The balance of payments

Question 1

Balance of payments definition

Answer 1

This is a record of all the financial transactions made between consumers, firms and the government from one country with foreign countries.

Question 2

What makes up the balance of payments

Answer 2

• The current account
• Capital and financial account

Question 3

Current account

Answer 3

• Includes all economic transactions between counties, incuding trade of goods and services, income and current transfers.
• Income trasnfers are from earnings on foreign investment. For example owning a flat in a foreign country and repatriating rent.
• Current transfers include aid and grants and have no return.
• Balance of trade is important, exports minus imports.

Question 4

Capital and financial account

Answer 4

• Capital transfers involve transfers of the ownerhsip of fixed assest.
• Financial account incolves investment.

Question 5

Meaning of a balance of payments imbalance

Answer 5

• The components of the balance of payments should balance to give a net vaue of 0.

However each component can have a imbalance which means theri is either a deficit or a surplus of that compponent.

E.G
UK has a net deficit of the current accont, whilst there is a net surplus on the capital and financial accounts.

Question 6

Current account deficit

Answer 6

Uk spend more on imports from foreig countries than they earn from exports to foreign comapnies.

Question 7

Causes of a current account deficit

Answer 7

• Appreciation of the currency, stronger currency means imports are cheaper and exports are relatively more expensive, which menas the current account deficit will worsen.
• Economic growth, during periods of economic growth, consumers have high levels of spending. Consumers have a high marginal propensity to import in the UK so there is likely to be more spending on imports. Worsens current account deficit.

HOWEVER, export-led growth can lead to a high current account surplus.

• Deindustrialisation, manufacturing sector has declined in the UK since the 1970s, goods that UK previouslt made domesticaly are now imported, worsens deficit.
• Membership of trade union, the UK pays fees to be in the EU, current transfers are high and negative.
• Low productivity in export sector.
• Rise in commodity prices such as oil.

Question 8

Causes of a current account surplus

Answer 8

• More competitive, if a country becomes more competitive internatioanly, for example if their is growth and inovation in exports markets, exports should increase, current account deficit should improve.
• Depreciation/weak exchange rate
• High incomes abroad and boom in trading partners.
• Recession and low incomes at home
• Low labour costs, exports are price competetive.

Question 9

Current account surplus

Answer 9

When there is a current account surplus there is a capital and financial account deficit.

Question 10

Factors causing a current account deficit - Overvauled exchange rate

Answer 10

• Imports will be cheaper, there will be a higher quanitity of imports.
• Exports will be more expensive, uncompetitive, fall in quanitity of exports.

Question 11

Terms of trade

Answer 11

This measures the volume of imports and economy can recieve per unit of exports, it is calculated by the index price of exports over the index price of imports.

Index of average price of exports / index of average price of inports * 100

Terms of trade above 100 are improving, whilst those below 100 are worsening

Question 12

‘Structural’ current account surplus/deficit

Answer 12

• A “structural” current account deficit or surplus is an imbalance which is persistent and unrelated to the business cycle.

Question 13

Impact of ToT on BoP

Answer 13

An improvement in the terms of trade means that export prices are increasing faster than import prices, therfore a rise in export prices will cause a fall in quantity of exports and a rise in the current account deficit.

Question 14

Consequences of current account deficit

Answer 14

1. Fall in Growth
2. Cost push inflation/higher production costs
3. Unbalanced economy
4. Difficult to attract invesment
5. Difficulties in financing the deficit
6. Unemployment

Question 15

Consequences of current account deficit - Fall in growth

Answer 15

• X-M will fall, AD will fall and therefore there will be a fall in economic growth and this will mean less demand for labour and unemployment will also fall. REDUCTION IN GROWTH

Question 16

Consequences of current account deficit - Cost push inflation and higher production costs

Answer 16

• If imported raw materials are expensive, and a country relies imports are large number of products, there could be cost-push inflation in the domestic economy, since firms face higher production costs.

Question 17

Consequences of current account deficit - Unbalanced economy

Answer 17

• A surplus or deficit on the current account could indicate an unbalanced economy, and it could mean the country is too reliant on other economies for their own growth.

Question 18

Consequences of a current account deficit - Difficult to attract investment

Answer 18

• Unsutainable in the long run as it could be diffuclt to attract sufficient financial flows in order to finance a current account deficit. This could cause the pound to depreciate and result in inflationary pressures.

Question 19

Consequences of a current account deficit - Difficulties financing the deficit

Answer 19

It could become difficult to finance the deficit in the long run. In the US, the current account deficit is financed by Chinese investors buying US securities at low interest rates. If they lose confidence in the US economy, they would stop buying US debt. The interest rates would then have to be increased to encourage investors to buy the debt. This would be damaging to US consumers who have a lot of debt, since repayments would increase, and they would have less disposable income as a result.

Question 20

Consequences of a current account deficit - Unemployment

Answer 20

This could lead to job loses domestically, if more goods are being imported than fewer are being produced domestically, so unemployment may increase.

Question 21

EVAL of current account deficit

Answer 21

• A deficit financed by long-term capital investment is more sustainable than a deficit financed by borrowing.
• A deficit may occur due to high growth and strong consumer spending – rather than uncompetitiveness.
• Some countries like US and UK run current account deficit but they have many foreign assets
• A devaluation in the exchange rate could restore competitiveness and improve current account. But, would devaluation hurt or help the economy?
• The biggest concern for a current account deficit is when it is financed by borrowing, but a crisis of confidence causes this borrowing to dry up.
• Reduction in growth
• Depends of the size of the defecit, UK deficit is a very small percentage of GDP and the reduction on AD is very limited.

Depends what is causing the deficit, supply side factors are a major issue and are longer term.

Question 22

Solutions to dealing with sustained current account deficit

Answer 22

• Supply side policies
• Monetary policy
• Fiscal policy

Question 23

Solutions to dealing with sustained current account deficit - Supply side policy

Answer 23

• Could help increase productivity with increased spending on education and training, which could result in the country becoming more internationally competiitve. This could lead to a rise in exports.

EVAL
- Signifcant time lag, not a effecive immediate measure. Although in the long term it can be argued to be very effective

• More attractive economy to investors, able to finance the deficit through investment and not borrowing.
• More competitive economy through deregulation and privatisation, forcing firms to lower costs, increasing exports.

EVAL formation of monoploies due to deregualtion and privatisation.

• 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 24

Solutions to dealing with sustained current account deficit - Monetary policy

Answer 24

• Reduce demand in the economy, so spending on imports fall.
• Switch consumer spending towards domestic goods and away from imports.
• Lower interest rates to cause a depreciation in the currency, causing exports to become cheaper.
  EVAL, this could be inflationary for the domestic economy furthemore HOT MONEY may flow out of the economy as investors are not recieving as high return on investments.

Question 25

Solutions to dealing with sustained current account deficit - Fiscal policy

Answer 25

• If there is a deficit on the current account, income tax could be increased. This will
  reduce the amount of disposable income consumers have, which will reduce the
  quantity of imports. However, it might also impact domestic growth, since
  consumers will also spend less on domestic goods.
• Governments could also reduce their spendin, this would reduce AD and lead to less imports, it forces domestic firms to increase exports.

EVAL, fiscal policy is effective in the short run but not the long run, as soon as policy measures end households will revert expenditure back to exports.
- If taxes are imposed on trading partners, there is a risk of retaliation, wich could reduce demand fro exports.

Question 26

Consequences of a current acount surplus

Answer 26

• X-M is greater meaning a rise in AD and possible economic growth, a fall in unemployment but possible rises in demand pull inflation.
• Appreciation as the demand for the currency is greater than the supply, therefore there could be appreciation and the current account surplus may be short term and revert back to balance.
• They must run a financial account deficit, they can buy up debt of countries that are running current acount deficits, risk here.
• Using excessive protectionsim and managing their exchange rate may cause retaliation form other countries.
• Sign of a unbalanced economy, very reliant on exports and trade for growth, much prodcution will be for this and not for domestic consumers, less consumer spending. Demand for exports reducing would be a issue.