Macro 8 - The current account of the balance of payments and exchange rates

Question 1

What is the balance of payments?

Answer 1

The balance of payments is a record of payments between one country and the rest of the world. It is made up of the current account, the capital account and the financial account

Question 2

What is the balance of payments made up of?

Answer 2

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

Question 3

What is the current account?

Answer 3

The current account is the part of the balance of payments which records trade in goods, services, investment income and current transfers

Question 4

What are the four sections of the current account?

Answer 4

• Trade in goods
• Trade in services
• Investment income (primary income)
• Current transfers (secondary income)

Question 4

What are the four sections of the current account?

Answer 4

• Trade in goods
• Trade in services
• Investment income (primary income)
• Current transfers (secondary income)

Question 5

What does the trade in goods part of the current account consist of?

Answer 5

Trade in goods measures the movement of tangible products across international borders

Question 6

What does the trade in services part of the current account consist of?

Answer 6

Trade in services measures the movement of intangible output between countries

Question 7

What does the investment/primary income part of the current account consist of?

Answer 7

Investment/primary income covers flows of money in and out of a country resulting from employment or earlier investment. It comprises interest, profits and dividends

Question 8

What does the current transfers/secondary income part of the current account consist of?

Answer 8

Current transfers/secondary income measures the payment of money across international borders that has no corresponding output

Question 9

How do you calculate the current account balance?

Answer 9

Add up the individual balances of the four different components of the current account to find the overall current account balance.
A positive balance is a current account surplus and a negative balance is a current account deficit

Question 10

When does a current account surplus occur?

Answer 10

When the value of inflows on the current account are greater than the value of outflows

Question 11

When does a current account deficit occur?

Answer 11

When the value of outflows on the current account are greater than the value of inflows

Question 12

For how long has the UK had a current account deficit?

Answer 12

The UK has had a deficit on its current account every year since 1984

Question 13

Define the term ‘exchange rate’

Answer 13

Exchange rates refer to the price of one currency in terms of another currency

Question 14

How can the exchange rate for pounds be thought of as for another country?

Answer 14

It can be thought of as how much of another currency can be bought with a certain amount of pounds

Question 15

Define the term ‘hot money’

Answer 15

Hot money flows refer to capital flows moving to countries with higher interest rates

Question 16

How do interest rates affect exchange rates?

Answer 16

1- As interest rates fall, saving in British banks becomes less attractive
2- This means people currently saving in British banks in the UK withdraw their savings
3- They switch their pounds into another currency for a country with higher interest rates
4- They then put these dollars (for example) into American banks. This money in known as flows of hot money
5- The process of lots of people swapping their pounds for dollars has caused less demand for the pound and so it has depreciated
6- This makes UK exports appear cheaper as the currency is now cheaper
7- This increases exports and decreases imports helping the net exports on the current account on the balance of payments

Question 17

What are the causes of a current account deficit?

Answer 17

1- Rising income domestically (in the UK)
2- Falling income levels abroad
3- A strong pound
4- Protectionism in other countries
5- Structural problems such as poor quality goods

Question 18

What is free trade?

Answer 18

Free trade is international trade without restrictions such as tariffs or quotas. Free trade provides benefits from specialisation, increases competition and the ability to transfer resources

Question 19

When does free international trade occur?

Answer 19

Free international trade occurs when there are no restrictions imposed on the movement of goods and services in and out of countries

Question 20

What is protectionism?

Answer 20

Protectionism restricts free trade, it is the protection of domestic industries from foreign competition

Question 21

Why may the government use protectionist policies?

Answer 21

1- To protect jobs
2- To protect infant industries (industries that are just starting out)
3- To ban certain goods
4- To avoid overdependence
5- To protect against dumping (when companies sell goods abroad at a price below the cost of production to try and force other countries’ domestic firms out of business)
6- To correct imbalances in the balance of payments

Question 22

What are some of the disadvantages of protectionist policies?

Answer 22

• Retaliation from other trading partners can make exports less competitive
• It allows uncompetitive industries to continue - perhaps it would be better long term to let that industry collapse and allocate resources in a more efficient way

Question 23

What are the different protectionist policies?

Answer 23

1- Tariffs
2- Embargos
3- Government purchasing policies
4- Red tape
5- Quotas

Question 24

What are tariffs?

Answer 24

Tariffs are a tax on imports which makes them more expensive and less competitive. The country’s domestic goods now seem more attractive allowing domestic industry to grow

Question 25

What is an embargo?

Answer 25

An embargo is an outright ban on export or import of a particular product or trade with a particular country

Question 26

What are government purchasing policies?

Answer 26

Government purchasing policies are when the government may give preferential treatment to domestic suppliers

Question 27

What is red tape?

Answer 27

Red tape is when a country makes it difficult to import by making things take a long time in customs or by providing a lot of paperwork to be completed so firms are more likely to buy domestically

Question 28

What is a quota?

Answer 28

A quota is a limit on the amount of a good which can be imported. It can also apply to a limit on the amount exported. A restriction of this nature typically restricts the import of a product which pushes up its price therefore causing people to turn to domestic goods instead.