital needs to be brought by foreign businesses in pounds to operate in the UK. Staff need to be paid in pounds forcing an exchange of foreign currency into pound INCREASING DEMAND for pound forcing an exchange of currency into points. APPRECIATION
4. Imports- supply side. INCREASES
5. Speculators anticipating a rise in the pound- look to make a speculative gain. Speculators anticipate a rise in pound,buymorepound,increasingdemand-sellitwhenitincreases=gain.Shiftsdemandright-APPREC. a
6. Improvement in international competitiveness - better labour prod, investment/ low inflation rate. UK exports more price comp/ non-price comp demand for exports increase. UK goods bought in £ demand increases= apprec
7. High investor confidence into the economy- high confidence in l/t state with little economic volatility, investors move their money into UK banks for a good rate of return. Increase demand for pound= appreciate

FACTORS CAUSING A DEPRECIATION

UK Businesses investing abroad- selling the pound , shift supply curve right= depreciation. Outflows of FDI

Speculators anticipating a fall in pound-sell pounds, increasing supply= depreciation from P1 to P2

Increase in income domestically - MPI, consumers ‘sucking in’ imports, investors sell pound, supply curve to the right, depreciation

A fall in relative interest rates- investors move their money to foreign countries, better return. Hot money outflow shifting supply right, depreciation

Low investor confidence in the economy- sell the pound to get a more stable, reliable rate – sell ££- depreciate

Question 19

Intervention in the markets using int rates and forex transactions

Answer 19

Changing interest rates: if the Central Bank wants to appreciate the country’s currency, it would raise interest rates thereby making it more attractive for foreigners to move money into the country’s banks (hot money). Decreasing interest rates has the opposite effect & causes a depreciation

Buying & selling currency in the forex market: The Central Bank can change the demand or supply for their currency using their reserves. If they want to appreciate the currency then they buy it on the forex market using foreign currencies e.g. to bolster the value of the £, the Central Bank could take US$’s from their reserves & buy £’s. If they want to depreciate the currency then they sell their own currency & buy foreign currencies

Question 20

Advantages and disadvantages of depreciation/devaluation

Answer 20

Improved trade balance-exports cheap, imports dear. Theory suggests that demand for imports and thus expenditure on imports will decrease, demand for exports and revenue generated will increase= imp in trade balance of C.A – move to surplus or reduce def. esp true if country suffers larger trade in goods than services

Increased growth and reduced unemployment- exports cheap, imports dear. (X-M) component of AD, AD will rise increasing economic growth. Labour is a derived demand, more employment is needed to produce extra goods and services demanded reducing u/e in the economy

FDI: A fall in the currency may increase FDI because it becomes cheaper to invest. However, if the currency is continuing to fall then this is an indication that an economy has serious economic difficulties which will discourage investment

DISADVANTAGES:

.INFLATION- Demand pull inflation- AD increases putting pressure on existing factors of production, increasing prices of them. , firms may more for imported raw materials. Costs of production increases SRAS to the left and firms pass on extra costs via higher prices. Worse for a nation heavily dependent on imported commodities, significantly dampen economic growth; even leading to a recession alongside higher thn target inflation- stagflation

Evaluation (opposite for appreciation):

§ Depends on whether the Marshall-Lerner condition is satisfied. sum of elasticities for net exports in the UK is - 0.78 - demand for exports is inelastic, as the price of exports decrease, demand will increase -therefore decreasing export revenue. UK the Marshall-Lerner condition is not satisfied, there will be a net increase in import expenditure relative to export revenue, worsening the trade balance, worsening C.A deficit contrary to what theory suggests. This may therefore not increase AD where growth will not increase, U/E may not decrease and demand-pull inflation may not increase.

§ Marshall learner condition will not be satisfied in the s/t due to very price inelastic demand for M AND X. contractual agreements make it difficult to switch, business take a while to adjust to E/R, J curve effect- where the CA position for a country more likely to move from initial deficit to worse deficit, noticeable time lag when contracts end and economic agents adjust to a permanently lower E/R. satisfy condition

§ Depends on severity of the trade restrictions applied by foreign gov. fall in E/R insignificant impact if gov has strict controls on exports

§ Depends upon size of depreciation. Large depreciation- increase demand for exp sig, large drop in price of expo sway foreign firms and consumers to purchase exp that have dropped by a greater margin. Could lead to inflation AD increases further - economy reaches FE - pressureut on excess resources increasing demand pull inflationary pressure. Large depreciation greatly increase import prices thus increase firms COP- CPInflation

§ Whether a weak exchange rate will rectify a C.A deficit depends upon income and demand overseas. demand overseas is weak - recession in economies of major trading- demand for exports will be low despite fall in export prices via weak e/r . Export revenues = not increase leaving the c.a def unaffected/ even worsening it.

§ Incomes and thus demand at home. If demand at home is strong due to a boom demand for imports -high ‘sucking in’ imports despite rise in import prices via weak e/r. Import expenditure may therefore not decrease leaving the C.A deficit unaffected/ even worsening it.

§ Depends upon initial level of economic activity- initially operating large levels spare capacity- increase AD lead- larger increase output, decrease in u/e= easy for firms to expand production using up excess labour and capital- lack of pressure limits rise in inflation potentially no DPI= not making exports less competitive and worsening C.A position

Question 21

Impacts of the changes to exchange rates to an economy

Answer 21

The current account-

Depreciation of the £ causes exports to be cheaper for foreigners to buy & imports to the UK are more expensive

The extent to which this improves the current account balance depends on the Marshall-Lerner condition

This follows the revenue rule which states that in order to increase revenue, firms should lower prices for products that are price elastic in demand
If the combined elasticity of exports/imports is less than 1 (inelastic), a depreciation (fall in price) will actually worsen the current account balance

It is also important to recognise that there is a time lag between the depreciation of the £ and any subsequent improvement in the current account balance

This is explained by the J-Curve effect
It takes time for firms & consumers to respond to changes in price
Once it becomes evident that price changes will last for a longer period of time, firms & consumers switch
E.g. a firm in the USA has been importing electric scooters from the UK. If the Euro depreciates, the price of scooters in France becomes relatively cheaper. In the short-term, the USA firm will not switch immediately to purchasing scooters from France as the exchange rate may soon bounce back. They also have a good relationship with their UK suppliers. In the long term they are likely to switch

ECONOMIC GROWTH-
Net exports are a component of aggregate demand (AD)
A depreciation that results in an increase in net exports will lead to economic growth

INFLATION-
Cost push inflation is likely to occur as the price of imported raw materials increases with currency depreciation
Net exports are a component of aggregate demand (AD)
A depreciation that results in an increase in net exports will lead to an increase in aggregate demand
This may lead to an increase in demand pull inflation
An appreciation of the currency will have the opposite effect

UNEMPLYOMENT- If depreciation leads to an increase in exports, unemployment is likely to fall as more workers are required to produce the additional products demanded
An appreciation of the currency will have the opposite effect

LIVING STANDARDS-
The impact of a depreciation on living standards can be muted
As imports are more expensive, households face higher prices & less choice, which detracts from living standards
Rising exports can decrease unemployment & increase wages/income which means an improved standard of living for some households
The impact of an appreciation on living standards will be the opposite

FDI- Depreciation of a currency makes it cheaper for foreign firms to invest in the country and can increase the FDI
The money they have available to invest is worth more when the currency has depreciated
An appreciation has the opposite effect

Question 22

Case for floating exchanged rate to be used

Answer 22

Reduced need for currency reserves- no e/r target – little need CB hold large scale reserves of foreign currency. Holding them is ££- carries large OC-allow for > expenditure- productive areas in economy, sustained, sustainable growth over l/t

Freedom (autonomy) for domestic monetary policy. Allows I/R to be set to meet domestic macroeconomic obj such as stabilising growth or inflation. Cannot happen under fixed E/R – any changes to I/R – fixed rate not being maintained

Useful instrument of macroeconomic adjustment- depreciation= boost to net export demand, stimulate growth. Countries inside eurozone might be hoping for more competitive, weaker euro as a means of creating an injection of demand into slow growing economies. Appreciation useful in keeping inflation under control and towards target

Partial automatic correction for trade imbalances. Floating e/r offers degree of adjustment when BOP is in fundamental disequilibrium- i.e. large trade deficit downward pressure on e/r. should boost export rev and reduce demand for imp and expenditure- rectified c.a deficit. Large trade surplus upward pressure on e/r, reduce exp rev and increase imp exp reducing surplus back to balance

Reduced risk of currency speculation. Explicit e/r target reduced risk of spec. currency market speculator target fixed e/r, believe to be over or undervalue, under floating e/r – risk is minimal as theory PPP is reflected in e/r. consequence of less likelihood of speculative arrack, e/r is unlikely to collapse and trigger econ crisis.

Evaluation against floating e/r:
Floating exchange rates can create uncertainty if volatile- businesses planning future- difficult for predictions about costs, risk and investment harder to assess- levels of investment decline. Once exporters/importers find more difficult to interpret short VS l/t changes in the e/r = uncertainty reduces volume of trade. Foreign firms wary of volatile e/r acts as deterrent to invest abroad (less FDI)= reduced actual and potential growth for economy

Floating exchange rates do not necessarily self-adjust to eliminate trade imbalances nor do they always reflect PPP
often more dominating factors than trade that affect movements in the E/R that can stop PPP being reflective and downward pressure on E/R due to trade deficit. consequently, benefits if do exist will be minimal

Floating exchange rate may worsen inflation. Country high relative inflation - exports less competitive and imports less expensive – E/R fall, more supply of currency than demand however could increase DPI as (X-M) increases also increasing import prices; cost push inflation fuelling overall inflation rate above target

Question 23

Case for fixed exchange rate to be used

Answer 23

Trade and investment increase, reduced e/r uncertainty. Businesses forecast costs easier, risk and ROI easier to predict, increase FDI. Increase actual, potential growth

Some flexibility permitted- If economic case becomes unstoppable and e/r are set damagingly high/ low; occasional devaluation or revaluation of currency can take place if agreement can be reached with other countries. Countries with fixed e/r reluctant to make parity adjustments

Reductions in the costs of trade (currency hedging)- impossible to predict what will happen to market value of currency, businesses hedge against this volatility by buying currency they need in the forward currency markets, more risky and could be more ££ in SPOT markets. With fixed e/r, businesses spend less on currency hedging if they know currency will hold value in FOREX markets, enabling money to be used more productively to invest

Disciplines on domestic producers- exporters forced to improve competitiveness of goods and services to maintain strong export sales and rev- they know they’ll receive no benefit from weaker e/r. implementing training programmes, exploit E.O.S, negotiating better deals with raw materials. S/T and L/T growth can be promoted, increases in AD, LRAS as result of persistent net export increases and competitiveness improvements

EVAL:

Countries must ensure they have a large level of foreign exchange reseves to maintain a fixed exchange rate- to intervene in FOREX, requires huge reserves. Highly expensive to maintain, OC huge-huge

Interest rate changes to maintain a fixed exchange rate may have detrimental side effects on the rest of the economy- Fixed e/r- danger of falling, I/R rise to maintain value- deflationary impact – lowering AD, reducing. Growth and increasing u/e. no freedom to cut i/r given the lower pressure it’s put on the fixed rate forcing policy

Question 24

International competitiveness

Answer 24

Ability of a country to produce goods and services of a quality and price attractive to consumers abroad

Question 25

Measures of international competitiveness

Answer 25

§ The lower level of international competitiveness, more likely that the country will face a C.A deficit. For goods to be competitive internationally= cheap, have good quality, design or after-sales and good marketing.

MEASURES:

Relative unit labour costs: = total wages divided by real output: the cost of employing workers for each unit of good. A rise in relative unit labour costs in the UK shows that labour cost per unit is rising faster in the UK compared to other countries - UK is becoming less competitive.

§ Relative export prices: This is the price of UK exports compared to the exports of the UK’s main trading partners.

Question 26

Factors influencing international competitiveness

Answer 26

Exchange rates: rise in pound - cause exports to become more expensive, UK goods less competitive as their price changes. However, this depends on the elasticity the good and the reaction of the firms as explained in. China e/r policy- artificially low- export led growth

Productivity: rise = rise in the UK’s competitiveness- costs are lower = prices fall. UK-20% BELOW G7 AVG

Regulation-less adaptable to changes in global market- increases cost of production- reduces competitiveness because of higher costs and slow decision making.

Investment: Investment in infrastructure improves productivity and ensures firms can deliver and produce their product reliably, cheaply and efficiently. Allows firms to develop new products, increases competitiveness

Taxation: High levels of taxation reduce investment and so cause a reduction in international competitiveness in the long term.

Inflation- Low levels of inflation increase competitiveness - UK goods become more competitive over time.

Economic stablity- If the country is not seen as stable, then there will be little long-term investment and so this will reduce competitiveness overtime.

Flexibility: If the labour market is flexible, this will improve competitiveness as businesses will be able to move labour in response to changes in demand prevent unnecessary wage rises- costs and prices low. Flexible and efficient managers manage change within the company adapt production when demand for products changes.

Competition and demand at home: A good level of domestic demand - firms in the country will have economies of scale, and so have low AC curves. Similarly, high levels of competition will mean firms will have to have good quality or cheap products to survive. compete internationally.

Factors of production: good quality FOP - produce more and better-quality goods Openness to trade:

§ Country will experience C.A surpluses- opportunity to invest overseas/ build up a surplus of assets ove

Question 27

Benefits and problems of competitiveness

Answer 27

BENEFITS:

Country will experience C.A surpluses- opportunity to invest overseas/ build up a surplus of assets overseas, on which interest, profit and dividends can be earned.

§ A competitive economy is likely to attract inflows of foreign investment, whether this be by establishing new companies (creating jobs) or buying domestic firms. This will lead to a transfer of knowledge, skills and technology to firms. L/R GROWTH

§ Employment is likely to increase because more goods are being produced, since more goods are exported and less are imported, so more are sold internationally and domestically. A rise in demand for labour will lead to a rise in wages.

§ There will be economic growth, both by supply side improvements due to efficiency and investment and by demand side improvements relating to X-M.

Problems of competitiveness:

§ Competitiveness can be easily lost. Developing countries who’ve benefits - low costs of labour/ costs of materials - could see this eroded - experience export led growth due to comp. C.A surplus - rise in e/r reduce competitivene

§ Less competitive countries may implement trade barriers to protect themselves.

§ Countries who are competitive may become more dependent on overseas countries - suffer from larger issues if global recession