The balance of payments Flashcards
Balance of payments definition
This is a record of all the financial transactions made between consumers, firms and the government from one country with foreign countries.
What makes up the balance of payments
- The current account
- Capital and financial account
Current account
- 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.
Capital and financial account
- Capital transfers involve transfers of the ownerhsip of fixed assest.
- Financial account incolves investment.
Meaning of a balance of payments imbalance
- 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.
Current account deficit
Uk spend more on imports from foreig countries than they earn from exports to foreign comapnies.
Causes of a current account deficit
- 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.
Causes of a current account surplus
- 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.
Current account surplus
When there is a current account surplus there is a capital and financial account deficit.
Factors causing a current account deficit - Overvauled exchange rate
- Imports will be cheaper, there will be a higher quanitity of imports.
- Exports will be more expensive, uncompetitive, fall in quanitity of exports.
Terms of trade
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
‘Structural’ current account surplus/deficit
- A “structural” current account deficit or surplus is an imbalance which is persistent and unrelated to the business cycle.
Impact of ToT on BoP
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.
Consequences of current account deficit
- Fall in Growth
- Cost push inflation/higher production costs
- Unbalanced economy
- Difficult to attract invesment
- Difficulties in financing the deficit
- Unemployment
Consequences of current account deficit - Fall in growth
- 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
Consequences of current account deficit - Cost push inflation and higher production costs
- 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.
Consequences of current account deficit - Unbalanced economy
- 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.
Consequences of a current account deficit - Difficult to attract investment
- 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.
Consequences of a current account deficit - Difficulties financing the deficit
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.
Consequences of a current account deficit - Unemployment
This could lead to job loses domestically, if more goods are being imported than fewer are being produced domestically, so unemployment may increase.
EVAL of current account deficit
- 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.
Solutions to dealing with sustained current account deficit
- Supply side policies
- Monetary policy
- Fiscal policy
Solutions to dealing with sustained current account deficit - Supply side policy
- 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.
Solutions to dealing with sustained current account deficit - Monetary policy
- 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.
