Macro - Balance of Payments Flashcards
Demand side causes a current account deficit
1) Strong domestic growth (higher incomes at home). fI real disposable incomes are high at home due to a boom for example, the marginal propensity to import will increase. There will be a greater ‘sucking in’ of imports effect, increasing demand and thus the expenditure on imports. Ceteris paribus, this will worsen the trade balance of the current account causing a current account deficit.
2) A strong exchange rate makes exports dearer and imports cheaper. Economic theory suggests that the demand for imports and therefore the expenditure on imports will rise whereas the demand for exports and therefore the revenue generated by exports will decrease. Both effects will worsen the trade balance of the current account causing a current account deficit.
Supply side causes of a current account deficit
1) Low labour productivity. Low labour productivity means output per hour worked is low relative to competitor countries around the world. This increases unit labour costs, a major cost of production for firms who will reflect such costs in higher prices charged, reducing the price competitiveness of a country’s exports. This will reduce the demand and thus revenue generated from exports, worsening the trade balance of the current account causing a current account deficit.
2) Poor Investment. Poor investment implies that capital machinery is out-dated, depreciating, inefficient and costly to maintain. This means that costs of production are relatively higher than competitor countries whose capital machinery is more productive, with firms reflecting higher costs in
higher prices charged reducing the price competitiveness of a country’s exports. Once more, non-price competitiveness of exports will fall as the final quality of goods produced is likely to be lower. These two factors will reduce the demand and thus revenue generated from exports, worsening the trade balance of the current account causing a current account deficit.
Consequences of a current account deficit
1) A country with a current account deficit is very likely to have a trade deficit given that the trade balance accounts for a much greater share of the current account than the income balance. As a result, import expenditure on goods and services exceeds export revenue generated from goods and services which reduces the value of (X-M) in the AD equation, causing AD to decrease from AD1 to AD2. The fall in AD causes actual growth to decrease from Y1 to Y2. This is because with lower demand in the economy, firms respond by decreasing output. This decrease in output will translate into a decrease in real GDP, which is a reduction in economic growth. Therefore unemployment increases (use diagram Rees likes to use), however demand-pull inflation will decrease.
2) Current account deficits will put downward pressure on the exchange rate as supply increases for the
currency outstrip demand. This weaker exchange rate can be beneficial for a net exporter as exports become cheaper and imports dearer. Economic theory suggests that the demand for imports and
therefore the expenditure on imports will decrease whereas the demand for exports
and therefore the revenue generated by exports will increase. Both effects will improve the trade balance rectifying a current account deficit.
For a net importer however, a weak exchange rate due to a current account deficit could be dangerous. This is because a weak exchange rate will make imports dearer when bought in foreign currency thus for firms who import raw materials, costs of production will rise decreasing SRAS culminating in higher cost
push inflation and lower economic growth in the economy, potentially causing a recession but even worse stagflation, that is stagnant or reducing growth with higher than target inflation.
Current account deficit evaluation
1) The cause of the deficit. If the current account deficit is caused by too much consumption i.e. the ‘sucking ni of imports’ effect, this could be a sign of a healthy growing economy with a current account deficit as a side effect without much concern. Imports increase the living standards of the population and therefore should not be regarded as an issue particularly fi financing the deficit is relatively simple. If ever the sucking in of imports becomes too large for a government, they are safe in the knowledge that booms do not last forever; income levels will follow the economic cycle automatically reducing the expenditure on imports when growth starts to reduce from the peak. Furthermore dealing with excessive import expenditure through expenditure reducing policies is not difficult fi the government feels like the severity of losing the balanced trade macroeconomic objective is too great or fi the economy is need of re-balancing. However, fi the deficit is caused by underlying structural weaknesses in the economy (low productivity, poor investment and high relative inflation for example), the current account deficit will be long term, persistent and dangerous for an economy who wil have keep borrowing to finance it. This is not sustainable and could lead to a currency crisis over time. Once more, dealing with a current account deficit caused by structural factors requires supply side policies, which have no guarantee of success, are costly and take a long time to have an effect on the price and non-price competitiveness of exports. In that sense, structural causes of a current account deficit can be long term and very difficult to solve, they are a much greater concern.
Consequences of a current account surplus
1) A country with a current account surplus is very likely to have a trade surplus given that the trade balance accounts for a much greater share of the current account than the income balance. As a result, export revenue generated from goods and services exceeds import expenditure on goods and services which increases the value of (X-M) in the AD equation, causing AD to increase from AD1 to AD2. The increase in AD causes actual growth to increase from Y1 to Y2. This is because with greater demand in the economy, firms respond by increasing output exhausting spare capacity; Y2 is now closer to the full employment level of output. This increase in output is an increase in real GDP, which is an increase in economic growth. Therefore unemployment decreases (Rees diagram) however demand pull inflation increases.
Policies to rectify current account deficit
1) Examples of expenditure reducing policies include contractionary fiscal policies such as an increase in
income tax, an increase in corporation tax and cut in government spending and contractionary
monetary policies such as a rise in interest rates or a decrease in the money supply. These policies
would reduce the level of AD in the economy and thus reduce incomes throughout the economy, which will reduce the marginal propensity to import; less ‘sucking in’ of imports. This reduces the demand for
imports and thus the expenditure on them which will, ceteris paribus, improve the trade balance in the current account thus rectifying a current account deficit.
Evaluation. Expenditure reducing policies conflict greatly with other macroeconomic objectives of government. In this case the trade balance improves but as a side effect, there is a fall in economic
growth (potentially a recession) and a rise in unemployment. These side effects are often much worse than the benefits of an improved trade position and hence are rarely used to reduce current account deficits.
2) Protectionism. This could be for example imposing or increasing tariffs, quotas, embargoes, domestic subsidies and non-tariff barriers like red tape and standards.
These policies will either increase the price of imported goods or simply block imports from entering the
country thus reducing the expenditure on imports which will, ceteris paribus, improve the trade balance in the current account and thus rectify a current account deficit.
Policies to rectify current account deficit - evaluation
Evaluation 2) Protectionism such as tariffs will increase prices for consumers and create a deadweight welfare loss of consumer surplus. This is because a tariff is a tax on imports which increases the price of imported goods. Key imports with tariffs often include clothing, food, vehicles and manufactured goods
- goods that the poor rely on and spend a greater proportion of their income on. These tariffs can therefore also be regressive.
Evaluation 1) The biggest problem with using protectionism to close a trade deficit is likelihood of strong retaliation by trading partners. Countries will frown upon the fact that their economy and their exporters are made to suffer due to a trade deficit in o t h e r country and not react kindly to any protection imposed on them. Retaliation would take place where protectionism is enacted back on the initial country’s imports but much more strongly reducing that country’s export revenue more so than the import expenditure they have saved thus worsening their trade deficit over time. Protectionism therefore can be argued to culminate in tit-for-tat, punitive retaliation that is a zero-sum game for all involved.
Evaluation 1) Supply side policies are very expensive to implement. Consider government spending on infrastructure which reduces the costs of production of firms, improving the
efficiency of business operations. Spending on improving the road network or building bridges will costs millions fi not billions of pounds. There is a huge opportunity cost involved here. fI money has been borrowed, taxes wil have to rise burdening future generations. Maybe to fund supply side policies, cuts will
be made elsewhere in the economy (such as on policing or healthcare/education). This wil have negative implications on those who rely on the day to day function of such services.
1) The cause of the current account deficit. It is crucial that in attempting to reduce a current account deficit, governments know the root cause and target policies that will directly overcome the underlying problem. For example expenditure reducing policies wil only be useful fi there si excessive import expenditure due to high incomes, not when there are structural issues causing a current account deficit.
Here, supply side policies are needed to provide a long term solution to such a deficit. The consequence of using the wrong policies, which do not target the cause, could be macroeconomic objective conflicts, burdens on future tax payers or worsened international relations.
Supply side policies to improve price and non-price competitiveness of countries exports
i) Government spending on education and training. For example this could include spending on apprenticeship schemes, adult-re training and school curriculum reform. fI successful, this will improve the skills and therefore productivity of the labour force, reducing unit labour costs. This will improve both the price and non-price competitiveness of goods and services produced, allowing for greater export revenue.
iii) Reducing corporation tax. Reducing corporation tax increases the incentive for firms to invest. Firms have a greater level of retained profits to fund investment, which involves spending on new capital, upgrading machinery, building a new factory, improving technology, engaging in research and development and spending on innovation. This investment increases both the quantity and the quality of the capital stock in the economy, improving the productive efficiency of the economy leading to greater price and non-price competitiveness of goods and services produced and higher export revenue generated.
