MACRO - balance of payments

Question 1

what is the balance of payments

Answer 1

a record of all the money going into and out of an economy

it ISNT the budget deficit which is government spending vs taxation

Question 2

what are the subsections of the current account

Answer 2

• trade in goods
• trade in services
• investment income
• transfers

Question 3

what is trade in goods

Answer 3

value of the balance of X-M
a good is a physical product

Question 4

what is trade in services

Answer 4

value of trade in non physical products eg financial services

81% of jobs are in the service sector in the UK, 30% of service sector jobs are internationally tradable

Question 5

what is investment income

Answer 5

• IPD = interest (on savings/bonds) profit (on enterprise, business activity) dividends (shares)
• income earned on investment overseas, not the investment but the return itself on the investment

Question 6

what are transfers

Answer 6

money moving across international boundaries without any trade or economic activity
eg migrants sending money home (remittances)

Question 7

what are the capital and financial accounts made up of

Answer 7

• direct investment
• portfolio investment
• flows of ‘hot money’
• net errors and omissions

Question 8

what is direct investment

Answer 8

foreign direct investment (FDI) money moved across international boundaries for business activity

Question 9

what is portfolio investment

Answer 9

if direct investment is 10% or less of an asset eg buying shares in an international company

Question 10

what are flows of hot money

Answer 10

• money moving around the world following high interest rate increases
• eg going up quicker in america than in eurozone so money could be worth more
• the scale matters, transfers are smaller

Question 11

what are net errors and omissions

Answer 11

in theory, two parts of balance of payments are meant to balance.
balancing items are net errors and omissions, set statistical projection

Question 12

why is the current account a bad thing

Answer 12

• dependency, imports are bigger than exports
• can weaken exchange rates which is worse for inflation
• demand side impact, growth and employment

Question 13

what is wrong with a current account surplus and which countries have them

Answer 13

• germany, china and japan have surpluses
• bad for dependency, dependent on export earnings. factors out of their control can strongly influence their economy
• can strengthen the exchange rate too much. everyone will want to change their money into the currency = stronger currency = reducing price competitiveness = bad when dependent

Question 14

what is a current account deficit

Answer 14

the UK spends more on imports from foreign countries, than they earn from exports to foreign countries.

If the deficit is large and runs for a long time, there could be financial difficulties with financing the deficit. This is known as an external deficit

Question 15

how does an appreciation of the currency impact bofp

Answer 15

a stronger currency means imports are cheaper and exports are relatively more expensive, which means the current account deficit would worsen.

Question 16

how does competition affect bofp

Answer 16

if a country becomes more internationally competitive, such as with lower inflation or if there is economic growth in export markets, exports should increase.

This also occurs when a country becomes more productive, since that causes average unit costs to fall. This could cause the current account deficit to improve, or increase the current account surplus.

Question 17

how does deindustrialisation affect bofp

Answer 17

In the UK, the manufacturing sector has been declining since the 1970s. The goods that the UK previously made domestically now have to be imported, which worsens the deficit.

Question 18

how does attractiveness to foreign investors affect bofp

Answer 18

A capital account surplus could be caused by incoming finance from investors buying UK bonds, securities and financial derivatives. This could help fund a current account deficit.

Question 19

how does membership of trade unions affect bofp

Answer 19

The UK has traditionally had negative current transfers, since fees are paid for membership of the EU.

Question 20

structural causes of current account deficit

Answer 20

• Relatively low productivity / high unit labour costs
• Insufficient investment in capital which limits a nation’s export capacity
• Low levels of national saving
• Long term declines in the real prices of a country’s major exports

Question 21

impact of productivity on bofp

Answer 21

• If the UK becomes more productive, the UK will be more internationally competitive. This causes exports to increase relative to imports.

Question 22

consequences of current account surplus

Answer 22

1) A loss of aggregate demand if there is a trade deficit (M>X) causes weaker real GDP growth = reduced living standards and rising unemployment
2) Big current account deficits will usually cause the currency to depreciate = higher cost-push inflation and a deterioration in the terms of trade
3) Some countries running current account deficits may choose to borrow to achieve a financial account surplus but this increase in external debt carries risks especially if interest rates rise
4) Unsustainable current account deficits = loss of investor consequence = capital flight and a possible currency / balance of payments crisis

Question 23

causes of current account surplus

Answer 23

• A large and persistent surplus of savings (S) over investment (I) for households, firms and the government. In these countries, consumption could be higher, and this would help to rebalance trade
• A large positive gap between exports and imports, when net income balance and net transfers are small
• An export surplus may be the result of high world prices for exports of commodities such as oil and gas.
• A surplus on the current account would allow a deficit to be run on the financial account.
• For example, surplus foreign currency can be used to fund investment in assets located overseas
• For example, some current account surplus countries have large sovereign wealth funds
• Current account surplus countries nearly always have a strong exchange rate as a result

Question 24

consequences of investment flows between countries

Answer 24

• FDI can help create employment, encourage the innovation of technology and help promote long term sustainable growth. It provides LEDCs with funds to invest and develop.
• Portfolio investments are passive such that control over the company is not gained. The investment aims to make a financial gain.
• FDI, on the other hand, allows the investor to gain some control over the firm. It includes finance such as pension funds, hedge funds and stock market money flows.

Question 25

how can fiscal policy correct deficit/surplus

Answer 25

DEFICIT:
- income tax increase = reduce disposable income = reduce imports
- gov reduce spending = reduce AD = less imports and forces firms into increasing exports = improves disequilibrium

Question 26

fiscal policy evaluation

Answer 26

• Fiscal policy is effective in the short term, but not so much in the long term. As soon as the policy measures end, household are likely to revert their expenditure back on imports.
• If taxes are imposed on trading partners, there is the risk of retaliation, which could reduce demand for exports, too.
• Governments might have imperfect information about the economy, so it could lead to government failure.
• If ‘green taxes’ are implemented, such as carbon taxes, or if there are minimum prices on pollution permits, the competitiveness of domestic firms could be compromised. This could reduce exports from domestic firms.

Question 27

monetary policy to help deficit/surplus

Answer 27

expenditure reducing policies:
- aim to reduce demand so M falls and switch consumer spending to domestic goods not imports
- reducing money supply = expenditure reducing/switching

• lower interest rates to cause depreciation in currency = cheaper exports but inflationary
• high interest rates = expenditure reducing = M demand falls and inflation falls

Question 28

monetary policy eval

Answer 28

Changing the exchange rate could be a government expenditure-switching policy. However, it is hard to control the supply of money in reality. Moreover, there is a significant time lag with changing the interest rate and seeing an effect.

Question 29

how can supply side policies help deficit/surplus

Answer 29

• increase spending on education/training = increase productivity = country more internationally competitive = rise in X
• make domestic economy attractive to investors
• deregulation/privatisation = force firms to lower average costs = monopolies formed

Question 30

supply side eval

Answer 30

• education incurs a significant time lag, so it is not effective as an immediate measure. In the long term, this can be an effective policy.
• monopoly forming = no increase in efficiency
• If governments provide subsidies to some industries to encourage production, there could be retaliation from foreign countries that see this as an unfair protectionist policy.

Question 31

the j curve explanation

Answer 31

• short term, a currency depreciation may not improve the current account of the Balance of Payments because the price elasticities of demand for exports & imports are likely to be inelastic in the short term
• Initially the quantity of imports bought will remain steady in part because contracts for imported goods are already signed.
• Export demand will be inelastic in response to the exchange rate change as it takes time for export businesses to increase their sales following a fall in prices.
• Earnings from selling more exports may be insufficient to compensate for higher total spending on imports.
• The balance of trade may therefore initially worsen. This is known as the ‘J-Curve’ effect

Question 32

what is the marshall lerner condition

Answer 32

states that a depreciation / devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports > 1.

Question 33

why are deficits more worrying in the eurozone

Answer 33

the countries have a fixed exchange rate. This means they cannot devalue the currency to restore their level of international competitiveness.

Question 34

how does China’s surplus affect its macroeconomic performance

Answer 34

• Since 2006, the US deficit with China narrowed and China’s surplus also fell. A surplus indicates low consumer spending and a low savings ratio, which puts China at the risk of having unsustainable economic growth. However, the government now aims to grow the economy using domestic spending, rather than exports.

Question 35

how did china make their exports more competitive

Answer 35

by undervaluing their currency.
This makes their imports more expensive, however, so it could be inflationary and cause a boom or bust. A stronger Yuan causes lower growth, lower inflation and reduces the current account surplus.
The US would prefer a stronger Yuan since it makes their domestic industries more competitive.