Balance of Payments

Question 1

Balance of payments

Answer 1

A record of all the financial transactions that occur between it and the rest of the world

Question 2

Surplus of an account

Answer 2

Whenever a balance has positive value (credit > debit)

Question 3

Deficit of an account

Answer 3

Whenever a balance has a negative value (debit > credit)

Question 4

Current Account Balance with other accounts

Answer 4

Current account + Capital account + financial account = 0

Question 5

Payments in Current account

Answer 5

Exports/Imports:

• Goods/Services

Income: (Different forms of income)

• Wages (for labor)
• Dividends (for shares)
• Interest (for capital)

Current Transfers: (transfers from abroad)

• (Foreign) Aid
• Remittances (sent home from workers abroad)

Question 6

Payments in Capital Account

Answer 6

Capital Transfers (inflows - outflows):

• debt forgiveness
• investment grants (provided by governments)
• sale of fixed assets

Transactions non-financial assets (inflows - outflows:

• land, mineral rights, forestry rights, airspace

Question 7

Payments in Financial Account

Answer 7

FDI (inflows - outflows):

• investments in physical capital (buildings, factories)

Portfolio Investment (inflows - outflows):

• bonds & stocks

Reserve Assets (official reserves):

• Foreign currencies held by central bank to manage exchange rates.

Official Borrowing:

• Govt borrowings abroad

Question 8

Current Account

Answer 8

The sum of the balance of trade in goods and services, income and current transfers.

Question 9

Capital Account

Answer 9

The sum of the balance of capital transfers and transactions in non-produced, non financial assets.

Question 10

Financial Account

Answer 10

The sum of (FDI), portfolio investment, reserve assets and official borrowing.

Question 11

Balance of trade

Answer 11

Trade balance:

• Export of goods - the imports of goods = Visible exports - visible imports = 0

Question 12

Export

Answer 12

Exports are produced in domestic country and bought by foreign country

Question 13

Imports

Answer 13

Imports are goods produced in foreign countries and bought by domestic country

Question 14

Debit

Answer 14

payments made from the economy - money flows out

• debits create supply of the currency - depreaciation

Question 15

Credit

Answer 15

• payments received by the economy from other economies - money flows in
• credits create demand for a currency - appreaciation

Question 16

Why are the current account and financial account interdependent?

Answer 16

• Due to imports, it consume outside the PPC, hence there must be a matching financial account surplus to provide the country with the necessary foreign exchange to pay for excess imports over exports
• A current account surplus means consuming less than produced, and a part of the income generated from the sale of extra output produced correspond to a financial account deficit.

Question 17

Causes of Current Account Deficit (Imports > Exports)

Answer 17

• If the economy is at full employment (all resources are used in an economy)
• If you are less efficient than the rest of the world

Question 18

Causes of Current Account Surplus
(Exports > Imports)

Answer 18

• Price of a country’s exports increases (and quantity is unchanged).
• Recession → consumer cut down consumption, including imports → export > imports
• If a country is more efficient than the rest of the world

Question 19

Consequences of a Current Account Deficit
(Imports > Exports)

Answer 19

• Increase imports demand → reduce domestic output → causing layoffs and unemployment. (-)
• Increase imports demand → AD decrease → Recession (-)
• Increase in imports of capital goods may lead to a current account surplus in the future (+)

Question 20

Consequences of a Current Account Surplus
(Exports > Imports)

Answer 20

• Can build up foreign reserves (+)
• Improves AD and leads to economic growth (+)
• Deindustrialization (-)
• Feedback effects (-)
• Can be inflationary (AD increase) (-)
• Depression of domestic living standards (-)

Question 21

Implications of a persistent current account deficit (HL Only)

Answer 21

• Depreciating Exchange Rate
• High Interest Rates (increase financial account)
• Foreign ownership of domestic assets (increase financial account)
• High Debt
• Low Credit Ratings
• Lower Economic Growth

Question 22

Implications of a persistent current account surplus (HL Only)

Answer 22

• Lower domestic consumption and investment
• Appreciation of domestic currency
• Reduced export competitiveness (depends on PED)
• Both an inflationary and deflationary effect on price levels
• increase employment

Question 23

BOP and Exchange Rates (HL): Current Account

Answer 23

Current account surplus = appreaciation

• Demand for export increase → appreaciation → demand for imports increase → depreaciation → rebalance

Current account deficit = depreaciation

• Demand for import increase → depreaciation → demand for exports increase → appreaciation → rebalance

Question 24

BOP and Exchange Rates (HL): Financial Account

Answer 24

Financial account surplus = appreaciation

Financial account deficit = depreciation

Question 25

Ways a government can correct a persistent Current Account Deficit 1 : (HL) | Expenditure-switching policies

Answer 25

**Expenditure-switching policies:** Policies that aim to switch spending from imports to domestic goods and services. * can cause higher prices for domestic goods * lower domestic consumption * inefficiencies ## Footnote E.g. trade protection

Question 26

Ways a government can correct a persistent Current Account Deficit 2: (HL) | Expenditure-reducing policies

Answer 26

**Expenditure-reducing policies:** Policies that aim to reduce overall spending in the economy, including spending on imports. (e.g. contractionary monetary/fiscal policies) * May create a recession * high interest rate might appreaciate currency

Question 27

Ways a government can correct a persistent Current Account Deficit 3: (HL only)

Answer 27

Supply side policies * increase competitiveness → more exports * promote industries that produce exports

Question 28

Marshall-Lerner Condition (HL Only)

Answer 28

Depreciation improves the current account if **sum of export and import elasticities is greater than 1.** ## Footnote PED of X + PED of M > 1

Question 29

J curve

Answer 29

Shows the effect of currency depreciation in a trade deficit → worsened BOT initially → improvement as consumers adjust.

Question 30

Short run J curve

Answer 30

* Depreciation lowers export prices * Inelastic (time lag) demand may reduce export revenue * Import prices rise → consumer still purchase because lack of substitutes * Current account worsen

Question 31

Long run J curve

Answer 31

* Demand for M and X are elastic * Foreigners buy export → revenue rise * Consumer find substitutes for imports → revenue rise * Current account improve