Macro 3 - Balance of Payments on Trade

Question 1

Balance of payments - definition

Answer 1

> A record of all payments or financial transactions between a country and other economies over a given period of time.

Question 2

Exports - definition

Answer 2

> Any good or service a domestic firm sells to foreign consumers in exchange for money.
Injection into CF.

Question 3

Imports - definition

Answer 3

> Value of goods and services from abroad that are bought into an economy.
Leakage CF.

Question 4

Trade deficit - implications

Answer 4

> If a country is spending significantly more money on imports than it’s receiving for exports, this can be harmful to the economy or suggest the economy is in poor health.
Number of reasons for this:
1. Suggests income is lower than expenditure.
2. May lead to increasing debt - difficult to pay off.
3. May mean economy is dependent upon other countries for essential goods and services while there’s less demand for domestically produced goods , which can mean a lack of revenue for domestic firms, and in turn, less income to domestic workers.
However, implications of deficit depends on a variety of factors.

Question 5

What 3 accounts is the BoP made up of?

Answer 5

> Current account
Financial account
Capital account

Question 6

What are the four sections on the current account?

Answer 6

1. Trade in goods.
2. Trade in services.
3. Primary income (Investment and employment income).
4. Transfers (or ‘secondary income’).

Question 7

Current account - trade in goods

Answer 7

> Measures the exports and imports of visible goods.
UK’s biggest visible exports: machinery, mechanical appliances and pharmaceuticals.
UK’s biggest visible imports: mineral fuels, oils, machinery and mechanical appliances.

Question 8

Current account - trade in services

Answer 8

> Measures exports and imports of invisible goods.
UK’s biggest invisible exports: insurance and banking.
UK’s biggest invisible imports: tourism.

Question 9

Current account - primary income

Answer 9

> This covers the flow of money in and out of a country resulting from employment or earlier investment. E.g:

• Deposits in foreign banks receive interest payments.
• Businesses set up overseas by a UK company will earn profits for the UK parent company.
• Shares bought in foreign firms will bring dividend payments to the UK shareholder - the shares themselves won’t appear on the current account.
• Salaries paid to UK residents working abroad.

Question 10

Current account - secondary income

Answer 10

> Transfers are the movements of money between countries which aren’t paying for goods or services and aren’t the result of investment.
Transfers include payments made to family members abroad and aid paid to or received from foreign countries.

Question 11

UK Current Account and BoP

Answer 11

> The UK has a large deficit on its current account, and it has had a deficit every year since 1984.
This means that the UK’s current macroeconomic policy includes having to deal with a BoP deficit.

Question 12

Capital Account

Answer 12

> The capital account includes transfers of non-monetary and fixed assets - the most important part of this is the flow of non-monetary and fixed assets of immigrants and emigrants, e.g. when an immigrant comes to the UK, their assets become part of the UK’s total assets.
Debt forgiveness is included on the capital account.

Question 13

Financial account

Answer 13

> The financial account involves the movement of financial assets. It includes:
-Foreign Direct Investment.
-Portfolio investment - investment in financial assets, such as shares in overseas companies.
-Financial derivatives - these are contracts whose value is based on the value of an asset, e.g. foreign currency.
-Reserve assets - these are financial assets held by the Bank of England to be used as and when they are needed.
Income from the financial account, e.g. in the form of interest, is recorded in the current account.

Question 14

FDI - Definition

Answer 14

> This is when a firm based in one country makes an investment in a different country.

Question 15

Short-term capital and financial flows

Answer 15

> Short-term flows (sometimes called ‘hot money’) are based on speculation and people/firms trying to quickly make more money.
E.g. by moving money from one currency to another expecting to make a profit through changes in exchange rates.

Question 16

Long-term capital and financial flows

Answer 16

> Long-term flows are due to things such as FDI and portfolio investment,
They’re usually quite predictable as, for example, FDI is often made when a country gains a comparative advantage in producing something, which tends to happen over a long period of time.

Question 17

Hot money

Answer 17

> When interest rates are high in the UK, big financial institutions want to buy the pound.
They do this so that they can put their money into UK banks to take advantage of the high rewards for savers brought about by the high interest rates.
This is likely to be a short-term movement of money and it’s called ‘hot money’.

Question 18

Variables that may affect the BoP for any economy

Answer 18

1. Inflation
2. Costs of production
3. Global trends
4. Exchange rates
5. Productivity
6. Interest rates
7. Household income

Question 19

Variables that affect BoP - inflation

Answer 19

> A country’s competitiveness will be reduced by inflation as exports will cost more to buy and imports will be cheaper. If exports fall and imports rise, then this could create a deficit in the balance of payments and increase unemployment.
Inflation discourages saving because the value of savings falls. This makes it more attractive to spend creating demand-pull inflation before prices rise further.
A reluctance to save creates a shortage of funds for borrowing and investment, which means that it is harder for firms to make improvements. If interest rates go up to reduce inflation this will also reduce investment.
Inflation creates uncertainty for firms as rising costs will reduce investment - harming future growth.

Question 20

Variables that affect BoP - costs of production

Answer 20

> E.g. if country A forms trade unions to protect rights of workers and increase pay, the labour force will be more expensive and hence, so will their goods.
Consumers will buy from a different source, reducing country A’s exports and increasing imports.
Creates deficit on the current account.

Question 21

Variables that affect BoP - global trends

Answer 21

> Influences on global tastes may increase/decrease demand for certain goods/services, affecting the current account.
Decline in smoking due to research could cause problems for the BoP of tobacco producing countries.

Question 22

Variables that affect BoP - exchange rates

Answer 22

> A higher exchange rate for the pound makes UK exports more expensive.
Now the cost of buying pounds is higher so foreigners have to pay more of their currency to gain the same amount of good in pounds.
When this happens exports go down worsening the current account on the balance of payments.

Question 23

Variables that affect BoP - interest rates

Answer 23

> High interests rates cause a short-term movement of money known as ‘hot money’, where big institutions want to buy the pound so they can take advantage of the high rewards for savings brought about by the high interest rates. An increased demand for the pound means its price goes up so the pounds exchange rate rises. A high exchange rate makes UK exports more expensive so they decrease. BoP worsens.
High UK interest rates mean imports from abroad become cheaper, worsening the current account.
Imports are a leakage in the circular flow of income so more spending on imports means a reduction in AD.

Question 24

AD

Answer 24

> Aggregate demand is the total demand, or the total spending on goods and services, in an economy over a given time period.

Question 25

Variables that affect BoP - productivity

Answer 25

> If relative productivity increases, costs of production will decrease so the BoP will improve and sales from rival economies will be driven down.

Question 26

Variables that affect BoP - household income

Answer 26

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Question 27

Causes of a current account deficit - structural causes

Answer 27

1. Under-investment
2. Relatively low productivity
3. Persistently high relative inflation
4. Inadequate research and development, innovation.
5. Emergence of lower cost competition.

Question 28

Causes of a current account deficit - cyclical causes

Answer 28

1. Over-valued exchange rate.
2. Boom in domestic demand.
3. Recession in key export markets.
4. Slump in global prices of exports.
5. Increased demand for imported technology.

Question 29

Structural causes

Answer 29

> Supply-side causes.

>Long-term

Question 30

Cyclical causes

Answer 30

> short-term

Question 31

Current account surplus - structural causes

Answer 31

> Surplus of savings over investment.
Significant long run competition advantage.
Long run rise in global prices of main exports.
Structural increase in net investment income.
Trend rise in factor productivity.

Question 32

Current account surplus - cyclical causes

Answer 32

> Depreciation of the exchange rate.
Strong consumer demand in key export markets.
Cyclical improvement in terms of trade.
Fall in prices of imports.
Rise in net flows of remittances/profits.

Question 33

Consequences of a BoP deficit

Answer 33

1. A BoP deficit could indicate that an economy is uncompetitive.
2. A deficit isn’t always a bad thing - it might mean that people in that country are wealthy enough to be able to afford lots of imports. A deficit may also allow people to enjoy a higher standard of living, as they’re importing the things they want and need. But, a long-term deficit is likely to cause problems.
3. The consequences of a deficit include a fall in the value of a currency, leading to a higher import prices - at least in the short run. This can lead to an increase in inflation.
4. A BoP deficit may also lead to job losses domestically - e.g. if more goods are being imported, that may mean fewer goods need to be produced domestically, so unemployment may increase.

Question 34

Consequences of a BoP surplus

Answer 34

1. Surpluses can show that an economy is competitive.
2. However, if a country has a surplus for a prolonged period of time, e.g. Japan, they may experience stagnation. This means that, for example, due to low domestic demand, they’ll experience low, or even negative, economic growth - which also has the potential to lead to other problems, such as high unemployment.
3. A large surplus on a current account may also be a result of an economy’s overreliance on exports.
4. If a surplus is created by a country having an undervalued currency, this will create inflationary pressures - the price of imported components for use in production will rise, meaning a rise in a the costs of production and therefore a rise in the price level.

Question 35

Causes of a current account deficit - list

Answer 35

1. There are high levels of consumer spending (low savings rate).
2. It’s struggling to compete internationally.
3. It has to deal with external shocks.

Question 36

Causes of a current account deficit - There are high levels of consumer spending (low savings rate)

Answer 36

> When there’s economic growth, consumers and firms buy more imports.
If the income elasticity of demand for imports is high then there will be a greater increase in imports.

Question 37

Causes of a current account deficit - It’s struggling to compete internationally

Answer 37

> Countries that can’t compete internationally will see a reduction in exports.
Some countries (especially more developed countries) may not be able to compete with low costs of production in other countries, e.g. newly industrialised nations.
-When the costs of production in a country rise faster than in competitor countries - e.g. due to higher labour costs, production inefficiencies, a fall in labour productivity eg., then exports will fall and imports will rise.
-Other countries may struggle to compete with countries that have access to more advanced technology or more efficient methods of production, which can lower costs and improve the quality of the products they make.
-If the country has structural problems, e.g. labour immobility, this could be making domestic products and exports more expensive.
A rise in the value of a currency will make goods more expensive to foreign buyers, so exports will fall. At the same time, foreign goods will be cheaper to buy, so imports will rise.
If inflation rises, exports will fall because they’ll become more expensive and less competitive in foreign countries. Imports will rise because it’ll become cheaper for consumers and firms to buy imports rather than domestic products.

Question 38

Causes of a current account deficit - it has to deal with external shocks

Answer 38

> If there’s a rise in the world prices of imported raw materials, e.g. oil, timber or metals, and the demand for these materials is relatively price inelastic, then a country will end up paying more for these imports - at least in the short run.
An economic downturn in countries to which a country exports can cause a sudden reduction in the amount of exports that are demanded.
The imposition of trade barriers on goods by a trading partner could mean a sudden reduction in the number of exports made to that country.

Question 39

Causes of a current account surplus

Answer 39

1. It’s been experiencing a recession - sometimes domestic producers will struggle to sell products domestically, so they’ll focus their efforts on competing in international markets instead. There may be a fall in imports too as a result of an overall reduction in spending.
2. Its domestic currency has a low value - this will make exports cheaper and imports more expensive.
3. High interest rates are causing more saving and less spending.

Question 40

Uk’s large deficit in visible trade - why?

Answer 40

> Partly caused by a lack of competitiveness in its manufacturing industries.