4.1.7 Balance of Payments

Question 1

The current account of a nation’s balance of payments is made up of 4 separate balances
What are they

Answer 1

1. Net balance of trade in goods
2. Net balance of trade in services
3. Net Primary income
4. Net Secondary Income

Question 2

What is included in the trade balance in goods

Answer 2

Manufactured goods/Components/raw materials

Energy products/Capital Technology

Question 3

What is included in the trade balance of services

Answer 3

Banking, Insurance, Consultancy

Tourism, transport, logistics

Shipping, Education, Health

Research, Arts

Question 4

What is included in the Net Primary Income

Answer 4

Profits, interest and dividends from investments in other countries

Net remittance flows from migrant workers and working overseas

Question 5

What is included in Net Secondary Income

Answer 5

Overseas aid/debt relief transfers

Military grants

UK payments to EU (prior to Brexit lol)

Question 6

The Capital account of the balance of payments is a small element or it

What are the main items included

Answer 6

• Sale/transfer of patents, copyrights, franchises (or internationally buying/selling land)
• Debt cancellations (counted as a negative)
• Capital transfers of ownership of fixed assets

Question 7

What is the Financial Account

Answer 7

includes transactions that result in a change of ownership of financial assets and liabilities between UK residents and non-residents

Question 8

What does the financial account include

Answer 8

• Net balance of FDI flows
• Net balance of portfolio investment flows (assets that is purchased in the expectation that it will earn a return or grow in value)
• Balances of banking flows (hot money)
• Changes to values of reserves of gold + foreign currency

Question 9

What is Foreign direct investment

Answer 9

is investment from one country into another

Could involve establishing operations/acquiring tangible assets/stakes in other businesses

Question 10

Explain a portfolio investment flow

Answer 10

happens when businesses from one country buy shares or other securities such as bonds in other nations

A UK investor buys some shares in Google - this is a portfolio investment outflow for the UK accounts

Question 11

What was the current account deficit as of 2018

What was this as a % of GDP

Answer 11

£82 Billion

3.9% of GDP

Question 12

What is a current account deficit

How would a country with a deficit achieve balance on their external accounts

Answer 12

It involves a net outflow from the economy’s circular flow

Deficit countries need to run a financial account surplus to achieve balance on their external payments

They are debtor countries

Question 13

Briefly list the reasons for a current account deficit

Answer 13

1. Poor price and non-price competitiveness
2. Strong exchange rate affecting demand for exports and imports
3. Reccession in one or more or major trade partner country
4. Volatile global prices
5. Strong domestic economic growth

Question 14

Explain how poor price and non-price competitiveness can lead to a current account deficit

Answer 14

• Higher inflation than trading partners over an extended period of time
• Low levels of capital investment and research and development spending
• Weakness in design, branding and product performance

Question 15

Explain how a strong exchange rate affecting demand for imports can cause a current account deficit

Answer 15

A high currency value increases the overseas prices of export - fall in demand

Appreciating currency also makes imports cheaper - increased import demand

Question 16

Explain why a recession in one or more major trading partners countries would lead to a current account deficit

Answer 16

recession cuts value of exports to these countries

Question 17

Explain why volatile global prices can lead to a current account deficit

Answer 17

• Exporters of primary commodities might be hit by a fall in global prices and a therefore direct fall in the value of their expert earnings
• Importing nations could be hit by higher would prices for oil/gas/raw materials
• if demand for imports is price inelastic, then increased world prices will cause higher spending on imports

Question 18

Explain why a strong domestic economic growth can also be a cause of a widening current account deficit

Answer 18

• Rising demand for imported raw materials and component parts used by domestic industries
• Increased demand for and spending on imported capital equipment/new technology
• Rising demand for luxury imported goods (positive YED)

Question 19

Would could be some structural causes of a current account deficit

Answer 19

1. Relatively low productivity/high unit labour costs
2. Insufficient investment in capital which limits a nation’s export capacity
3. Low levels of national savings
4. Long term declines in real prices of a country’s major exports

Question 20

What could be 4 possible consequences for a current account deficit

Answer 20

1. loss of aggregate demand if there is a trade deficit (M>X) causing weaker real GDP growth and might lead to reduced living standards/rising unemployment
2. cause the currency to depreciate, leading to higher cost-push inflation and a deterioration in the terms of trade
3. Some countries running current account deficits may borrow to achieve a financial account surplus but this increase in external debt carries risks if interest rates rise
4. lead to a loss of investment, leading to capital flight and a possible currency/balance of payments crisis

Question 21

What is a current account surplus

Answer 21

means that there is a net injection of income into a country’s circular flow

These nations are creditor countries

Question 22

What are the main causes of a current account surplus

Answer 22

• Large propensity to save and invest
• Large gap between export/import values, when the net income balance and net transfers are small
• Export surplus due to high world prices like oil/gas
• Deficit on financial account - FDI coming from revenue from exports
• Strong exchange rate as a result

Question 23

What are expenditure switching policies

Answer 23

Policies designed to change the relative prices of exports and imports

Like import tariff - cause consumers to switch to domestic consumers

Question 24

What are expenditure reducing policies

Answer 24

These are policies designed to lower real income and AD and thereby cut demand for imports

E.g. higher direct taxes, cuts in gov spending

Question 25

List 3 types of expenditure switching policies

Answer 25

1. Depreciation of the exchnage rate 2. Import tariffs 3. Low rate of inflation (perhaps deflation)

Question 26

Explain depreciation of the exchange rate as an Expenditure switching policy However, highlight a problem with it

Answer 26

Reduces relative price of exports and makes imports more expensive However, risk of cost-push inflation - erodes competitive boost + fall in real income

Question 27

Explain import tariff, as an Expenditure switching policy However, also explain the problems with it

Answer 27

Increases the price of imports and makes domestic output more price competitive However, risk of retaliation from other countries

Question 28

Explain low rate of inflation, as an Expenditure switching policy

Answer 28

Keeps general price level under control and makes exports more competitive However, risks from deflation as a way of achieving internal devaluation

Question 29

List 2 types of expenditure reducing policy

Answer 29

1. Increase in income taxes 2. Cuts in real level of government spending

Question 30

Explain increasing income taxes, as an expenditure reducing policy However, explain the problems with this

Answer 30

reduces real disposable income causing falling demand for imports however, cut in living standards and risk of damage to work incentives in labour market

Question 31

Explain cuts in real level of government spending, as a form of Expenditure reducing policy However, explain the problems with this

Answer 31

Lowers aggregate demand, firms may look to export their spare capacity However, damage to short term economic growth, risk that austerity hits investment

Question 32

What other methods could the Government use to increase price competitiveness and exports

Answer 32

Supply-side policies These can increase output and reduce domestic price levels Can lead to more innovation, making exports more desirable

Question 33

What is the J Curve Effect

Answer 33

shows the possible time lags between a falling currency and an improved trade balance

Question 34

Explain the shape of the J-Curve

Answer 34

* In short term - currency depreciation may not improve current account BoP * This is because the price elasticities of demand for export/imports is likely to be inelastic in short term * Initially, quantity bought will remain steady in part because contracts for imported goods are already signed. Exporting businesses will take time to increase sales following price drop * Earings from selling more imports may not be equal to higher total spending on imports * Balance of trade hence will worsen

Question 35

What does the Marshall Lerner Condition state

Answer 35

that a depreciation/devaluation of the exchange rate will lead to a net improvement in the trade balance provided that the sum of the price elasticity of demand for exports and imports \> 1 (elastic)

Question 36

What are global trade imbalances

Answer 36

Imbalances refer to persistent current account surpluses for some countries contrasted with deficits in other nations ## Footnote imbalances often tend to persist, because: a) not every country operates a freely-floating exchange rate b) there may be structural reasons why some countries run persistent trade deficits or surpluses.

Question 37

How could floating exchange rates be self correcting

Answer 37

It suggests that in a floating exchange, trade imbalances rate system will self-correct because if, say, a country has a trade deficit, then demand for exports will be low which in turn causes reduced demand for the currency. This leads to a depreciation of the currency, thus making exports more price competitive and stimulating demand for them.

Question 38

Why might a trade deficit be a problem

Answer 38

* Run up large external debts and are reliant on foreign capital * May decide to switch towards using protectionist policies * Deficits can lead to a fall in relative living standards over time if economic growth slows down

Question 39

Why might trade surpluses be a problem

Answer 39

* Are saving more than they spend, thereby depressing global economic demand and growth * May be adopting a policy to keep their currency deliberately under-valued * Might be under-consuming (thus affecting living standards) and allocating domestic scarce resources to exporting overseas rather than allowing higher levels of domestic consumer spending