The Balance of payments 4.1.7 Flashcards
What is the balance of payments
-Set of accounts recording all transactions conducted between residents of that country and residents of all other countries
Examples of transactions: (4)
-Importing and exporting goods
-Investments in financial assets (stocks, bonds)
-Investments in physical multinational corporations
-Sending or receiving gifts
-Anything that gives rise to a flow of money across international boundaries
How are transactions recorded?
-Inflows - credits
-For the UK, inflows can only be made if foreigners buy pounds
-Credits represent a foreign demand for £s
-Outflows - debits
-Outflows can only be made by selling pounds
-Debits represent a selling of £s to buy forgein currency
Components of the current account
-Visible balance of trade= exports-imports -goods
-Invisible balance if trade= exports-imports- services
-Net primary income- inflows of wages, rents, profits, interest - outflows
e.g. UK residents may earn income abroad and send their wages home
-Net secondary income - inflows from transfers abroad (gifts, foreign aid) - outflows
Components of the capital account
1) Capital transfers - inflow of debt forgiveness (when debt is cancelled), and investment grants (money given as a gift by governments to finance physical capital)
Minus
Outflows
2) Transfer of non-produced non-financial assets - inflow of natural resources that have not been produced (land, mineral rights, forestry rights, water, fishing rights)
Minus
Outflows
Financial Account
1) Foreign direct investment (FDI) - investments in physical capital (buildings, factories) usually undertaken by multinational corporations
2) Portfolio investment - shows investment in financial assets (savings, shares, bonds)
3) Reserve assets - Foreign currency reserves that the central bank can buy or sell to influence the value of the country’s currency in a fixed exchange rate system.
Causes of deficits on the current account
-Could be problematic depending on the cause of the surplus/deficit and what it shows about an economy
CAUSES:
1) Imports>exports - outflows are greater than inflows - Needs to be balanced by a surplus on the financial account
2) A surplus on the financial account might indicate a lack of domestic savings compared to investment opportunities - the finance needs to come from abroad - entail inflows on the financial account
Is a current account deficit a problem? YES
YES:
1)Can lead to a deprecating exchange rate
-Puts downward pressure on the exchange rate
-Imports are greater than exports so there is outflow of domestic currency
-Lead to cost-push inflation
-If there is a risk of default - people do not want to hold currencies expected to fall further - currency is vulnerable to speculative attacks
2)Involves borrowing money from abroad
-High indebtedness - Runs the risk of accumulating so much debt that they’ll be unable to pay it back - risk of default
-Possible need for higher interest rates to attract foreign financial investments - discourage domestic investment and consumption - leads to a recession
-Possibility of lower economic growth - resources used up on interest payments/ loan repayments.
3)Indicate lack of international competitiveness
-Price is too high / quality of export is lower than international competitors - indicate lack of domestic productivity/ lack of domestic innovation
Is the CA deficit a problem? NO
1)Not a problem if the country imports capital goods rather than consumer goods with the borrowed money
-increase productive capacity - shift LRAS outwards - generate future export growth - resolve the debt in the future
2)If borrowing is financed by FDI rather than hot money flows
-RWA: UK status of ‘safe haven’ economy for investments - steady and stable inflow of foreign investment money - sustained CA surplus - attractive safe assets in london
3)Signal rapid economic growth
-Countries import a lot during booms since incomes are higher, domestic production cannot meet the high demand
-Lots of domestic investment opportunities which cannot be financed by domestic savings - need to borrow money (inflow on FA)- outflow on primary income of CA
4) Less of a problem in a floating exchange rate system - CA deficit may self-correct
-High imports - CA deficit - currency depreciates - imports fall/exports rise
Measures to reduce imbalance on the current account - Do Nothing
For:
-Floating exchange rates act as a self correcting mechanism
-Over time, high levels of imports will depreciate the currency
-Lead to fall in imports - more expensive
-Rise in exports - cheaper
-Deficit improves
Against:
-May be other external factors that prevent the currency from depreciation
-Self-correction may take a long time
-Domestic industries may liquidate - companies close as they cannot pay their bills/ value of assets is less than its liabilities
-Firms will delay investment into the economy depending on the time frame
-High import prices often result in higher inflation - cost-push
-If the imported good includes capital goods/ other production inputs, firms may pass on higher costs of production to consumers
-SRAS shifts left - recessionary effects
-Benefit depends on whether Masrhall Lerner Condition has been met - the sum of the elasticities of exports and imports is greater than 1
Measures to reduce imbalance on the current account: Expenditure switching policies
FOR:
-Changes buying habits of consumers
-Switches consumption away from imports, and towards domestically produced goods
-Gov uses protectionist methods (tariffs, quotas, depreciates currency)
-Fall in imports will help improve current account deficit
AGAINST:
-Protectionist policies lead to retaliation by trade partners (reverse tariffs/quotas will decrease exports)
-Offset improvements initially made to improve CA deficit
-Higher domestic prices/ lower domestic consumption/ inefficient/ misallocation of resources
-The ability to use this method depends on the extent the country is free to pursue their own trade policies
Measures to reduce imbalance on the current account: Expenditure reducing policies
FOR:
-Contractionary fiscal policies reduce AD, which reduces output and discretionary incomes - leading to lower demand for imports
-contractionary monetary policy
-Leads to lower rate of inflation which makes domestic goods more competitive, increasing exports
-Combination of fewer imports and more exports can reduce size of current account deficit
AGAINST:
-Harm domestic economy - demand falls - output falls - GDP growth slows - unemployment rises
-Contractionary monetary policy - high interest rates - currency appreciation - discourage exports, encourage imports
Measures to reduce imbalance on the current account: Supply side policies
FOR:
-Lowers costs of production
-Improves quality of products
-increases exports - reduces CA deficit
-Examples - increased competition, reducing minimum wage, deregulation
-Shift in LRAS reduces inflation
-Over a long time low inflation may increase exports
-Interventionist supply-side policies (training, education, R+D) can promote industries that export
AGAINST:
-Long- term plan, benefits not measurable for a while
-Involves gov spending (subsidies) - opportunity cost
What does a CA deficit suggest?
SUGGESTS:
1)Low exports - lack of international competitiveness
2)High imports and low savings - sign of overspending
- a preference of borrowing over saving to fund current consumption
- consuming outside of its PPF
- improve current living standards but negatively impact future living standards when debt needs to be repaid
3)High investment - sign of rapid economic growth with lots of investment opportunities that can be funded domestically - attract FDI creating a surplus on the financial account
4) If a country is using a fixed exchange rate, its currency might be overvalued - artificially high exchange rate - imports cheaper - persistent trade deficits
Current account surplus
-More exports than imports
-outflows greater than inflows
-has to be balanced by deficit on FA
-Sign of international competitiveness
-Low imports - sign of underspending - preference of saving over borrowing
-operating within PPF
-undervalued exchange rate
-low investment opportunities
-Generally not problematic - suggest living standards are lower
