Theme 4 - Balance of payments

Question 1

what is the balance of payments

Answer 1

a spreadsheet that measures the inflows and outflows of money in and out of a country

Question 2

what does the current account consist of

Answer 2

trade in goods(visible trade) - Exports and imports of physical goods such as machinery, vehicles, food, and raw materials.

trade in services - Exports and imports of intangible services like banking, tourism, insurance, and consultancy.

investment income - Earnings from overseas investments, such as dividends, interest, and profits from foreign-owned assets.

transfers - Payments made without receiving goods or services in return, like foreign aid, remittances, and contributions to international organizations.

Question 3

what does the capital account consist of

Answer 3

• debt forgiveness
• inheritance taxes
• sales of tangible and intangeable assets
• death duties

Question 4

what does the financial account consist of

Answer 4

• portfolio investment - the buying and selling of financial assets, eg bonds,shares
• foreign direct investment flows - Long-term investment where investors acquire a significant degree of control in a foreign company, such as building new facilities or acquiring substantial stakes in foreign firms.
• reserves - The central bank’s holdings of foreign currencies, gold, and Special Drawing Rights (SDRs).

Question 5

what is a current account deficit

Answer 5

when countries are buying more from the world than it is selling. when imports exceed exports

Question 6

why does the balance of payments need to be balanced

Answer 6

• A balanced BoP ensures that a country’s transactions with the world are sustainable. If there’s a persistent imbalance, it may lead to issues like accumulating foreign debt, currency devaluation, or economic instability.

Question 7

how do countries with a current account deficit gain a financial account surplus from a country with a high current account surplus

Answer 7

• A country with a current account deficit imports more goods and services than it exports, leading to an outflow of funds.
• To finance this deficit, it must attract financial inflows, such as investments or loans from other countries. These inflows appear as a financial account surplus (e.g., through foreign direct investment or the purchase of domestic assets by foreign investors).
• Countries with current account surpluses, like China or Germany, often provide the needed capital by investing in the deficit country’s assets. This investment fills the gap created by the current account imbalance, ensuring the overall balance of payments is maintained.
• While China receives some foreign investment, its outward investment exceeds these inflows, leading to a financial account deficit.

Question 8

role of the balancing item

Answer 8

• there can be discrepancies in the BOP data (e.g., unreported or misclassified transactions).
• The balancing item corrects these statistical discrepancies by ensuring that the sum of the current, capital, and financial accounts equals zero

Question 9

consequences of a current account deficit

Answer 9

1. LOWER AD
   - A current account deficit means imports (M) exceed exports (X), so net exports (X-M) are negative.
   - This reduces aggregate demand (AD), leading to slower economic growth and potentially higher unemployment.
   - The economy may face a negative output gap, worsening economic performance.
2. DEBT BURDENS
   - To finance a current account deficit, a country may need to borrow from abroad, increasing its debt burden.
   - This can lower investor confidence if they see that the country might be unable to pay them back, leading to capital outflows and a potential currency crisis or economic crisis.
   - High debt repayments become unsustainable, pressuring the economy over time.
3. Lower Exchange Rate
   - A current account deficit increases the supply of the domestic currency in foreign exchange markets, leading to currency depreciation.
   - However, if the deficit is due to poor competitiveness, a lower exchange rate may not boost exports sufficiently, leading to stagflation (low growth with rising inflation), as import prices would still be high
4. Cost-push inflation
   - A depreciating exchange rate can make imported goods more expensive, causing cost-push inflation.
   - This raises production costs, especially in economies reliant on imports for raw materials, leading to higher inflation with stagnant growth.

Question 10

what are expenditure reducing policies

Answer 10

policies used to reduce the amount of spending on imports in the economy
- they work by reducing AD, reducing income and therefore reduce the marginal propensity to import
- contractionary monetary and fiscal policy are examples

Question 11

evaluation points for expenditure reducing policies

Answer 11

1. conflict of macro objectives
   - contractionary policies like increasing taxes/ lowering govt spending can lower aggregate demand and reduce imports but also slow down economic growth
   - this could lead to higher unemployment, low growth, maybe a recession and potentially deflation
2. Business and consumer confidence
   - if consumer and business confidence is high, households and firms may continue spending and investing despite government policies aimed at reducing expenditure
   - this could undermine the effectiveness of policies and worsen the deficit
3. Elasticity of imports
   - If imports are demand inelastic,reducing consumer spending may not significantly decrease import demand
   - therefore import expenditure may remain high and the deficit may worsen
4. size of the output gap
   - if the economy has a large output gap(below full capacity), expenditure reducing policies may have a stronger impact on reducing demand without significant inflationary pressure
   - however, if the output gap is small, these policies could push the economy into a recession

Question 12

what are expenditure switching policies

Answer 12

policies that aim to switch expenditure away from imports and towards domestic consumption
- eg protectionist barriers like quotas and tariffs

Question 13

evaluation points for expenditure switching policies

Answer 13

1. retaliation
   - protectionist measures could lead to retaliatory measures from trading partners, reducing export opportunities
   - this could harm domestic industries and escalate into trade wars, potentially worsening the trade balance instead of improving it
2. WTO laws
   - Many forms of expenditure switching pouches may violate WTO rules, which promote free trade and discourage protectionism
   - countries could face penalties, disputes and sanctions, limiting the effectiveness and sustainability of these policies
3. inflationary pressures
   - restricting imports can lead to higher domestic prices and demand shifts to local goods, which may have limited supply or higher production costs
   - this could create inflationary pressure, reducing consumer purchasing power and leading to lower economic growth
4. loss of efficiency
   - protectionist policies can shield inefficient domestic firms from international competition, reducing the incentive for them to innovate or cut costs
   - this can lead to long term inefficiency, misallocation of resources, and lower overall productivity in the economy

Question 14

how could expenditure switching policies lead to a weaker exchange rate

Answer 14

• lower interest rates
• hot money outflow in the economy
• more selling of that currency, reduces exchange rate

2. increasing money supply
   - increases supply of money
   - lowers value of exchange rate
3. central bank could sell domestic currency reserves
   - they create extra supply of their currency
   - reduces

Question 15

evaluation points for expenditure switching policies leading to a weaker exchange rate

Answer 15

1. marshall lender condition - states that a depreciation of the exchange rate will only improve the current account balance if the sum of the price elasticities of demand for exports and imports is greater than 1
   - if the condition is not met(eg if demand for exports and imports is inelastic), a weaker exchange rate might worsen the trade balance. imports will become more expensive but export demand won’t rise enough to compensate
2. inflation
   - a weaker exchange rate makes exports more expensive, increasing production costs for firms reliant on foreign goods, which could lead to cost push inflation
   - higher inflation reduces real income and purchasing power, potentially leading to stagflation, which can undermine the benefits of a weaker currency
3. retaliation/currency wars
   - countries might respond to a deliberate weakening of the exchange rate by devaluing their own currency(currency wars) where nations compete to maintain export competitiveness
   - this could lead to global instability in exchange rates, reduce global trade volumes, and further harm long-term economic growth for all countries involved

Question 16

general evaluation points for policies on trade

Answer 16

1 conflict of objectives
- policies like expenditure switching could conflict with other macro objectives

2. The cause of the current account deficit
   - it is important to understand whether the deficit is due to structural weakness(eg lack of competitiveness) or temporary factors(high domestic demands eg)
   - if the issue is structural, short term policies like tariffs or currency devaluation will only provide temporary relief. for the long term supply side policies are better
3. Time lags/costs
   - Many policies, such as SSPs, take time to have a meaningful impact on trade balance, and often involve significant upfront costs
   - while long term benefits might arise,the short term effect may be limited, and governments might face pressure if immediate results aren’t visible
4. is a current account deficit always a bad thing?
   - a current account deficit can be a reflection of high investment and capital inflows, which may signal strong future growth rather than economic weakness
   - if a country is running a deficit to finance productive investments(eg infrastructure, tech), this could improve future productivity and exports, thus reducing the deficit over time.
   - on the other hand, if the deficit is financing unsustainable consumption, it can lead to future debt crisis and instability
   - So the deficit isn’t really bad if it’s tied to growth enhancing activities

Question 17

causes of a current account surplus (demand side causes)

Answer 17

1. increased incomes abroad. if foreign incomes rise, their marginal propensity to import increases. this can enhance the current account surplus by boosting export sales
2. weaker exchange rate - a weaker domestic currency makes exports cheaper for foreign buyers, while making imports more expensive
   - this can lead to increased export volumes and a reduction in imports, contributing to a current account surplus

Question 18

causes of a current account surplus(supply side)

Answer 18

1. lower relative inflation - when a country experiences lower inflation, its goods become cheaper over time for trading partners, this can lead to u creased demand for exports
2. lower unit labour costs - this means they can produce goods at a cheaper rate than competitors
   - this cost advantage can boost export competitiveness, leading to higher sales abroad and a surplus in the current account
3. strong investment - investments in capital and technology can increase productivity and efficiency
   - improved production capabilities can lead to higher quality exports, which can increase the CA surplus
4. gains in comparative advantage - this means a country can export goods more effectively/efficiently
   - this specialisation can lead to increased export volumes, enhancing the surplus
5. new resource discoveries - discovering new natural resources can lead to increased production and exports
   - the country can capitalise on resource wealth as they export more

Question 19

consequences of a current account surplus

Answer 19

1. increased AD, as exports rise business may expand to meet higher demand, resulting in increased production. this can lead to more job opportunities.
   - as demand outpaces supply, upward pressure on prices can lead so inflation
   - this can erode purchasing power and lead to potential economic instability
2. appreciation of the exchange rate
   - increased demand for a countries exports raises demand for its currency, driving up its value in foreign exchange markets
   - stronger currency makes exports more expensive, potentially reducing export competitiveness in the long run
3. Financial account deficit
   - when a country has excess savings from its surplus, it may invest abroad rather than domestically, leading to a situation where more capital is leaving than entering
   - this can lead to over reliance on FDI
4. could be a sign of an unbalanced economy
   - excessive reliance on exports for growth can lead to vulnerabilities , such as overexposure to global market fluctuations, and reduced domestic consumption
   - this situation can inhibit sustainable long term growth, as the economy may struggle if external demand decreases or shifts, leading to potential economic instability (dependent on elasticity)