Chapter 5 - Balance of Payments Flashcards
What is the balance of payments?
A record of all international transactions between one country and the rest of the world
What is the current account?
Measures the total value of export revenue and import expenditure of trade in goods and services, investment income and current transfers
What are the demand side causes of a Current Account Deficit? (opposite for surplus) 3
1) Strong domestic growth (higher incomes at home)
Real disposable incomes at home are high -> increased marginal propensity to import -> increased import expenditure -> increased M -> decreased (X-M)
2) Recession abroad (low incomes abroad)
If real disposable incomes abroad are low -> low demand for exports -> fall in export revenue
3) A strong exchange rate
SPICED
What are the supply side causes of a current account deficit? (opposite for surplus) 7
1) Low labour productivity
Ouput per hour per worker is low compared to competitor countries around the world -> increasing unit labour costs -> increasing costs of production for domestic firms -> relfected in higher prices -> exports become less competitive -> worsening balance of CA
2) High minimum wages
High minimum wages in comparison to competitor countries -> increasing unit labour costs -> increasing costs of production for domestic firms -> relfected in higher prices -> exports become less competitive -> worsening balance of CA
3) Poor investment
Implying that capital machinery is outdated, depreciating, inefficient and costly to maintain -> increasing relative costs of production in comparison to competitor countries around the world -> reducing productivity of capital aswell with slower machinery -> non-price compeition will also fall due to a lower quality standards -> all of which either increase pfinal prices of goods OR decrase quality and therefore demand -> reducing export revenue -> worsening trade balance and CA deficit
4) HIgher realtive inflation
If country has higher inflation rates relative to competitor countries -> reduced price competitiveness of exports
5) Government restriction on free trade
If competitor countries have imposed protectionist measure on a countries exports -> reduced demand -> reduced revenue -> worsening of trade balance -> CA deficit
6) Loss of comparative advantage
If a country looses their comparative advnatage, perhaps due to imporvement in skills/machinery abroad OR better access to raw materials -> industries will go into decline where large exports revenues were previosuly being generated
7) Resource depletion
Strong argument for developing coutnries where extractio regulations are not enforced -> profit maximising firms will ignore full extent of the externalities (the depletion) due to self interest -> leading to depletion of natural resource -> primary commodity export revenue will fall -> worsening trade balance -> current accouint deficit
What are the consequences of a current account deficit? 5
What diagram do we use?
GENERAL = A country with a current account deficit is LIKELY to have a trade deficit given the trade balance accounts for a much greater share of current account than the income balance.
-> this means import expenditure will exceed export revenue -> reducing value of (x-m) in AD equation, causing AD to decrease from AD1 to AD2
DIAGRAM = Keynesian LRAS with AD shift left
Therefore, all of the problems with a CA deficit stem from a decrease in AD
1) Actual growth decreases from Y1 to Y2
Lower demand in economy -> firms decrease output -> decrease in real GDP -> a reduction in growth
2) Unemployment increases
Labour is a derived demand -> also as AD is low, revenues for firms will be falling implying to maintain profitability firms will have to reduce workforce szie
3) Demand pull inflation will decrease
Less pressure on and less competition for existing factors of production -> feeding through to lwoer prices in economy
4) Equal value financial account surplus
Countires with CA deficit must balance it by runnintg an equal value financial account surplus -> where is money coming from?
-4a) Borrowing from international investors
—Long term, reliance on issuiong external debt can panic investors -> lose confidence in ability of nation to pay back debt -> investors stop buying up debt and move investments to a safer coutry -> increase supply of currency -> weakening exchange rate -> furhter panic in economy -> ripple effect -> currency crisis and widspread economic crisis
-4b) Attracting inward FDI
—This would help fund a current account deficit but also wider benfits to economy -> higher growth -> greater employment -> increased tax revenue
-4c) LAST RESORT = selling foreign currency and gold reserves
—this would only occur in times of a balance of payments crisis given importance of such reserves in times of a full blown economic crisis
5) Downwards pressure on exhcnage rates
CA deficits will put downwards pressure on exchange rates -> as supply increases for the currency outstrip demand -> beneficial for exporters as WIDEC -> theory suggests that demand for imports will fall and revenue from exports will rise -> imporving trade balance and rectifying CA deficit
HOWEVER if country is net importer then a weak exchange rate can be very dangerous -> increasing costs of production for firms who import raw materials -> decrasing SRAS -> cost push inflation -> lower economic growth -> recession OR stagflation
What are the evaluation points for a current accout deficit? 2
1) Cause of the deficit
If caused by too much consumption of imports = could be healthy sign of growth, CA deficit side effect not much concern -> imports increase living standards -> if it becomes TOO large govs are safe in the knowledge that booms dont last forever -> income levels wil follow economic cycle
If caused by structural weaknesses (low productivity, poor investment, high relative inflation) = CA deficit will be long term -> dangerous for economy who will have to keep borrowing to finance it -> could lead to currency crisis ovetime -> requires supply side policies that do not have guarantee of success and are costly
2) Size of the deficit
compare rate at which it grows to GDP
Small = not likely to be difficult to finance especailly if GDP growth rates are increasing faster than the CA deficit -> country can afford borrowing to finance deficit
If large = CA deficit grows at a faster rate than GDP -> unsustainable and indicative of debt dependancy -> stronger negative consequences
What are the consequences of a current account surplus? 6
What diagram do we use?
GENERAL = A country with a current account surplus is LIKELY to have a trade surplus given the trade balance accounts for a much greater share of current account than the income balance.
-> this means export revenue will exceed import expenditure -> increasing value of (x-m) in AD equation, causing AD to increase from AD1 to AD2
DIAGRAM = Keynesian LRAS with AD shift right
1) Actual growth increases from Y1 to Y2 -> greater demand in economy -> firms respond by increasing output -> exhuasting spare capacity BLAH BLAH
2) Unemployment decreases
3) DEmand pull inflation increases
4) Upwards pressure on exchange rate
as demand increases for currency outstrip supply -> benficial for net importer -> decreasing costs of production for firms who import raw material -> increasing SRAS -> lower cost psuh inflationary pressure
OPPOSITE for net exporter as demand foe xports fall as they become les competitive
Both affects will worsen trade balance and canell out a current account surplus
5) RIsk of unbalanced economy
Large, perisiten CA surplus could indicate an unbalanced economy
with too much demand for foreign demand as opposed to domestic demand ->vunerable to reduction i export demand without alternative avanues to maintain strong rates of economic growth
6) One countrys CA surplus is another coutries CA deficit
Those with alrge CA deficit may react unfavourably to protectionist measures on imports from those wioth large CA surpluses attempting to rectify it -> potentially generating trade wards -> a negative sum game for all involved
What types of policies are available to the government to rectify a current account deficit?
Expenditure reducing policies = Policies designed to reduce import expenditure BY reducing incomes
Expenditure switching policies= Policies designed to reduce import expenditure WITHOUT reducing incomes
Supply side policies = Policies to improve price and non-price competitiveness of exports
What expenditure reducing policies can be used to reduce a CA deficit? + Evaluation for them
1) Contractionary fiscal policy such as:
-increase in income tax
-increase in cooporation tax
-cut in gov spending
2) Contractionary monetary policy such as:
-rise in interest rates
-decrease in money supply
1) + 2) = Reduce level of AD -> reduce incomes throughout economy -> reduce marginal propensity to import -> less ‘sucking in’ of imports -> reducing demand for imports -> reducing import expenditure -> certris paribus -> improving trade balance in CA -> recitfiying CA deficit
EVALUATION = Expenditure reducing policies conflict greatly with other macroeconomic objectives of gov.
Trade balance improves with side effects; fall in economic growth, potential recession, rise in unemployment. These are much worse than CA deficit therefore are rarely used to correct a CA.
What expenditure switching policies can be used to rectify a CA deficit?
1) Protectionism
I.E Imposing or increasing tariffs, quotas, embargoes, domestic subsidies and non-tariff barriers like red tape and standards. -> reducing demand for imports through increasing price or blocking imports -> reducing import expenditure -> fixing CA deficit
2) Weakening of exchange rate
Through reducing interest rates (hot money outflows), increasing money supply or selling domestic currency reserves -> WIDEC
What are the evaluation points / consequences for using protectionism to reduce a CA deficit? 6
1) Strong retaliation
Crountries will frown upon the fact that their economy and exporters are made to suffer and not react kindly to any protection imposed on them, often disagreeing with the initial reasons for the imposition -> protectionism will be enacted back on imports -> tit for tat -> trade war is a neagtive sum game for all involved
2) Tariffs and quotas will increase prices for consumers
Deadweight welfare loss of consumer surplus -> ALSO key imports often include clothing, food, vehicles and manufactured goods -> goods that pott consume frequently -> making policies regressive -> burdening those on lower incomes more -> widening income inequality
3) Harm domestic firms
Increasing price of imported raw materials -> increasing costs of production for domestic firms -> ALSO domestic industries may be target of retaliation
4) Goes against aims and prinicples of WTO
One core rule of WTO is for member countries to only impose protectionist measures approved by the WTO, which are fair, consistent and non-discrimnatory -> breaking rules leads to fines and permited retaliation
5) Worsening allocation of resources
Protectionsism promotes more domestic production where domestic firms do not have comparative advantage -> more resources going to inefficient producers -> comparative advnateg is distorted with resources being missalocaetd -> eallocative efficiency -> higher prices and lower quantity
6) Tariffs and quotas can be inflationary, leading to conflict of macro objectives
Increasing price of imported goods -> increased costs of production -> increased cost-push inflation -> ALSO finished goods that are imported will come at higher price
What are the evaluation points / consequences of weakenign the exchange rate as an expenditure switching policy to correct a CA deficit? 6
1) Marshall-Lerner condition
The success of the policy depends on whether the Marshall-Lerner condition is satisfied.
The Marshall-Lerner condition states that for a currency depreciation to improve a coutry’s current account deficit, the PEDx + PEDm > 1
Implying there must be a strong demand response to cheaper exports for export revenue to rise and a strong demand response to more expensive imports for import expenditure to fall enough to imporve a CA deficit.
If not satisfied, there will be a net increase in import expenditure relative to export revenue, worsening the trade balance and CA deficit
1a) Marhsall-Lerner condition will not be met in shor run due to very price inelastic demand for imports and exports -> contactual agreements make it difficult for countries to immediately switch -> consumers and businesses take time to adjust and find substitute goods -> leading to the J curve effect -> where a weakening of exchange rate will intially result in a worsening of CA deficit due to these inelasticities before improving and recording a surplus after economic agents adjust.
2) Inflation
Demand pull inflation is likely to increase because AD increases -> conflict of macroeconomic objectives -> cost push inflation will also occur due to increase in price of imported raw materials
SUPER BAD if economy depends heavily on imported coomodities and raw amterials -> maybe leading to stagflation
3) Could lead to retaliation and currency wars
Because countries where exchange rates are manageed and weakened to improve current account deficits are seen to be acting in a protecionist way -> outrage, retaliation -> protectionsit measures against country -> decreasing export revenue.
Countries could also react by weakening their own exchange rate, leading to no net difference in domestic countries rate
4) Success of weakening exhcange rate depends on severity of trade restrictions applied by foreign governments
If they are very strict -> fall in exchange rate may make little difference to competitiveness and revenue
5) Success depends on incomes and demands overseas
If weak due to recession then no difference
6) Success depends on incomes and demands at home
If strong due to boom then demand for imports will be high despite higher price through weakening of exchange rate
What are some supply side policies that a government could use to rectify a current account deficit? 4
Improving price and competitiveness of a country’s exports
1) Government spending on education and training
Improving skills and productivity of labour force, lowering cost
2) Gov spending on infra
REducing costs of production for firms and increasing efficiency
3) Reducing cooporation tax
Increasing retained profits for firms, increasing investment, advancements result in imporvements in competitiveness
4) Deregulation
Increasing competition -> increasing efficiency
ALSO lowering costs of production
What are the evaluation points for using supply side policies to rectify a CA deficit? 3
1) Very expensive
Opportunity cost
2) Very long time to take effect
3) Not garantueed to work
Subsidies to firms may not be used efficiently/ passed on
Deregulation may lead to Olis/Monops OR harm quality
Reductions in coorp tax may not be used efficiently
What must be considered when deciding which policy to implement to correct a current account deficit?
1) The cause of the deficit
Excessive import expenditure = Expenditure reducing policies
Structural causes = Supply side policies
2) Is the current accout deficit really a problem?
Small deficit where growth rates are increasing greater than the deficit, not much of a problem, Gov can afford borrowing to finance the deficit
