The balance of payments and exchange rates

Question 1

What is the BoP?

Answer 1

record of all financial transactions between one country and other countries.

Question 2

What is the BoP composed of?

Answer 2

• trade in goods balance (value of goods exported minus imports)
• trade in services balance (value of services exported minus imports)
• income balance (income flows into country from non-residents minus income flows out of country from residents to non residents)
• current transfers (e.g. food aid, UKs contribution to EU’s Common Agricultural Policy)

Question 3

Why does the UK have a deficit on its trade in goods balance?

Answer 3

• high value of sterling 1996 - 2008
• continuous economic growth 1992 - 2008 (UK has high MPC)
• relatively low productivity of UK’s workers results in higher average costs
• relocation of manufacturing to countries with lower labour costs
• ‘Chindia effect’: their industrialisation has led to flood of cheap imports into UK

Question 4

What is the exchange rate?

Answer 4

price of one currency in terms of another

Question 5

What are the main causes of changes in the exchange rate?

Answer 5

• relative inflation rates
• relative interest rates
• state of the economy
• BoP on the current account
• political factors
• speculation

Question 6

How do relative inflation rates affect exchange rates?

Answer 6

• if inflation rate is higher than competitors then according to PPP analysis currency should fall
• PPP is rate at which a particular good is sold at same price in UK and abroad when expressed in a common currency

Question 7

How do relative interest rates affect exchange rates?

Answer 7

• if UK has higher interest rates than those of other countries, foreigners with surplus balances are likely to place them in UK banks, increasing demand for sterling ∴ will strengthen

Question 8

How does the state of the economy affect exchange rates?

Answer 8

if UK economy is performing well speculators/ investors will buy sterling as they are confident, causing value to rise

Question 9

How does political stability affect exchange rates?

Answer 9

instability may cause loss of confidence in country’s currency

Question 10

How does speculation affect exchange rates?

Answer 10

e.g. if it is expected that economy will recover from recession more quickly than initially thought, speculators may buy sterling ∴ will strengthen

Question 11

What is likely to happen to the value of the Euro if members of the eurozone default on their debts?

Answer 11

This could result in a loss of confidence in the currency, so causing its value to fall. However, if defaulting countries left the eurozone, leaving just the strong members, the euro would likely strengthen

Question 12

What are the 2 effects of a change in the exchange rate of a currency?

Answer 12

• it will make price of goods exported from UK decrease in country of sale
• it will make price of goods imported into UK increase

Question 13

What is the Marshall-Lerner condition?

Answer 13

for there to be an improvement in the current account, the sum of the price elasticities of demand for imports and exports must be greater than 1

Question 14

What is the J-curve effect?

Answer 14

there could be a time lag before the full effects of depreciation of the currency work through the economy, such that in the short run, the sum of the price of demand would be less than 1 but greater than 1 in the long run

Question 15

What are the convergence criteria for joining the European Monetary Union (EMU)?

Answer 15

• fiscal deficit below 3% GDP
• public sector net debt less than 60% GDP
• inflation rate within 1.5% of 3 EU countries with lowest inflation rate, and long-term rates within 2%
• exchange rates must be kept within ‘normal’ fluctuation margins of Europe’s exchange-rate mechanism

Question 16

What are the main tests set out in 2002 and later to determine whether the UK should join the euro?

Answer 16

2002:
- are business cycles of UK and European economies converging, so that interest rates set by ECB will be suited to needs of UK economy
- are economies flexible enough to cope if there are external shocks to world economy
- will joining euro encourage FDI into UK
- will joining euro be good for financial services
- will joining euro promote higher econ. growth, stability and long term employment rises
Later:
- is the pound over-valued against the euro?

Question 17

What are the main advantages of monetary union?

Answer 17

• elimination of transaction costs i.e. commission charged on exchange of currencies (however only small % of GDP)
• price transparency; easy to compare price of goods across countries which adopted euro, which should increase competition
• easier trading conditions for firms inside euro zone, could benefit from EoS
• encouragement to transnational companies to invest in euro zone countries as opposed to countries of non-members (little evidence to support this)

Question 18

What are the main disadvantages of monetary union?

Answer 18

• loss of independent monetary policy (needs of individual countries placed second to needs of euro zone members as a whole)
• ECB’s inflation target is to keep inflation below 2% (less flexible and more deflationary than UK)
• loss of exchange rate flexibility against other countries that have adopted the euro
• transition costs e.g. changing slot machines, menus etc.
• meeting convergence criteria could slow growth & ∴employment e.g. not meant to run fiscal deficits higher than 3% GDP

Question 19

What is the financial account

Answer 19

measures transactions in financial assets e.g. investment flows

Question 20

What is the capital account

Answer 20

• relatively small

- contains capital transfers, the largest item being associated with migrants

Question 21

What is a devaluation

Answer 21

process whereby a government reduces the price of its currency relative to an agreed rate in terms of foreign currency

Question 22

What is a revaluation

Answer 22

process whereby a government raises the price of its domestic currency relative to a foreign currency

Question 23

What are the main concepts you need to understand in relation to devaluation of a currency?

Answer 23

The J-curve and the Marshall-Lerner condition (see 136.-137. smith book)

Question 24

What are the main determinants of floating exchange rates?

Answer 24

• in the short run hot money

- in the long run PPP theory of exchange rates

Question 25

What is the PPP theory of exchange rates?

Answer 25

in the long run exchange rates (in a floating rate system) are determined by relative inflation rates in different countries

Question 26

What is hot money?

Answer 26

stocks of funds that are moved around the world from country to country in search of the best return

Question 27

You should read whole of chapter 7 in smith book many many times for revision

Answer 27

give it 5

Question 28

What are the risks in relation to EoS developing in single european markets?

Answer 28

They could become too big and be in a position to make monopoly profits. e.g. Vodafone Airtouch acquired Mannesmann AG in 2000 for a reported £100bn and became on of UKs largest firms

Question 29

See Paul Krugmans use of cost-benefit analysis to evaluate whether a country should join a single currency area on 158.

Answer 29

give it 5

Question 30

Why is it not be sustainable to balance a deficit on the current account of the balance of payments by a surplus on the financial account in the long run?

Answer 30

• may be a limit on foreign exchange rate reserves

- limit on extent to which it is desirable to fund current account by borrowing or selling UK assets

Question 31

What are the 3 basic routes a government could pursue to reduce the size of a current account deficit?

Answer 31

• Demand management: YED for imports is high in UK ∴ by controlling level of AD you could limit demand for exports. However, this could damage other aspects of economy e.g. unemployment so depends on priority of objectives
• Supply-side policies: policies to inc. competitiveness of domestic firms should inc. trade ∴ reduce imports
• Exchange rate adjustment: not too sure how