The international economy - Balance of payments and exchange rates

Question 1

Current account

Answer 1

The current account of the balance of payments comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers. A positive current account balance indicates the nation is a net lender to the rest of the world, while a negative current account balance indicates that it is a net borrower from the rest of the world.
Made up of:
- net balance of trade in goods
- net balance of trade in services
- net primary income
- net secondary income

Question 2

Financial account

Answer 2

Includes transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-residents.
Includes:
- net balance of FDI flows
- net balance of portfolio investment flows
- balance of banking flows
- changes to the value of reserves of gold and foreign currency

Question 3

FDI

Answer 3

Investment from one country to another (normally by companies rather than governments) that involves establishing operations or acquiring tangible assets, including stakes in other businesses.

Question 4

Portfolio investment flows

Answer 4

Happens when people/ businesses from one country buy shares or other securities such as bonds in other nations.

Question 5

Measures to reduce a country’s imbalance on the current account

Answer 5

Expenditure switching policies: Policies designed to change the relative prices of exports and imports. For example, an exchange rate depreciation ought to improve the price competitiveness of exports and also make imports more expensive when priced in a domestic currency. Import tariffs are also designed to create expenditure-switching effects.
Expenditure reducing policies: Policies designed to reduce real incomes and AD and thereby cut demand for imports. E.g. Higher direct taxes, cuts in government sending or an increase in Monetary policy interest rates.

Question 6

The J-curve

Answer 6

In the short-term, a currency depreciation may not improve the current account of the Balance of Payments. This is because the PED for imports and exports are likely to be inelastic in the short-term. Initially the quantity of imports bought will remain steady in part because contracts for imported goods are already signed. Export prices will also be price inelastic in response to the exchange rate change as it takes time for businesses to increase their sales following a fall in prices. Earnings for selling exports may be insufficient for the increased spending on imports. The balance of trade therefore may initially worsen - this is known as the ‘J-curve’ effect. Providing the PED >1 then the trade balance will improve over time. AKA Marshall-Lerner Condition.

Question 7

The Marshall Lerner condition

Answer 7

States that a depreciation in the exchange rate will lead to a net improvement in the trade balance provided that the sum of the PED for X and M >1.

Question 8

Global trade imbalances

Answer 8

Refer to persistent Current account surpluses for some countries contrasted with deficits in other nations. Theory suggests that in a freely-floating ER system, trade imbalances will self-correct.

Question 9

What is an exchange rate?

Answer 9

The rate at which one country’s currency can be exchanged for other currencies in the foreign exchange.

Question 10

Effective exchange rate

Answer 10

This is a weighted index of sterling’s value against a basket of currencies with the weights based on the importance of trade between the UK and each country.

Question 11

Exchange rate systems

Answer 11

• Free-floating currency
• Managed-floating currency
• Fixed exchange rate system

Question 12

How do you describe exchange rates?

Answer 12

Depreciation: is a fall in the value of a currency in a floating exchange rate system.
Devaluation: is a fall in the value of a currency in a fixed exchange rate system.
Appreciation: is the rise in the value of a currency in a floating exchange rate system.
Revaluation: is a rise in the value of a currency in a fixed exchange rate system.

Question 13

Free floating exchange rates

Answer 13

Occurs when a government allows the exchange rate to be determined purely by market forces and there is no attempt to ask the central bank to influence the external value of the exchange rate.

Question 14

What factors cause changes in the currency in a floating system?

Answer 14

• Trade balances
• FDI
• Portfolio investment
• Interest rate differentials
• speculation

Question 15

Managed floating exchange rates

Answer 15

The currency is usually set by market forces but a central bank may intervene occasionally to influence the price. The currency becomes a key target of monetary policy.

Question 16

Competitive devaluations (dirty floating)

Answer 16

Occur when a country deliberately intervenes to drive down the value of their currency to provide a competitive lift to demand, output and jobs in their export industries.

Question 17

Fixed exchange rates

Answer 17

An exchange rate that is fixed against other major currencies through action by governments or central banks, usually within small margins of fluctuation around the central rate. Likely to involve periodic intervention in the foreign exchange market by one or more central banks to buy or sell the currency in question if it moves below or above its margins.

Question 18

Purchasing power parity

Answer 18

Purchasing Power Parity is the exchange rate needed for say $100 to buy the same quantity of products in each country. PPPs measure the total amount of goods and services that a single unit of a country’s currency can buy in another country. Much data is given a purchasing power parity adjustment to help make more meaningful comparisons and contrasts between countries.

Question 19

International competitveness

Answer 19

External competitiveness is the sustained ability to sell goods and services profitably at competitive prices overseas. Can involve price or non-price competitiveness.
Non-wage factors:
- environmental taxes
- employment protection laws and health and safety regulations
- statutory requirements for employer pensions
- employment taxes

Question 20

Relative unit labour costs

Answer 20

total labour costs/ total output

Question 21

Relative export prices

Answer 21

One country’s export prices in relation to another countries, usually expressed as an index.

Question 22

Policies to improve competitiveness

Answer 22

• competitive exchange rate
• competitive tax environment to attract inward investment and encourage new business start-ups.
• investment in human capital to improve the quality of the workforce.
• increased research and development to drive a faster rate of innovation.
  stronger market competition to raise factor productivity and lower relative export prices.
• stable macroeconomic environment
• Investment in critical infrastructure.