LS7/8 - Balance of Payments and Exchange rates

Question 1

Accounts in the BoP

Answer 1

Current account - trade of goods and services, income, transfers
Capital account - capital transfers, non financial asset transfers
Financial account - FDI flows, portfolio investment flows, banking flows, values of reserves of gold/foreign currency

Question 2

Advantages of international capital flows

Answer 2

• Growth in world trade
• Additional source of finance for firms - important for firms in developing countries
• FDI can lead to transfer of technology and skills

Question 3

Disadvantages of international capital flows

Answer 3

• Interconnected global financial system comes with stability risks
• Can potentially undermine national security
• Can lead to excessive borrowing

Question 4

Causes of current account deficits/surpluses

Answer 4

Relative export competitiveness, exchange rates, states of the economy
Export competitiveness is determined by inflation, productivity, innovation, protectionism

Question 5

Problems of CA Deficit

Answer 5

AD is reduced - but depending on size of deficit and its causes
Debt burden increases - but depending on how the deficit is corrected

Question 6

Problems of CA Surplus

Answer 6

Heavy dependence on exports - but depending on size of surplus and also a good thing if a result of successful SSPs
Can be harmful to the economies of trade partners - depends on level of AD in trade partners economies

Question 7

Expenditure reducing policies

Answer 7

Contractionary monetary policy, contractionary fiscal policy
Fall in income -> fall in demand for imports -> rise in net exports -> fall in CA deficit -> position in CA improves
EV: could lead to recession, depends on MPM, business/consumer confidence and the level of output gap

Question 8

Expenditure switch policies - protectionism

Answer 8

Tariffs, quotas, embargoes, admin barriers, subsidies
Imports become more expensive -> exports are cheaper -> net exports rise and domestic output rises -> deficit falls
EV: retaliation, could break WTO rules, could be inflationary -> higher prices for domestic consumers, reduced comp so higher prices

Question 9

Expenditure switch policies - weaker ex rate

Answer 9

Lower int rates, increase money supply, sell more domestic currency reserves
Export competitiveness rises, import competitiveness falls -> net exports rise -> deficit falls, better position on CA
EV: depends on ML condition is satisfied or not, could lead to inflation

Question 10

Expenditure switch policies - SSPs

Answer 10

Spending on infrastructure, education/training, tax cuts, subsidies, etc
Higher output and productivity in long run -> boost domestic consumption -> net exports rise -> better position on CA

Question 11

Exchange rates

Answer 11

Value of one currency in relation to another
Floating - determined by market forces (S&D) cannot be set
Managed - value of currency is set by CB/govt against another currency/ies or gold
Fixed - market forces determine value, but is influenced by CB/govt - buying and selling currency, changing int rates, and currency control

Question 12

Marshall-Lerner condition

Answer 12

For a depreciation in currency to cause improvement in BoP, PED of imports + PED of exports have to be >1

Question 13

J curve

Answer 13

Initially, a depreciation of currency will lead to a deterioration in the CA position before it starts to improve in long run
This occurs due to contracts preventing firms from immediately switching suppliers, and firms and consumer need time to adjust to changes in price