The Balance Of Payments & Exchange Rates

Question 1

What are the balance of payments?

Answer 1

Set of accounts showing 1 country’s financial transactions with other countries

• inflow of foreign currency into UK = +ve item
• outflow of foreign currency = -ve item

Question 2

What is the current account composed of?

Answer 2

Sum of the below will give the c.a

1) Trade in goods balance
- value of goods X minus value of goods M
2) Trade in services balance
- value of services X minus value of services M
3) Income balance
- income flows into country from non-residents minus income flows out country from residents to non-residents
4) Current transfers
- relates to items such as food aid & UK’s contribution to EU’s Common Agricultural Policy

Question 3

What is the current account?

Answer 3

Shows country’s day-to-day transactions with other countries

Question 4

What is the capital and financial account?

Answer 4

Show LT investment & ST capital flows

Question 5

What does the capital and financial account compose of?

Answer 5

Transactions associated with changes of ownership of UK’s foreign financial assets & liabilities

• FDI
• shares & bonds
• ST capital flows often referred to as hot-money flows
• changes in foreign currency reserves

Question 6

What are the reasons for a c.a deficit in the UK? (trade in goods balance has deteriorated over no. of years)

Answer 6

1) High value of sterling
- 1996-2008
- loss of competitiveness
2) Continuous E.G
- 1996-2008: UK has high MPM
- rising real incomes have led to a significant increase in M’s
3) Relatively low productivity
- higher AC
- goods & services not been competitive
4) Relocation of manufacturing to countries with lower labour costs
e. g China & Eastern European countries
- however, labour & transport costs have been increasing recently so some firms have returned to UK
5) ‘Chindia’ effect
- industrialisation of China & India led to a flood of cheap M’s into UK

Question 7

What factors might cause a balance of trade surplus?

Answer 7

Relatively low unit labour costs
Relatively high productivity
Relatively low inflation rate
Undervaluation of currency
Non-price competitive advantages e.g design, quality & reliability of production

Question 8

What is the significance of a c.a deficit?

Answer 8

Persistent c.a deficit may be undesirable if:

• indicates that country’s goods & services are uncompetitive
• result in increasing rate of unemployment
• country may be forced to borrow foreign currency from other countries or from IMF if reserves fall too low
• under system of floating exchange rates, could get sudden depreciation of exchange rate

May not be regarded as major problem if:

• caused by M’s of capital goods
• SR problem
• financed easily by inflows into financial account

Question 9

What measures would be used to reduce a c.a deficit?

Answer 9

1) Cut corporation tax
- promote enterprise & provide incentives for firms to increase I
- may also be achieved by ax breaks to companies who use profits for I
- increase productivity making goods more competitive
2) Improved infrastructure
- help improve supply side of economy
3) Superfast broadband
- help boost competitiveness
4) Training & education
- increase productivity & occupational mobility of labour
5) Reduction in regulation & red tape
- help reduce costs of firms
6) Modern apprenticeships
- increase employability & productivity of workforce
7) Reduction in employers’ national insurance contributions
- reduce costs of production & help improve competitiveness
8) Improved childcare provision
- if adopted in UK >1m more women would join workforce

Question 10

What are the implications of a global imbalance?

Answer 10

If deficits easily financed by inflow on financial account there’s no cause for concern
- under floating exchange rates over time should be automatic adjustment i.e deficit cause exchange rate to fall
Continuous deficits by USA for example have been financed by Chinese
- may not be sustainable in LR
- further exchange rate adjustments may occur suddenly
e.g value of £ fell 27% 2008-09

Question 11

What is an exchange rate?

Answer 11

Rate at which 1 currency exchanges for another;

Price of 1 currency in terms of another

Question 12

What factors influence exchange rates?

Answer 12

1) Relative interest rates
- if country has much higher IR’s than other
- may attract money into its banks from abroad as prospect of gaining higher return
- creates increased D for currency causing value to rise
2) Relative inflation rates
- if country has higher inflation rate than competitors PPP will fall relative to competitors
- LT likely exchange rate will fall
3) Current account balance
- if country running persistent c.a deficit that supply of currency increasing relative to D for it
- resulting in depreciation of currency
- however, financial flows between countries relating to trade now much less significant than currency flows relating to other transactions
4) Foreign direct investment (FDI)
- country which is a net recipient of FDI experience increased D for its currency causing value to appreciate
5) Speculation
e. g future state of economy, change in government or impending strikes

Question 13

What is the impact of a depreciation in the value of a currency?

Answer 13

1) Decrease in foreign currency P of country’s X
- X decrease
2) Increase in domestic P of M’s
- M’s increase

Fall in currency:

• makes goods more competitive for that country
• D X’s rise
• D M’s fall
• reduction in size of deficit on c.a Bop
• increase in AD, rise in real output & increase in P.L
• increased P of imported commodities/ raw materials cause increase in costs of production = cost-push inflation
• rise in real output help to reduce unemployment

Question 14

What are monetary unions?

Answer 14

Trading blocs which have adopted a single currency.

e.g EMU 17 countries, UK opt-out

Question 15

What are the benefits of monetary unions?

Answer 15

1) Elimination of transaction costs
- transaction costs: commission charged on exchange of currencies
- however, represent only small proportion of GDP
2) Price transparency
- easy to compare prices of goods across countries which have adopted euro for example
- competition within euro zone should therefore increase & likelihood of P discrimination should be diminished
- however, still evidence of P differences between members of euro zone
3) Easier trading conditions for firms inside monetary union (Eurozone)
- benefit from economies of scale
4) Increase in FDI
- encouragement to TNCs to I in euro zone countries as opposed to countries of non-members
- however, evidence this has happened is weak

Question 16

What are the costs of monetary unions?

Answer 16

1) Loss of independent monetary policy
- countries no longer have ability to set their own IR’s
- IR set by ECB
- however, means needs of individual countries placed 2nd to those of euro zone members as whole
2) More stringent monetary policy
- ECB’s inflation target keep inflation below 2% more stringent than that of Bank of England
- Criticism that policy less flexible & more deflationary than of UK
3) Loss of exchange rate flexibility
- individual members of Eurozone use euro so no longer have their own currencies
- country whose goods & services have become uncompetitive can no longer rely on a depreciation to restore competitiveness
4) Transition costs
- one-off costs associated with changing slot machines, menus, price lists & so on to the new currency
5) Diversity of economies in union
- within EMU great difference in economies of the different countries
e. g labour costs in Greece, Italy & Portugal rose considerably relative to those in Germany during 2000-10
- makes economic management of whole monetary union v.problematic