4.3 Balance of payments and exchange rates Flashcards
What is the current account made up of?
- Net balance in trade in goods - energy, resources, manufacturing etc.
- Net balance in trade in services - banking, insurance, tourism, transport, shipping, R&D
- Net primary income from oversea assets - money transferred from one country to another by firms/citizens who earn money abroad. Profits, interest, dividends, net remittance flows from migrant workers etc.
- net secondary income/transfers - money transferred between countries e.g. foreign aid, money taken abroad during emigration, remittances and inflows, military grants, payments to the EU.
What is the capital account?
Records the flows of money between countries in the form of capital e.g. if a UK investor bought a factory in China
- Sale and transfer of patents, copyrights and contracts
- Debt cancellation
- Capital transfers of ownership and fixed assets
- May include FDI if just flow of money
What is the financial account?
Transactions resulting in change of ownership of financial assets and liabilities between uK and non UK residents:
- FDI
- Net balance of portfolio investments - debt and equity
- Balance of banking flows
- Buying financial assets in other countries e.g. bonds
- Foreign currency and gold assets bought and sold by central bank
- Short term capital flow of hot money
What is FDI and portfolio investment?
- Investment from one country to another establishing operations or acquiring assets in other businesses. Inward would be a foreign factory setting up in the UK and outward would be the opposite
- Portfolio investment flows is when people/businesses buy from one country buy shares or other securities such as bonds in other nations.
What is a current account deficit?
- Net outflow of income
- Run a financial account surplus to achieve balance - may be financed by FDI or debt
Causes:
- Poor price and non price competitiveness (inflation, low investment, weak non price factors)
- Strong exchange rate affects demand for exports and imports - SPICED
- Recession
- Volatile global prices usually in commodities - importing nations hit harder, if demand is price inelastic then world prices increasing causes increased spending on imports
- Strong domestic growth - demand rises as real incomes rise
- Low productivity, high labour cost, insufficient investment, lack of capital saving, long term declines in exporting industries
Why is the UK runnning a deficit?
- Strong GDP growth - imports
- High value of pound
- Rise of BRICS make competitiveness hard
- Depletion of North Sea Oil reserves
Supply:
-Lack of productive capacity in UK firms, low investment, depreciation of currency, less competitive, supply falls, production costs rise
- Productivity gap in business in export sectors
- High labour costs and low productivity
- Low cost competition
- Poor quality - non price competition
What are the consequences of a current account deficit?
- Loss of AD, lower growth and reduced living standards
- Currency depreciates so cost push inflation
- May borrow, accumulating debts
- Unsustainable lead to loss of investment and capital flight
- Fall in industrial capacity
- Vulnerable to volatile imports
- Funded by borrowing or selling national assets
- If Exceeds 5% of GDP is an issue
What are the causes of a surplus?
- Surplus of savings and over investment, lower than consumption
- Positive gap between exports and imports - net income balance and net transfers small
- High world prices for exports such as commodities e.g. surplus foreign currency funds investment in assets overseas and current account surplus countries have large sovereign wealth funds
- Strong exchange rates
Why may a persistent deficit/surplus be a problem?
Deficit:
- Fall in industrial capacity
- Low investment and productivity
- Depends on imports - volatility
- Funded by borrowing
- Funded by selling national assets
- Exceeds 5% of GDP
Surplus:
- Dependence on a single product
- Good and services which domestic population cannot afford or access
- Locks trading partners into deficit elsewhere
What government policies are used to reduce deficits?
- Supply side policies reduce production costs and price level to make exports more competitive. Can also lead to innovation. May involve reducing tax, employer national insurance contributions, education and training
- Demand side policies - reducing disposable incomes and consumption of imports - deflationary fiscal policy - high tax or cuts in G
- Expenditure switching - change in price of exports and imports e.g. exchange rate depreciation to improve price competitiveness of exports. Import tariffs have same effect
- Expenditure reducing policy - lower real incomes and AD and cut demand for imports - higher direct tax, cut in government spending, increase in monetary policy interest rates.
- Countries do not operate floating exchange rates could devalue currencies
- Countries not in trading blocs could impose tariffs and non tariff barriers to protect domestic industry and reduce import penetration
What is an exchange rate and exchange rate systems?
Rate at which a currency can be exchanged for other currencies in the foreign exchange market. There are 3 systems:
Floating exchange system - value depends on price mechanism and market equilibrium
Fixed: - value is hard pegged to another currency board system or membership.
If the countries rate goes up they will buy up supplies of the currency they are fixed to and reduce the supply of their currency and increase demand of the fixed currency
If the countries rate goes down, they sell foreign exchange reserves so they can rise the demand for their currency to meet the fixed currency
What is devaluation, depreciation (and the opposites)
Depreciation - currency falls in floating system due to market forced opposite is appreciation
Devaluation - fall in the currency in a fixed system, often done by the government on purpose opposite is revaluation
What are free floating exchange rates?
- Set by market forced demand and supply
- No intervention by central bank
- Does not alter interest or intervene by selling/buying currencies
- No target for exchange rate
Changes:
-Trade imbalances - exports tend to affect demand for currency whereas imports affect supply of currency as supply pounds to foreign exchange market to buy imports
Portfolio investment - strong PI will attract currency appreciation
- High interest rate leads to hot money - short term capital flows in causing an appreciation to the exchange rate
- Speculation
How may exchange rates be managed/influenced?
- Relative interest rates - low rates put off investments, high rates attract hot money
- Relative inflation
- Changes in domestic income
- Current account balance - deficit have surplus of supplies devaluating it
- FDI
- Speculation
Managing:
- Changing interest rates
- quantitative easing - increase liquidity causes outflow of money - depreciation
- Direct buying
Why may a country devalue and what are the effects of a devaluation?
Country may devalue currency as a form of trade protectionism, faced with deflationary investment, wish to attract foreign investment, reduce deficits
Benefits:
- AD rises as X-M bigger WPIDEC
- GDP and growth rises
- Employment in domestic industry
- Higher exports
- Exporters, workers, domestic industries benefit
Costs:
- SRAS shifts left as imports more expensive
- Demand and cost pull inflation
- Discourages FDI due to lower returns but may encourage in the long run
- Import demand falls
- expenditure falls
- Consumers see higher costs, higher production costs
- Foreign exports see lower returns
