4.2 Balance of Payments

Question 1

What is the balance of payments?

Answer 1

• the balance of payments is a record of all financial transcations between a country and the rest of the world in a given time period
• It is divided into the current account and the capital and financial account

Question 2

What is a current account?

Answer 2

• a current account balance is a measure of the country’s balance of payments with the rest of the world in trade, primary income and secondary income

Question 3

What should the current account, the capital and financial account and the balancing item add to?

Answer 3

0

Question 4

What are the 4 things that the current account records and between what?

Answer 4

• records the money flows between the UK and the rest of the world for:
  1. Trade in Goods
  2. Trade in Services
  3. Net Income from abroad
  4. Net Overseas Transfers

Question 5

What components make up trade in goods/services?

Answer 5

• Exports (+) on current account - it is the money received
• Imports (-) on current account - money paid leaves the UK

Question 6

What is an export?

Answer 6

Goods and Services sold to foreigners by UK firms

Question 7

What is an import?

Answer 7

Goods and services bought by UK residents from foreigners

Question 8

What are the components of net income abroad/primary income?

Answer 8

includes:
- profits earned by foreign companies operating in the UK (-)
- profits earned by UK firms operating abroad (+)
- interest on foreign bank accounts (+)
- dividends from foreign stocks and shares
- rent from overseas property

Question 9

What makes up transfers/secondary income?

Answer 9

includes:
- remittances - money sent by foreign nationals in Uk to their home (-) or money sent by UK nationals in foreign countries back to the UK (+)
- Foreign Aid
- Contributions to NATO, UN etc.

Question 10

if CA balance > 0 then?

Answer 10

current account surplus

Question 11

if CA balance < 0 then?

Answer 11

current account deficit

Question 12

Formula for CA balance?

Answer 12

Exports - Imports + Net Income Flows + Transfers

Question 13

What are 5 possible causes of a Current Account Deficit?

Answer 13

1. There has been an economic boom domestically so consumers and businesses are spending more on imports
2. Our trading partners are experiencing a recession leading to lower demand for our products overseas and therefore less exports
3. Domestic firms are not innovating and keeping up with the latest goods and tech, so they are less competitive on the world stage
4. Our goods seem expensive to foreigners, maybe due to our higher relative inflation rate or our currency is appreciating
5. Investments foreigners hold in our country are earning more than investments held by nationals abroad

Question 14

what are 5 costs of having a current account deficit?

Answer 14

1. Falling demand for domestic goods can lower economic growth
2. Lower output can mean higher unemployment
3. Lower income and more unemployment means less income tax revenue and more benefit payments
4. fall in AG spending may lead to a fall in business confidence and investment, which will lead to less and less spending due to negative multiplier effect
5. Increased foreign debt for the country as imports are financed by abroad borrowing and not export revenue

Question 15

What are 2 benefits of having a current account deficit?

Answer 15

1. Current Account Deficit may reduce inflation as if imports are greater than exports this reduces AG spending in the economy, reducing pressure of prices
2. May lead to a fall in the exchange rate over time which can increase international competitiveness and eventually increase exports

Question 16

What can the government do about a current account deficit?

Answer 16

It can deal with a CAD using:
- demand side policies
- supply-side policies
- protectionist policies

Question 17

How can raising income tax(fiscal policy) reduce a current account deficit?

Answer 17

• increasing taxation will mean that consumers have left disposable income
• this means consumer spending on both domestic goods and imported goods will fall (depends on elasticity of demand for imports)
• likely to reduce current account deficit size

Question 18

How can a depreciation of the £ lower a current account deficit (monetary policy)

Answer 18

• foreigners needs less currency to buy one pound, so British exports are more attractive to them, while at the same time imports seem more expensive to us
• therefore exports are likely to rise and imports are likely to fall reducing current account deficit

Question 19

How can you evaluate the use of monetary policy/depreciation of the pound to lower a current account deficit?

Answer 19

• depends on the price elasticity of demand for imports, if they are essentials PED will be more inelastic meaning consumers will buy them anyway
• this means consumers may even spend more on imports worsening the CAD

Question 20

How do protectionist policies decrease a current account deficit?

Answer 20

• they place tarrifs on imported goods, making the prices higher compared to UK goods as cost of productions has increased
• therefore, housholds will prefer domestic goods, reducing imports used and reducing current account deficit

Question 21

How does lowering minimum wage (supply-side policy) lower a current account deficit?

Answer 21

• leads to a lower cost of production for firms as the minium wage has gone down
• this means domestic goods are more competitive both domestically and internationally, leading to more exports and less imports
• OR lowering the minimum wage can lead to a lower income among some households which can reduce demand for imported goods

Question 22

How does increasing government spending on R&D lead to a decrease in the current account defict?

Answer 22

• the increase in gvnmt spending into R&D will improve efficiency and productivity in certain sectors
• cost of production will go down and quality of goods will increase
• this means UK goods are more competitive leading to higher exports and therfore less CAD

Question 23

What does an increasing current account deficit do to economic growth?

Answer 23

• means that spending is likely more on imports compared to domestic goods
• this means AD in an economy is likely to fall and therefore lower economic growth
• HOWEVER consumers may have wider access to goods and services and therefore have a higher standard of living
• HOWEVER is the goods being imported are capital goods then this may mean more investment which may lead to greater future economic growth

Question 24

How can an increasing CAD affect unemployment?

Answer 24

• the fall in AD (due to greater imports) means a fall in the demand for labour as labour demand is derived demand
• may be cyclical or structural unemployment if there is movemnet of industries e.g from manafacturing to services
• surpluses in the capital/financial account due to increasing CAD may also mean more FDI and they may higher local workers

Question 25

How can an increasing current account deficit lead to a higher government budget deficit?

Answer 25

• fall in AD and fall in labour due to this will mean that more unemployment means more government benefits and less income tax revenue
• this will make the gvnmt budget more negative
• faced with a rising CAD the government may try and stimulate the domestic industry with subsidies or lower corporate taxes, further lowering the budget deficit

Question 26

What can an increasing CAD do to inflation?

Answer 26

• fall in AD due to higher imports
• therefore demand pull inflation will decrease as there is less AD
• lower inflation means our goods are relatively cheaper to foreigners
• exports will be cheaper
• may means greater demand for exports depending on PED for exports
• if demand for exports does increase CAD may start to lessen

Question 27

What factors influence whether we should care about a CAD?

Answer 27

• cause of the deficit
• side of CAD relative to GDP