The Balance of Payments

Question 1

The balance of payments

Answer 1

A set of accounts showing the transactions conducted between a country and the rest of the world
- keeps a record of all the inflows and outflows of money coming in and out the country
- informs about the demand and supply of the pound

Question 2

Why is the balance of payments more relevant in the present day?

Answer 2

• increasing globalisation
• interdependence of other countries
• specialisation

Question 3

The Current Account

Answer 3

The transaction in goods and services, also includes income payments and international transfers

Question 4

What are the four components of the current account?

Answer 4

• balance of trade in goods = tangible products
• balance of trade in services = intangible products
• primary income = net investment income such as: shares, dividends, interest, remittances
• secondary income = current transfers that involve no exchange of goods or services, such as providing aid

Question 5

The Financial Account

Answer 5

Transaction in financial assets between residents and the rest of the world

Question 6

What are the three components of the financial account?

Answer 6

• portfolio investments = purchasing of stocks, shares and bonds
• direct investments = net investments abroad, firms producing abroad in other countries
• reserve assets = official reserves of foreign currencies and gold

Question 7

Current Account Surplus

Answer 7

When the value of exports exceeds the value of imports

Question 8

Current Account Deficit

Answer 8

When the value of imports exceeds the value of exports

Question 9

Causes of a current account deficit

Answer 9

1. Strong exchange rates
- if the exchange rate appreciates, imports are cheaper and exports are more expensive
- domestic consumers start importing more goods and services as cheaper
- imports exceed exports, worsening the balance of payments and causing a current account deficit

2. Low levels of investments
- if less producers are investing in capital and avanced machinery, low quality goods and services
- domestic consumers start importing goods from abroad of higher quality
- imports exceed exports, worsening the balance of payments and causing a current account deficit

3. Rise in income
- people have more money to spend so consumption of imports may increase as one to enjoy a variety of goods
- imports increase more than exports which worsens current account deficit

4. Increase in level of inflation
- if inflation in UK is higher than in other countries than exports will be more expensive and people abroad stop buying from the UK so exports decrease
- people will also import more as it is cheaper to buy from a broad so imports increase which worsens balance of payments

5. Loss of comparative advantage
- when countries are able to produce goods for a cheaper price as they have lower costs of productions as they are naturally endowed
- a decline in the UK manufacturing sector which led to the industrialization as it became cheaper to produce goods like steel abroad
- the UK have to abide by lots of regulation which leads to higher cost of productions, so higher prices

6. Demographics
- if the population is aging and there is more people retired, they are more likely to run down their wealth and savings by buying from abroad
- as they are not part of the labour force, they are not going to produce any goods so imports increase while exports stay the same

Question 10

Advantages of a current account deficit

Answer 10

1. Increase in productive capacity
- if firms are importing capital then having a deficit is not that bad as only a short-term issue
- in the long term it would improve the productive capacity of the economy which improves the quality of goods
- increase in exports in the future improving productive capacity meaning that cost the production goes down
- to the price of goods go down so more internationally competitive
- current account deficit means that there is a surplus in the financial account this is good especially if it is inwards Investments from FDI which further improves the productive capacity by bringing in advanced capital
- also bring in more jobs and so government collect more tax revenue and so debt to GDP ratio goes down

2. Help aids development
- if importing capital goods that can be used to improve infrastructure this increases GDP and attracts FDI to invest
- gives the government higher tax revenue so they could spend on welfare

3. Self-correcting
- a current account deficit self-correct itself as when the pound depreciates, export decreases and imports increase
- imports increasing means that the supply of the pound increases, as more people converting pound into foreign currency causing exchange rates to depreciate
- International competitiveness increases, exports increase as cheaper and imports decrease
- appreciates the pound as demand for money shifts to the right and the cycle continues

4. May be due to incomes rising
- isn’t concerning if incomes rise as imports also increase
- consumers will have a wide variety of goods and services to choose from improving their standard and quality of life
- due to interdependence if domestic incomes are increasing it means that other countries incomes are also increasing so domestic exports will increase as well

Question 11

Disadvantages of a current account deficit

Answer 11

1. Decrease in AD
- net exports is a component of AD and so as net exports decrease, AD decreases and shifts to the left
- as demand decreases firms produce less and so unemployment increases and less incomes so consumption decreases
- government collect less cooperation tax as firms are producing less or government spending decreases
- leads to a negative multiplier effect

2. Structural unemployment
- If there is a curent account deficit due to the loss of comparative advantage, alot of low skilled workers lose their jobs
- structural unemployment increases as lack the transferrable skills to move to another industry
- become long term unemployed and suffer from hysteresis

3. Foreign ownership of assets
- because there is a depreciation of the pound it may incentivize foreigners to buy up assets through bonds as it is cheaper for them
- this is bad as it means a higher proportion of assets are owned by foreigners
- this is detrimental to the economy if they decide to just leave
- interest gained by the bonds are taken by foreigners back to their homes which is a leakage out of the circular flow of income

4. Debt burdance
- the current account needs to be balanced by the financial account
- gov needs to borrow money, increases national debt
- increase interest rates as money supplied fixed but the demand for money increases
- crowding out as IR s too high and firms can’t invest so leave the market
- this makes the UK look internationally weak which deter FDI

5. Risk of capital flight
- investors feel less confident because government has high depth burdens and may not be able to pay their debt back and economic growth goes down due to negative multiplier effect
- may leave the country and set up somewhere else so the supply of the pound increases which causes a devaluation of the pound
- this causes imports to be expensive so cost push inflation
- increase in unemployment

Question 12

What does the harms of a current account deficit depend upon?

Answer 12

1. Current account deficit as a percentage of GDP
- if the deficit is 5% of GDP, that it is particularly bad as it signifies that the country is heavily reliant on other countries for imports
- if that country were to go through a recession then it would impact the country even more negatively

2. Cause of current account deficit
- if importing capital it is not that bad as it improves the productive capacity of the economy in the long run

3. How it is financed
- if it is financed through the financial account being in a surplus due to high levels of revenue coming in through assets or shares isn’t bad but it is bad if it is financed through FDI
- this is because FDI can leave the country whenever they want

4. Developed or developing country
- developing countries are more vulnerable to current account deficits
- if a developed country has a current account of say it is not particularly bad as they can fund it through their financial current or FDI as they are seen as a strong economy
- if a current account deficit in a developing country firms may lose confidence and pull out meaning that they cannot fund it via financial account