Balance of Payments and Exchabge Rates - Lecture 16

Question 1

What is a balance of payments?

Answer 1

It records all the flow of money between residents of that country and the rest of the world
Receipts from abroad = credits
Outflows from the country = debits

Question 2

What are the 3 main components of balance of payments?

Answer 2

Current Account, capital account and financial account

Question 3

What is the function of the current account?

Answer 3

Records payments for imports + exports of goods and services so incomes flowing into and out of the country and net transfers in and out of the country (divided into the sub-divisions)

Question 4

How are imports and exports of visible goods recorded?

Answer 4

Recorded in the (current) trade in goods account. Balance of this account is known as the trade in goods or balance of visible trade or merchandise balance

Question 5

What is called if the exports and imports are unbalanced

Answer 5

Exports > imports = Surplus
Exports < imports = Deficit

Question 6

How are imports and exports of services recorded (transport, insurance and tourism)

Answer 6

In the trade in services account
E.g. foreign holiday = debit = outflow of money
Ourchase of uk insurance policy = credit
This is known as services balance

Question 7

What is the addition of the trade in goods account and trade in services known as?

Answer 7

Balance of trade/ balance of trade in goods and services

Question 8

Is there a relationship between the balance of trade and aggregate demand?

Answer 8

Balance of trade directly affects aggregate demand
- a balance in trade deficit means less aggregate demand as imports (withdrawals) are larger than exports(injections)
- a balance of trade surplus means more aggregate demand as exports (injections) are larger than imports (withdrawals)

Question 10

Why does the balance of trade need to be at equilibrium?

Answer 10

Deficit balance must be offset by a net injection through investment being larger than saving
Or tax revenue being larger than governemnt spending

Question 11

What are income flows?

Answer 11

They consist of wages, interest and profits flowing in and out of the country e.g. dividends earned from foreign investment

Question 12

What are current transfers if money

Answer 12

Government contributions, receipts from the EU, international organisations, individuals and firms e.g. money sent from Greece to a Greek student in Uk

Question 13

What components consist of the current account balance?

Answer 13

The trade in goods accounts, the trade in services account, income flows and current transfers of money

Question 14

What is a current account surplus and deficit

Answer 14

Surplus is when credits exceed debits
Deficits is when debits are exceed credits
lol the UK current account deficit is driven by a large trade deficit in goods

Question 15

What does the capital account record?

Answer 15

Records flow of funds into the country (credits) and out of the country (debits) associated with the acquisition or disposal of fixed assets (e.g. land, intangibles, patents and trademarks)
Transfer of funds by migrants, the payment of grants by the government for overseas projects, debt forgiveness by the government
Typically smaller account

Question 16

What does the financial account record?

Answer 16

• only net changes are recorded
  Records cross border changes in the holding of shares, property, bank deposits and loans etc
  (Not concerned with money incomes but concerned with the sales + purchases of assets

Question 17

What does the financial account consider?

Answer 17

• Direct Investment (e.g. lasting business in another country) through acquisition and sales of assets
  Note that the profits are recorded as investment income outflow - current account)
• Portfolio investment (debt and equity securities without control)

Question 18

What do other investment and financial flows consist of?

Answer 18

Various types of short-term monetary flows between the UK and the rest of the world (s.g. Bank deposits and loans driven by interest rate differences and exchange rate expectations)

Question 19

What are flows to and from reserves?

Answer 19

Selling reserves (of other currencies) to buy sterling bc there is a deficit in the balance of payments = credit
Building reserves when there is a surplus in the balance if payments = debit
So overall the balance of payments must balance , if not, exchange rates adjust or the government intervenes

Question 20

How are net errors and omissions regarded in the balance of payments?

Answer 20

• statistical discrepancies are inevitable
• they are included in the balance of payments to make sure it balances

Question 21

What are exchange rates?

Answer 21

• it’s the price of one currency in terms of another (used by individuals in travel, trade and investment)
• Forwign exchange markets determine daily exchange rates
  -dealers aim to balance currency supply + demand to avoid losses as its constantly changing due to market forces + dealer adjustments

Question 22

What’s the most effective way to determine exchange rate?

Answer 22

• exchange rate index and effective exchange rate since many currencies flunccuate and fall against strong currencies and rise against weak currencies
• the weigh of each currency in the index depends on the proportion id trade done with the country, baseline being jan 2005 = 100

Question 23

How do you determine the exchange rate in a free market?

Answer 23

• determined by supply and demand for a currency
• uk importers sell pounds to buy foreign goods which would increase pound supply
• us buyers if uk goods demand pounds - increased pound demand
  Excess supply of pounds = depreciation
  Shortage of pound leads to appreciation

Question 24

Describe the curves that represent supply and demand of pound sterling

Answer 24

• supply curve of pounds = upwards sloping
• demand curve = downwards sloping

Question 25

What are possible causes of depreciation?

Answer 25

- a fall in domestic interest rates (less competitive for savers, most likely to deposit money abroad) - higher rates of inflation in the domestic economy that abroad (Exports become less competitive, demand falls, imports cheaper for Uk consumers) - a rise in domestic incomes relative to incomes abroad (if incomes in the uk rise, more imports, increase supply in sterling, if incomes in other counties fall, uk exports will fall, demand for sterling will fall) - relative investment prospects improving abroad - speculation the exchange rate will fall

Question 26

How can a government prevent the rate of exchange falling in the short term?

Answer 26

- central bank purchases of the domestic currency in the foreign exchange market either by selling foreign currency reserves or by using foreign loans - central bank can raise interest rates Reverse can be used to prevent rate from rising

Question 27

How can the government prevent the rate from falling in the long term?

Answer 27

- contradictory policies - protectionist policies - supply-side policies to increase the competitiveness of the county’s exports

Question 28

What are the advantages of fixed exchange rates?

Answer 28

- brings advantage for the business community through encouraging trade and foreign investment - help prevent government policies from pursuing irresponsible macroeconomic policies

Question 29

What are the disadvantages of fixed exchange rates?

Answer 29

- conflicting policy goals - competitive contradictory polices - problems of ensuring adequate international liquidity to enable intervention and the restrictions that fixed rates place upon countries when attempting to resound to system shocks

Question 30

What are the advantages of free floating exchange rates that automatically balance the balance of payments?

Answer 30

- eliminate need for reserves - give the government a greater independence to pursue their chosen domestic policy

Question 31

What are the disadvantages if free floating exchange rates?

Answer 31

- highly unstable (especially when the elasticities of demand for imports and exports are low) also speculation may be destabilising - may discourage firms from trading and investing abroad - may encourage governments to pursue irresponsible domestic policies for short-term political gain