BoP and ER Flashcards
What is the balance of payments?
The Balance of Payments measures the inflows and outflows of an economy. It is made up of 3 accounts:
- Current Account
- Trade in goods - net value of goods being exported/imported.
- Trade in services - net value of services being exported/imported.
- Primary income - Bringing income from abroad back into the UK economy or vice versa.
- Secondary income - Money being sent out in the form of transfers or remittances.
- Trade in goods and trade in services are also known as the trade balance
- Primary and secondary income are also known as the income balance.
- If the value of the current account is positive, we have a current account surplus, if it is negative there is a current account deficit. - Capital Account
- Financial Account
- Portfolio investment transactions - the buying and selling of financial assets.
- Foreign direct investment flows - foreign firms setting up in the UK or domestic firms moving abroad.
- Reserves
How is the BoP balanced?
Current account deficits are usually balanced by surpluses in the other two accounts. In order to balance the current account, a country can sell financial assets to those that have a surplus and are sitting on excess cash. By selling these assets, the country will have a surplus on the financial account, balancing the current account deficit. Similarly, for the country buying the assets, they will have a financial account deficit, also balancing their current account surplus. This balancing on the financial account could occur in different ways, such as domestic firms setting up abroad.
What are the causes of a current account deficit?
Causes of a current account deficit:
Demand side causes:
-Strong domestic growth - incomes are high meaning consumers can buy more imports, increasing the deficit
-Recession overseas - incomes abroad are falling so demand for exports falls
-Strong exchange rate - SPICED - imports appear cheaper, exports appear more expensive, worsening the trade deficit.
Supply side causes:
-Low investment - reduced efficiency of firms, higher prices and lower competitiveness, foreigners will import from elsewhere due to the price
-Low productivity - high costs of production, reduced competitiveness
-High relative inflation - high prices will lead to lower competitiveness
-High unit labour costs - high costs of production, high prices, low competitiveness
Supply side causes are a lot more harmful than demand side causes. This is due to them being long term causes and very hard to change, with it being costly and time consuming to do so.
What are the consequences of a current account deficit?
A current account deficit will worsen the trade balance, meaning AD must be falling. This results in a reduction in growth, higher unemployment, lower wages and lower standard of living.
However, it could be argued that if the deficit is only a small percentage of GDP, it will have little effect on AD and on the economy.
What are policies to address a current account deficit?
In order to decide what policy to use, it must first be decided what the cause of the deficit is.
- Contractionary fiscal/monetary policy - reduces AD which will reduce income and reduce spending on imports. However, there are clear side effects of reduced growth and higher unemployment.
- Protectionist measures - Artificially increase the price of imports by using tariffs and quotas, making domestic producers more competitive. Also, the government may subsidise domestic firms to make them more internationally competitive. However, it could result in retaliation and inflation (due to imported goods being more expensive).
- Allow a currency to depreciate - WPIDEC - increases the trade balance, reducing the deficit on the current account. However, this will largely depend on PED of imports and exports (MLC) and inflation (with imports becoming more expensive).
- Supply side policies - Increase productive capacity, reducing price levels, making exports more competitive. However, these policies take a long time, may not work and are very expensive.
Why might the government not intervene to address a current account deficit.
The government may decide to not get involved in trying to address the deficit. For example, if the deficit is caused by strong demand side growth, and is only a small deficit, the outcomes of reducing the deficit could conflict with other objectives.
The government could also adopt expenditure reducing and expenditure switching policies to reduce the current account deficit.
What are expenditure switching and expenditure reducing policies?
Expenditure reducing policies are policies to reduce the spending on imports in an economy. They aim to reduce AD, reduce incomes and reduce MPM. An example of this is contractionary fiscal/monetary policy, directly aiming to reduce AD. However, there is a clear conflict of objectives, with the government possibly opting to prioritise growth, unemployment and inflation above correcting a current account deficit. Also, these policies depend upon consumer and business confidence, such that AD does not fall; the level of the output gap; MPM, with consumers possibly still spending on imports even after incomes fall.
Expenditure switching policy aims to switch consumer’s spending on imports to domestic firms. Such policies may include:
-Protectionism - In order to increase the price of imports and make domestic firms more competitive. However, there is a risk of retaliation, inflation, higher prices for consumers and loss of efficiency.
-Weaker exchange rate - WPIDEC - This can be achieved by reducing the interest rate or increasing the money supply - However, MLC, risk of inflation and possible retaliation or currency wars.
Eval of policies to address a current account deficit
- Conflict of objectives - is it worth the lower growth and higher unemployment to reduce the deficit
- What is the cause of the deficit - It may not be a problem if it is demand side
- Time lags and cost of the policies - opportunity cost and high burden on the taxpayer
- How large is the deficit - if it is only a small percentage of GDP, it may not be worth intervening
What are the causes of a current account surplus?
Demand side causes: -High incomes abroad -Low domestic incomes -Weak exchange rate - WPIDEC Supply side causes: -Low relative inflation -Low unit labour costs -Strong investment -Gains in comparative advantage
What are the consequences of a current account surplus?
- Greater trade surplus, increased AD, stronger growth, lower unemployment, higher inflation
- Appreciation in the exchange rate - high demand for exports will result in high demand for the currency
- Financial account deficit - A country may have to buy up another’s financial assets in order to have a financial account deficit and balanced BoP.
What is the MLC and J curve?
The Marshall Lerner Condition (MLC) states that a currency depreciation will only correct a current account deficit if |PED(M) + PED(X)| > 1. This can be used to evaluate the fact that devaluing a currency will solve the deficit on the current account.
Also, in the short term, it will take time for consumers and businesses to adjust to the new/higher price of imports, after devaluing the currency. This time lag means that before the current account deficit starts to improve, it will worsen due to them continuing to purchase imports before adjusting to the higher prices. This can be shown on the J curve.
What is the exchange rate?
The exchange rate is the price of one currency in another country.
The market for a currency (such as £s) can be shown on a market diagram, showing demand and supply curves for the £. The exchange rate will be determined by the forces of demand and supply within this market.
If demand and supply of the currency change then there will be an appreciation/depreciation of the exchange rate. For example, if demand for a currency were to increase, there would be an appreciation of the exchange rate.
What can increase demand for a currency?
- Increased interest rates relative to those in other countries
- Increase in FDI - foreign firms will need £s to set up in the UK, increasing demand
- Rise in incomes abroad - foreigners may now demand UK exports that they must buy in £s, increasing demand for £s.
- Increase in international competitiveness - make UK exports more competitive, meaning more exports will be sold, increasing demand for UK exports and demand for the £.
What can increase supply of a currency?
- Fall in interest rates - hot money outflows
- Firms moving away from the UK (FDI going abroad)
- Increase in incomes domestically - UK consumers will demand more imports, meaning that they will have to sell/supply their £s for the other currency.
What are the impacts of an exchange rate?
A strong exchange rate (SPICED) will lead to imports appearing cheaper and exports appearing more expensive to foreigners. This means that the demand for imports will rise and demand for exports will fall, worsening the trade deficit. This can shift AD left, increasing the negative output gap, resulting in reduced growth, higher unemployment and lower prices. However, with imports becoming cheaper, a firm’s costs of production will fall, increasing SRAS, meaning that there is less of both demand pull and cost push inflationary pressures.
A weak exchange rate (WPIDEC) will lead to imports appearing expensive and exports appearing cheaper. This means that demand for imports will fall and demand for exports will rise, reducing the trade deficit. This will shift AD right, resulting in greater growth, reduced unemployment and inflation. However, with imports becoming more expensive, cost push inflation will rise, resulting in a rise in prices for consumers and further inflationary pressures.
