4.1.7 - Balance of payments

Question 1

What are the components of the balance of payments

Answer 1

o the current account
o the capital and financial accounts

Question 2

Define expenditure reducing policies

Answer 2

Policies designed to lower real incomes and aggregate demand and thereby cut demand for imports E.g. higher direct taxes or increased interest rates.

Question 3

Define expenditure switching policies

Answer 3

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.

Question 4

Define capital account

Answer 4

Formerly known as financial account, now a small section of the account which includes effects of debt forgiveness, sale/transfer of patents, copyrights, franchises, leases and other transferable contracts across
borders.

Question 5

Define financial account

Answer 5

Transactions that result in a change of ownership of financial assets and liabilities between residents of different countries – includes net flows of money into equities, bonds, property.

Question 6

Define secondary income

Answer 6

Net flow of overseas aid / debt relief, military grants and so on.

Question 7

Define capital flows

Answer 7

Movements of capital between countries. Outward capital flows are movements of domestically owned capital abroad; inward capital flows are movement of foreign-owned capital to the domestic economy

Question 8

advantages of international capital flows across the world

Answer 8

1) Capital flows facilitates growth in world trade.
2) Capital flows provide an additional source of finance for firms (especially important for firms in developing countries).
3) FDI can lead to the transfer of technology and skills.

Question 9

three disadvantages of international capital flows for the world economy:

Answer 9

1) An interconnected global financial system carries stability risks.
2) Capital flows can potentially undermine national security.
3) Capital flows can lead to excessive borrowing.

Question 10

Describe the financial account

Answer 10

split into three main parts:
- foreign direct investment (FDI), portfolio investment and other investments.
- Foreign direct investment is the flow of money to purchase part of a foreign
firm (10% of more of the ordinary shares) e.g. BT buying a 15% share in a
telecommunications company in Brazil. Portfolio investments are the same thing but where they buy less than 10% of the company. Other investments include loans, purchasing of currency and bank deposits.

Question 11

causes of a current acc/ount deficit/surplus

Answer 11

1) Relative export competitiveness
2) Exchange rates
3) The state of the economy

Question 12

What is relative competitiveness of exports determined by

Answer 12

inflation, productivity, innovation and protectionism.

Question 13

demand causing a current account deficit

Answer 13

• if EG = rise in consumer spending & rise in Ms = deterioration of current account.
• this effects is even larger if YED of M is high bc then there is greater increase in imports following economics growth

Question 14

Nature of uk consumer, app point

Answer 14

Research suggests that UK consumers have a high-income elasticity of demand for imports so the deficit tends to grow when the economy enjoys a period of consumption led growth.

Question 15

International competitiveness as a cause of CAD

Answer 15

• Struggling to compete internationally:
  + Exchange rates = appreciation (strong exchange rate) means X’s more expensive = X’s fall and less competitive = deterioration of CA
  + Inflation = If UKinflationrises faster than our main competitors then it will make UK exports less competitive (pass on higher costs) and imports more competitive = deterioration in thecurrent account

EVAL:
This assumes that PED of imports/exports?

Question 16

External shocks causing CAD

Answer 16

External shocks:
- Downturn in the countries that UK exports too = fall in X’s
- Trade barriers imposed = can reduce Xs made to a country.
- rise in world prices of imported materials e,g oil, timber, metals and demand fro these materials is relatively price inelastic, then a country will pay more for these imports at least in SR

Question 17

Causes of a CAS, CAD

Answer 17

CHECK PAGE 161 CGP - ALREADY REVISED IN 2.1

Question 18

Causes of a current account surplus

Answer 18

1) Export competitiveness; being a low cost producer = improvement on current account.

2) External shocks:
- The state of the economy = recession results in fall economic growth (fall in spending), fall IR to encourage spending, ER depreciates(unattractive to invest), X’s cheaper and M’s dearer = improvement in CA

Question 19

productivity and innovation as causes of current account surplus

Answer 19

3) Rising productivity implies that the economy is becoming more competitive and will be able to produce goods at a lower cost. If UK firms can produce goods at a lower cost this will make UK exports more competitive and therefore increase exports= improvement in CA.

4) Innovation = more innovative products = attractive exports = improvement in CA

Question 20

Effects of a current account deficit

Answer 20

• AD falls (so employment and growth falls)
• debt burden increase (eval: Depends on how sustainably current account deficit is financed)
• job losses domestically because domestic production is lowered seeing as many people consumer imports
• can potentially cause fall in vALUE OF CURRENCY

Question 21

evaluate the idea that AD falls due to CAD

Answer 21

Depends on the size of the deficit;
- small – so essentially irrelevant
- if more capital goods = rise productivity BUT if Ming consumer goods then unlikely to benefit EG.

Depends on the causes (ER, X or State of economy) of the deficit : supply side causes are far more severe than demand side, if it was caused by strong domestic demand then thats a healthy sign of growth

Question 22

How does AD fall due to CAD

Answer 22

• CAD MEANS net outflow ofdemandand income from a country’s circular flow.

In other words,tradein goods and services and net flows from transfers and investment income are taking more money out of the economy than is flowing in (negative CA).
Aggregate demandwill fall (as more spent on Ms = fall in UK productivity = AD falls

Question 23

How is CAD financed

Answer 23

running surpluses on capital and financial accounts by (positive flows to these accounts) ..
1) country could be attracting lots of FDI
2) regular investments (government taking on debt)

Question 24

define fdi

Answer 24

FDI – is investment by foreign firms into a country: either through setting up operations or taking a controlling interest in a firm

Question 25

problem with gov running up debts to finance CAD

Answer 25

Loans (borrowing from banks and other financial institutions) and bonds (corporate or government) … this adds to the overall debt which means the interest on the debt gets bigger as well … this isn’t a problem if creditors think the country can pay back its debt …

… however, if creditors lose confidence, they’ll stop lending to the country which can a financial crisis … we’ll explore this issue in more depth when we look at financial markets

much better to finance by long term capital investment; surplus on capital account

Question 26

Problems with current account surplus

Answer 26

1) indicator of a heavy reliance on exports
2) can be harmful to the economies of trade partners
3) if CAS caused by undervalued currency, inflationary pressures rise due to pricer imported components used in prod so cost of prod rise and GPL rise

Question 27

evaluate CAS as indicator of heavy reliance on exports

Answer 27

1) depends on the size of the surplus = sign of competitiveness
2) Could be argued to be a good thing if it’s a result of successful supply-side policies (growth & efficiency); incentives for firms & indiv. to be productive

Question 28

Evaluate idea that CAS harms economy of trade partners

Answer 28

• depends on the level of aggregate demand in trade partners’ economies.
• It’s more likely to be a problem in recessions and for countries with limited ‘fiscal space’ (meaning that their fiscal situations don’t allow them to raise spending or cut taxes as a way of stimulating domestic demand).

Question 29

examples of expenditure reducing policies and their intended effect

Answer 29

• contractionary monetary/fiscal policy
  intended effect:
• to reduce aggregate demand = reduce incomes =(reduce import expenditure assuming high mpm = reduce deficit on current account of the balance of payments in SR

Question 30

evaluate expenditure reducing policies

Answer 30

• spending on domestic goods also decreases, causing unemployment and a fall in the rate of economic growth, thereby creating a conflict of macro objectives
• biz/consumer confidence may be so high that higher interest rates or taxation doesnt reduce AD
• mpm: if mpm is not very high in an economy, using these policies to reduce import expenditure will be ineffective

Question 31

examples of expenditure switching policies

Answer 31

protectionism, weaker exchange rate, supply side policy

Question 32

intended effect of protectionism as an ESP

Answer 32

tariffs, quotas, embargoes, domestic subsidies, non-tariff barriers

increase competitiveness of exports and reduce competitiveness of imports =reduce imports and increase exports = reduce deficit on current account of the balance of payments

Question 33

intended effect of SSP as an ESP

Answer 33

increase competitiveness of exports = increase exports = reduce deficit on current account of the balance of payments

Question 34

evaluate SSP and weaker exchange rate as an ESP

Answer 34

• ssp: But take time/ time-lag, cost, no guarantee of success
• weaker exchnage rate: depends on whether Marshall-Lerner condition is satisfied, likely to be inflationary due to higher import prices, could lead trading partners to weaken exchange rates in response

Question 35

intended effect of a weaker exchange rate as an ESP

Answer 35

higher investment in FOPs = increase competitiveness of exports and reduce competitiveness of imports(higher M prices)= reduce imports and increase exports = reduce deficit on current account of the balance of payments in LR.

Question 36

evaluate protectionism as an ESP

Answer 36

• could lead to retaliation = X’s to fall so export revene falls more than saving on import expenditure so CAD wprsens medium term, potentially
• breaks WTO rules; heavy fines
• could be inflationary due to import tariffs and reduced competition (loss of efficiency), higher prices for domestic consumers

inflation likely if demadn for imports is too price inelastic

Question 37

significance of global trade imbalances

Answer 37

• SSPS to correct trade deficit will increase world trade and growth
• restrictions on imports = trade wars, reducing intl trade and lower global efficiency
• reducing your own deficits means less exports from developing countries, so EG in these countries limited , limiting development porgress and employment opportunities

Question 38

supply side causes of CAD

Answer 38

1) low inv
2) low prod
3) high relative inflation
4) high labour costs
5) poor quality
^^^^ basically overall causes is lower relative competitivness of exports from UK
6) depletion of resources - Uk was a big exporter of north sea oil but when this depleted Uk exports fell

Question 39

evaluating cuases of deficit

Answer 39

supply side causes are much worse than demand side reasons (like high domestic demand, strong exhcnage rate, recession in receivers of exports), explaining why UK has been in a long term CAD. Supply side reasons are hard to reverse

Question 40

Demand side causes of cas

Answer 40

high incomes abroad
low incomes at home
weak exchange rate

supply side:
low relative inflation
Strong inv
gains in comparative advant
new resource discoveries
Low labour costs

Question 41

consequences of CAS

Answer 41

appreciation in exchange rates (more demand fro currency to buy exports leads to appreciation so surplus isnt long lasting, revert to deficit)

financial acc deficit?????
harm intl relations -managed exchange rates, protectionsims trigger attack
sign of unbalanced economy

Question 42

How to weaken exchnage rate as an esp

Answer 42

central bank reduces interest rates so hot money outflows from this country as investors sell currency (seek highest interest rates), reducing exchnage rate

QE increases supply of money so value of currency reduced

Central bank sells domestic currency reserves to increase supply avaiable , thus reducing its value

Question 43

general evaluation of measures to eliminated current account imbalance

Answer 43

• conflict of objectives
• cause of CAD
• time lags/cost
• is the CAD really a problem?