Theme 4 - Balance of payments Flashcards
what is the balance of payments
a spreadsheet that measures the inflows and outflows of money in and out of a country
- consists of the current account, capital account, and financial account
what does the current account consist of
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.
what does the capital account consist of
- debt forgiveness
- inheritance taxes
- sales of tangible and intangeable assets
- death duties
what does the financial account consist of
- 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).
what is a current account deficit
when countries are buying more from the world than it is selling. when imports exceed exports
why does the balance of payments need to be balanced
- 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.
how do countries with a current account deficit gain a financial account surplus from a country with a high current account surplus
- 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.
role of the balancing item
- 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
consequences of a current account deficit
- 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. - 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. - 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 - 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.
Reduced investor confidence
- A significant and sustained current account deficit may signal an economy that is dependent on foreign capital and borrowing.
- Foreign investors might become concerned about the country’s ability to service its debt or manage its external liabilities.
- This could lead to a reduction in investment inflows or even capital flight, which could destabilize the economy.
- The outflow of capital can increase the deficit further and weaken economic growth prospects.
what are expenditure reducing policies
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
evaluation points for expenditure reducing policies
- 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 - 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 - 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 - 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
what are expenditure switching policies
policies that aim to switch expenditure away from imports and towards domestic consumption
- eg protectionist barriers like quotas and tariffs
evaluation points for expenditure switching policies
- 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 - 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 - 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 - 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
how could expenditure switching policies lead to a weaker exchange rate
- lower interest rates
- hot money outflow in the economy
- more selling of that currency, reduces exchange rate
- increasing money supply
- increases supply of money
- lowers value of exchange rate - central bank could sell domestic currency reserves
- they create extra supply of their currency
- reduces
evaluation points for expenditure switching policies leading to a weaker exchange rate
- 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 - inflation
- a weaker exchange rate makes imports 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 - 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
general evaluation points for policies on trade - expenditure switching and reducing
1 conflict of objectives
- policies like expenditure switching could conflict with other macro objectives
- 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 - 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 - 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
causes of a current account surplus (demand side causes)
Increase in foreign demand for domestic goods and services
Higher foreign demand increases exports, leading to an increase in the current account surplus.
This leads to more revenue flowing into the domestic economy.
The domestic currency strengthens due to increased export activity.
This further encourages exports, contributing to the sustained current account surplus.
Improvement in domestic competitiveness
If domestic industries become more efficient or innovative, their goods and services become more attractive to foreign consumers.
This leads to an increase in exports.
As exports rise, the current account balance improves.
The stronger export performance helps the economy accumulate more foreign currency, contributing to the surplus.
Lower domestic consumption of foreign goods
If domestic consumers reduce their demand for imported goods, imports decrease.
With reduced imports, the current account deficit shrinks or a surplus may form.
As domestic demand is satisfied by domestic producers, the economy’s current account balance improves.
This reflects a shift toward more local production and consumption, reinforcing the surplus.
Exchange rate depreciation
A depreciation of the domestic currency makes exports cheaper for foreign buyers and imports more expensive for domestic consumers.
As a result, exports increase and imports decrease.
The resulting higher exports and lower imports lead to an improvement in the current account surplus.
This effect tends to be more pronounced if the demand for exports is price-elastic.
causes of a current account surplus(supply side)
- 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
- 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 - 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 - 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 - 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
consequences of a current account surplus
Increase in foreign reserves
A current account surplus means that a country is exporting more than it imports.
This leads to an inflow of foreign currency.
As a result, the central bank may accumulate more foreign reserves.
This provides the country with a buffer for future economic shocks or external debts.
Appreciation of the currency
A current account surplus results in high demand for a country’s currency (because of export transactions).
This increases the value of the currency relative to others.
An appreciating currency makes imports cheaper.
This could reduce export competitiveness in the long run if the currency becomes too strong.
Increased national savings
A surplus reflects that domestic savings exceed domestic investment.
This can signal an increase in national savings.
The extra savings can be used for investment in infrastructure or domestic business development.
However, it could also imply under-investment in the domestic economy if too much capital is directed abroad.
Impact on global trade relations
A persistent surplus may lead to trade tensions with other countries.
Countries with deficits may pressure the surplus country to reduce its exports or increase imports.
This can lead to the imposition of tariffs or trade restrictions.
Such actions may disrupt international trade relations and impact global economic stability.
how to reduce a current account deficit
Reduce Domestic Consumption:
Reducing domestic consumption lowers the demand for imported goods.
This leads to a decrease in the volume of imports.
As imports fall, the current account deficit narrows.
Lower consumption can also reduce domestic inflationary pressures.
Encourage Exports:
Governments can incentivize exports through subsidies or improved trade agreements.
This boosts the country’s exports, increasing export revenue.
As exports rise, the current account balance improves.
Increased exports lead to higher employment in export-oriented industries.
Depreciate the Currency:
A weaker currency makes imports more expensive and exports cheaper.
Consumers are less likely to buy imports due to higher prices.
Foreign demand for cheaper exports rises.
This leads to a more favorable balance of trade and reduces the current account deficit.
Attract Foreign Investment:
Encouraging foreign direct investment (FDI) can increase financial inflows.
FDI creates income from dividends and profits that offset the current account deficit.
The influx of capital strengthens the currency and helps balance payments.
Increased investment can lead to higher production and export potential, reducing the deficit further.
Reduce Domestic Consumption and Spending on Imports
Tight fiscal policies, such as increasing taxes or reducing government spending, can lower disposable income and domestic demand. With less purchasing power, consumers and businesses may cut back on imports, reducing the current account deficit. However, this approach may slow economic growth, leading to potential trade-offs between addressing the deficit and maintaining economic stability.
Supply-Side Policies to Improve Competitiveness
Enhancing the productivity and efficiency of domestic industries can increase their ability to compete globally. Policies like investing in education, research, infrastructure, and innovation can help improve the quality and cost-effectiveness of exports. While this reduces reliance on imports and boosts export revenues, these policies require time to take effect and significant upfront investment.
Protectionist Measures
Imposing tariffs, quotas, or other trade barriers can reduce the volume of imports by making them more expensive or less accessible. This helps protect domestic industries and shifts demand toward locally produced goods. However, such measures may lead to retaliation from other countries, disrupting international trade relationships and potentially offsetting the gains in the current account.
How can a current account deficit affect macroeconomic objectives?
Economic growth: A deficit may indicate high domestic demand for imports, which could stimulate economic growth, but excessive deficits can lead to unsustainable borrowing.
Inflation: A deficit can put downward pressure on the exchange rate, potentially leading to imported inflation.
Unemployment: A deficit might reflect a decline in domestic industries, leading to job losses, especially in manufacturing.
Exchange rates: Persistent deficits may lead to currency depreciation, which can help restore balance by making exports cheaper and imports more expensive
How can a current account surplus affect macroeconomic objectives?
Economic growth: A surplus can indicate a competitive export sector, contributing to economic growth.
Unemployment: A surplus is usually associated with a stronger domestic industry, potentially leading to more jobs, especially in export-oriented sectors.
Inflation: A surplus can keep inflation in check by balancing aggregate demand with supply.
Exchange rates: A surplus may lead to an appreciation of the currency, which could reduce export competitiveness and increase imports.
How does international trade connect economies?
International trade allows countries to specialize in the production of goods and services in which they have a comparative advantage, leading to increased efficiency, lower costs, and greater variety for consumers. Countries depend on each other for goods, services, and financial capital.
disadvantages of a current account surplus
- Strain on Foreign Relations
A persistent current account surplus may lead to tensions with trading partners.
This can result in retaliatory measures, such as tariffs or trade barriers.
Retaliation may lead to a trade war, damaging global trade relationships.
Long-term, these tensions can negatively impact future trade negotiations and cooperation.
- Reduced Domestic Consumption
A country running a surplus is often saving more than it is spending domestically.
This can lead to lower consumption levels in the economy.
The lower consumption may reduce demand for domestic goods and services.
This could negatively affect domestic businesses, leading to slower economic growth.
- Inflationary Pressures on the Domestic Economy
A current account surplus can increase demand for a country’s currency in foreign exchange markets.
This could lead to an appreciation of the currency.
A stronger currency makes imports cheaper and could hurt domestic producers’ competitiveness.
It may lead to reduced export demand, negatively impacting industries reliant on international sales.
- Over-reliance on Exports
A current account surplus often implies a strong reliance on exports for economic growth.
If global demand for a country’s exports weakens, the economy could suffer significantly.
This over-reliance can make the economy vulnerable to global economic fluctuations.
It limits the potential for diversified growth, as industries focus primarily on international markets.
- Imbalance in Global Trade
A large current account surplus in one country can create an imbalance in global trade.
This imbalance can contribute to trade disputes and political tensions between countries.
The trade imbalance may be seen as unfair by countries running deficits, leading to potential protectionist policies.
This could disrupt global economic stability and negatively affect international cooperation
causes of current account deficit
Low Domestic Savings
When a country’s savings rate is low, it may need to borrow from abroad to finance its investment.
This results in a higher demand for foreign capital.
Increased borrowing from foreign investors leads to an outflow of funds, widening the current account deficit.
It also leads to higher interest payments on foreign loans, putting further strain on the current account balance.
High Domestic Consumption
If domestic consumption outpaces income growth, consumers tend to import more goods and services.
An increase in imports, with domestic production unable to meet the demand, raises the trade deficit.
The trade balance worsens as the value of imports exceeds exports.
This imbalance contributes to a current account deficit.
Overvalued Exchange Rate
An overvalued currency makes exports more expensive for foreign buyers, leading to a reduction in demand for domestically produced goods.
At the same time, it makes imports cheaper for domestic consumers, increasing the volume of imports.
The result is a widening trade deficit, which directly impacts the current account.
This imbalance can lead to further borrowing from abroad to finance the deficit.
Declining Export Competitiveness
If a country’s exports lose competitiveness due to factors like increased production costs or lower global demand, exports decline.
This decline leads to a reduction in export revenue.
Simultaneously, higher import demand continues, worsening the trade balance.
The current account deficit widens as exports do not generate enough income to offset the costs of imports.
Structural Issues in the Economy
A country may have a structural imbalance, such as relying heavily on imports for essential goods or services that cannot be produced locally.
This structural issue leads to persistent import dependency.
As imports continue to exceed exports, the current account balance remains negative.
Without significant reforms to diversify production, the deficit may persist.
