Macro 16 - Balance of Payments

Question 1

What is the balance of payments?

Answer 1

The balance of payments is a record of all of a country’s financial dealings with the rest of the world over the course of a year

Question 2

What are the three parts of the balance of payments?

Answer 2

• The current account
• The financial account
• The capital account

Question 3

What are the four parts of the current account?

Answer 3

• Trade in goods
• Trade in services
• Investment income / Primary income
• Current transfers / Secondary income

Question 4

What is the primary income part of the current account?

Answer 4

Primary / Investment income comprises income earned by domestic citizens who own assets overseas minus income earned by foreign citizens who own assets in this country. It includes profits, dividends on investments abroad and interest

Question 5

What is the secondary income part of the current account?

Answer 5

Secondary income / Current transfers are the movements of money between countries which aren’t paying for goods or services and aren’t the result of investment

Question 6

What is the financial account?

Answer 6

The financial account is comprised of transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities. It includes FDI, portfolio investment in shares and bonds and other investments

Question 7

What is foreign direct investment (FDI)?

Answer 7

FDI refers to flows of money to purchase a controlling interest in a foreign firm. A controlling interest is defined as 10% or more of shares

Question 8

Define the term portfolio investment

Answer 8

Portfolio investment includes flows of money to purchase shares where this involves less than 10% of the company

Question 9

What is the capital account?

Answer 9

The largest transfers recorded by the capital account are those of immigrants and emigrants bringing financial capital to the UK or taking it abroad and of government transfers such as debt forgiveness to developing countries

Question 10

What are the factors affecting the current account?
(Causes of a surplus/deficit)

Answer 10

• Productivity
• Value of a country’s currency
• Rate of inflation
• Economic growth

Question 11

What is meant by cyclical causes of a current account deficit?

Answer 11

Cyclical causes refer to the trade cycle of the economy

Question 12

What is meant by structural causes of a current account deficit?

Answer 12

Structural causes refer to the supply side of the economy and are often associated with long term effects

Question 13

What are the different types of measures to reduce a current account deficit?

Answer 13

• Expenditure-reducing policies
• Expenditure-switching policies
• Supply side policies
• Do nothing

Question 14

What are expenditure-reducing policies?

Answer 14

Expenditure reducing policies relate to measures designed to reduce aggregate demand such as deflationary fiscal policy

Question 15

What are expenditure-switching policies?

Answer 15

Expenditure switching policies involve the use of protectionist measures such as tariffs or quotas or a devaluation of the currency under a fixed exchange rate regime

Question 16

What does the J curve show?

Answer 16

The J curve shows how a time lag will occur before the full effects of a depreciation or devaluation of a currency works through the economy to improve the current account position

Question 17

Draw a general J curve and label it

Answer 17

See page 11 in pack 16

Question 18

What goes on the x-axis on a J curve?

Answer 18

Time

Question 19

What goes on the y-axis on a J curve?

Answer 19

X-M

Question 20

State the Marshall-Lerner condition

Answer 20

The Marshall Lerner condition states that a depreciation/devaluation of the exchange rate will eventually lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports is greater than 1

Question 21

What is the relationship between the Marshall Lerner condition and the current account?

Answer 21

For a weaker currency to cause an improvement in the current account the Marshall-Lerner condition must be fulfilled

Question 22

What are some of the problems of a current account deficit?

Answer 22

• Persistent large deficits may be unsustainable in the long run and could be a sign of structural problems
• Large and persistent deficits are a problem due to the need to finance the increasing expenditure on imports
• Persistent current account deficits can mean a lack of aggregate demand as domestic consumers buy from abroad causing a withdrawal from the circular flow of income

Question 23

What are some of the problems of a current account surplus?

Answer 23

• Large and persistent surpluses can be a problem as resources are focused on producing to meet export demand rather than domestic demand so living standards could fall
• Large surpluses may be associated with low wages to gain competitiveness
• Surpluses involve high injections and can therefore cause demand-pull inflation
• Large surpluses may trigger protectionist responses from trading partners