Theme 4.1.7-4.1.9 Flashcards
What are the components of the balance of payments?
-The current account
-The capital account
-The financial account
What is the capital account in the balance of payments?
-The capital account is relatively unimportant as it mainly records transfers of
immigrants and emigrants taking money abroad or bringing to the UK, or
government transfers such as debt forgiveness to Third World countries.
-It is essentially a measure of short-term capital flows.
What is the financial account?
o The financial account is more important and is split into three main parts: foreign direct investment (FDI), portfolio investment and other investments.
-Foreign direct investment
-Portfolio investments: purchasing and selling of equities and securities
-Other assets: Includes various forms of financial derivatives such as options and financial futures.
-Reserve assets: Includes gold and foreign exchange held by the Bank of England.
Why must the balance of payments be balanced?
The balance of payments shows all flows into and out of the country and since total inflows must equal total outflows, the balance of payments must balance. If there is a recorded deficit or surplus, this is a balancing item, all the transactions that fail to be recorded by the statisticians.
How can deficits and surpluses occur on the balance of payments?
There can be deficits and surpluses on particular part of the accounts; a country can run a deficit on the current account if they are able to have a surplus on the capital account. France and Chile tend to have a current account balance, China and Germany tend to have a current account surplus and Britain and the USA tend to have a current account deficit.
What are the short-term causes of an imbalance on the balance of payments?
● Changes in consumer demand.
● Exchange rates
-Relative inflation
How will changes in consumer demand influence the balance of payments?
● It can be caused by high levels of consumer demand. If real household spending grows more quickly than the supply side of the economy can deliver, the only way of meeting this demand is by importing those goods and services. High incomes in a country lead to high imports but have no effect on the level of exports.
What is the UK consumer’s general YED for imports?
Elastic, imports tend to significantly increase with a rise in real income.
How can a strong exchange rate impact the balance of payments?
Moreover, it can be caused by a strong exchange rate which reduces the UK price of imports and leads to an expenditure-switching effect away from domestically produced output. The high value of the pound improves the terms of trade between the UK and other countries, allowing us to buy and consume more imports with each pound. It increases the price of exports and so leads to a fall in the value of exports. This assumes that PED is inelastic.
How can relative inflation impact the balance of payments?
● A high level of relative inflation will decrease exports since it will increase their price compared to goods produced by other countries.
What are the medium term causes of a change in the balance of payments?
● As a country loses its comparative advantage, people will transfer their purchases to other countries and the UK will need to switch resources to production of other things. Similarly, the growth of cheap imports from countries like China has caused a substitution effect.
What are the long-term causes for a change in the balance of payments?
● A lack of capital investment means firms use older and more out of date technology. This contributes to a lack of productivity. Germany has 35% higher productivity per hour worked than the UK. In the UK, productivity is only growing at 1%.
● Deindustrialisation in the UK has led to a decrease in the relative importance of industry and manufacturing in the economy. This makes it more difficult to export, since services are harder to export.
● Countries with a large amount of natural resources tend to export more, and if they also have a small population (e.g. Saudi Arabia) then they tend to have a current account surplus.
● Some countries are more competitive than others, for example high labour productivity or a reputation for high quality.
● Countries with corruption and where it is difficult to set up a business tend to find it difficult to export.
What causes the UK to have a trade deficit?
-Much of the UK’s trade deficit is due to structural rather than cyclical factors, due to supply side deficiencies.
-In the context of the UK, the main issues are low levels of investment, the impact of the banking crisis on preventing borrowing, low innovation, skills shortages, inefficient monopolies and underperforming businesses and poor infrastructure.
-Even though we have a surplus in trade of services, the deficit in trade of goods is much more significant.
What strategies can be used to reduce imbalance on the balance of payments?
-Demand side policies
-Supply-side policies
-Expenditure switching policies
-Expenditure reduction policies
What demand side policies may be used to reduce imbalance on the balance of payments?
● Monetary or fiscal policy can be used to reduce AD. This reduces income so reduces demand for imports. It should be effective since there is high income elasticity for imports.
-However, they are only short term and limit output of the economy, causing a reduction in living standards and growth.
What supply side policies can be used to reduce imbalance on the balance of payments?
● They could also use a range of measures to improve productivity and efficiency or improve quality. This could include competition policy, improving labour or improving infrastructure.
● They can seek and encourage industries to exploit opportunities in export market overseas and focus resources on industries where the -UK has a real comparative advantage, accepting some industries should close. This will be politically unpopular and will cause job losses in the short term.
-These are much longer-term solutions but will solve the balance of payment issues in the long term rather than temporarily as with aggregate demand.
What expenditure switching policies could be used to reduce imbalance on the balance of payments?
-Tariffs
-Depreciation of the exchange rate
-Low rate if inflation
What is the issue with expenditure switching
policies?
No expenditure switching policy will solve a long-term cause of a deficit.
When can a current accounts imbalance become an issue?
● Some can argue that a current account imbalance is not much of a problem as long as the capital and financial account is in surplus. However, the financial crisis of 2008 dramatically reduced the amount of capital flowing around the global economy and showed how quickly the position of the capital account can change. The uncertainty around Brexit increased the concern about the balance of payments due to fears over the response of the financial markets.
Why are current account deficits not so much of an issue for developed nations?
- Because they are trusted on a global scale.
● Today, deficits are less of a concern to countries: the US and UK have no problem financing their deficits and borrowing has not built up unsustainable debts.
● Current account imbalances become a problem when governments can’t repay their foreign currency debts.
● Countries with large deficits are seen as having a problem, whilst those with large surpluses are seen as being successful but in reality, those with surplus cause just as much instability as those with deficits.
● Current account surpluses cause losses for citizens in a country who don’t see the high living standards which they could enjoy from consuming more.
Why are current account imbalances and imbalances in assets/borrowing owned abroad linked?
Since the late 1990s, there have been concerns about global imbalances which can be measured in two ways: imbalances on the current account and imbalances in assets owned abroad or borrowing owned abroad. The two are linked since if a country has a constant surplus, then it will tend to build up a stock of assets abroad whilst if they have a constant deficit, they will owe more and more to foreign creditors. This may become an issue if imbalances are large.
What affect can depreciating the exchange rate have on reducing imbalances?
● They could also devalue/depreciate the pound as this will makes exports cheaper and imports dearer. However, this will not always work. It is not feasible for many countries as they have a floating exchange rate and so central banks intervening in the market will only nudge the exchange rate for a short period of time. The best way to affect the value of the currency is by changing the interest rate, but this has effects on AD and so may not have the intended effect.
However, depreciating the currency could cause cost-push inflation on imports which have an inelastic PED, like energy and food.
What affect can import tariffs have on reducing imbalances?
● Tariffs or quotas will reduce the attractiveness of imports. However, they are likely to cause trade wars as other countries implement protectionist policies and so therefore may even worsen the deficit. These are almost impossible to implement, given trading blocs and the laws of the WTO.
-Other nations will likely retaliate with their own tariffs.
How can controlling inflation reduce imbalances?
● They could attempt to control inflation which will mean that the price of British goods rises slower than those in other countries, meaning that they become more competitive over time. The problem is that it will lead to a fall in demand for domestic goods and so therefore could cause unemployment and a fall in growth.
What is the Marshall-Lerner condition?
This is the condition that devaluation will have a positive effect on the current account only if the sum of the elasticities of demand for exports and imports is negative and numerically greater than 1.
What is the J-curve effect?
The J-curve shows how the current account will
worsen before it improves. People will not immediately recognise that British exports are cheaper and it will take a while to find a source for them, whilst UK consumers will not see that imports are more expensive and may be unable to switch straight away (e.g due to contracts between firms). Demand tends to be inelastic in the short run. Therefore, the amount sold of each will stay the same but the price of exports will fall, so the value will fall, and the price of imports will rise, so the value will rise. However, in the long term, the current account deficit will fall as demand becomes more elastic.
What is an exchange rate?
The exchange rate is the purchasing power of a currency in terms of what it can buy of
other currencies.
