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Flashcards in The balance of payments and exchange rates Deck (31)
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1
Q

What is the BoP?

A

record of all financial transactions between one country and other countries.

2
Q

What is the BoP composed of?

A
  • trade in goods balance (value of goods exported minus imports)
  • trade in services balance (value of services exported minus imports)
  • income balance (income flows into country from non-residents minus income flows out of country from residents to non residents)
  • current transfers (e.g. food aid, UKs contribution to EU’s Common Agricultural Policy)
3
Q

Why does the UK have a deficit on its trade in goods balance?

A
  • high value of sterling 1996 - 2008
  • continuous economic growth 1992 - 2008 (UK has high MPC)
  • relatively low productivity of UK’s workers results in higher average costs
  • relocation of manufacturing to countries with lower labour costs
  • ‘Chindia effect’: their industrialisation has led to flood of cheap imports into UK
4
Q

What is the exchange rate?

A

price of one currency in terms of another

5
Q

What are the main causes of changes in the exchange rate?

A
  • relative inflation rates
  • relative interest rates
  • state of the economy
  • BoP on the current account
  • political factors
  • speculation
6
Q

How do relative inflation rates affect exchange rates?

A
  • if inflation rate is higher than competitors then according to PPP analysis currency should fall
  • PPP is rate at which a particular good is sold at same price in UK and abroad when expressed in a common currency
7
Q

How do relative interest rates affect exchange rates?

A
  • if UK has higher interest rates than those of other countries, foreigners with surplus balances are likely to place them in UK banks, increasing demand for sterling ∴ will strengthen
8
Q

How does the state of the economy affect exchange rates?

A

if UK economy is performing well speculators/ investors will buy sterling as they are confident, causing value to rise

9
Q

How does political stability affect exchange rates?

A

instability may cause loss of confidence in country’s currency

10
Q

How does speculation affect exchange rates?

A

e.g. if it is expected that economy will recover from recession more quickly than initially thought, speculators may buy sterling ∴ will strengthen

11
Q

What is likely to happen to the value of the Euro if members of the eurozone default on their debts?

A

This could result in a loss of confidence in the currency, so causing its value to fall. However, if defaulting countries left the eurozone, leaving just the strong members, the euro would likely strengthen

12
Q

What are the 2 effects of a change in the exchange rate of a currency?

A
  • it will make price of goods exported from UK decrease in country of sale
  • it will make price of goods imported into UK increase
13
Q

What is the Marshall-Lerner condition?

A

for there to be an improvement in the current account, the sum of the price elasticities of demand for imports and exports must be greater than 1

14
Q

What is the J-curve effect?

A

there could be a time lag before the full effects of depreciation of the currency work through the economy, such that in the short run, the sum of the price of demand would be less than 1 but greater than 1 in the long run

15
Q

What are the convergence criteria for joining the European Monetary Union (EMU)?

A
  • fiscal deficit below 3% GDP
  • public sector net debt less than 60% GDP
  • inflation rate within 1.5% of 3 EU countries with lowest inflation rate, and long-term rates within 2%
  • exchange rates must be kept within ‘normal’ fluctuation margins of Europe’s exchange-rate mechanism
16
Q

What are the main tests set out in 2002 and later to determine whether the UK should join the euro?

A

2002:
- are business cycles of UK and European economies converging, so that interest rates set by ECB will be suited to needs of UK economy
- are economies flexible enough to cope if there are external shocks to world economy
- will joining euro encourage FDI into UK
- will joining euro be good for financial services
- will joining euro promote higher econ. growth, stability and long term employment rises
Later:
- is the pound over-valued against the euro?

17
Q

What are the main advantages of monetary union?

A
  • elimination of transaction costs i.e. commission charged on exchange of currencies (however only small % of GDP)
  • price transparency; easy to compare price of goods across countries which adopted euro, which should increase competition
  • easier trading conditions for firms inside euro zone, could benefit from EoS
  • encouragement to transnational companies to invest in euro zone countries as opposed to countries of non-members (little evidence to support this)
18
Q

What are the main disadvantages of monetary union?

A
  • loss of independent monetary policy (needs of individual countries placed second to needs of euro zone members as a whole)
  • ECB’s inflation target is to keep inflation below 2% (less flexible and more deflationary than UK)
  • loss of exchange rate flexibility against other countries that have adopted the euro
  • transition costs e.g. changing slot machines, menus etc.
  • meeting convergence criteria could slow growth & ∴employment e.g. not meant to run fiscal deficits higher than 3% GDP
19
Q

What is the financial account

A

measures transactions in financial assets e.g. investment flows

20
Q

What is the capital account

A
  • relatively small

- contains capital transfers, the largest item being associated with migrants

21
Q

What is a devaluation

A

process whereby a government reduces the price of its currency relative to an agreed rate in terms of foreign currency

22
Q

What is a revaluation

A

process whereby a government raises the price of its domestic currency relative to a foreign currency

23
Q

What are the main concepts you need to understand in relation to devaluation of a currency?

A

The J-curve and the Marshall-Lerner condition (see 136.-137. smith book)

24
Q

What are the main determinants of floating exchange rates?

A
  • in the short run hot money

- in the long run PPP theory of exchange rates

25
Q

What is the PPP theory of exchange rates?

A

in the long run exchange rates (in a floating rate system) are determined by relative inflation rates in different countries

26
Q

What is hot money?

A

stocks of funds that are moved around the world from country to country in search of the best return

27
Q

You should read whole of chapter 7 in smith book many many times for revision

A

give it 5

28
Q

What are the risks in relation to EoS developing in single european markets?

A

They could become too big and be in a position to make monopoly profits. e.g. Vodafone Airtouch acquired Mannesmann AG in 2000 for a reported £100bn and became on of UKs largest firms

29
Q

See Paul Krugmans use of cost-benefit analysis to evaluate whether a country should join a single currency area on 158.

A

give it 5

30
Q

Why is it not be sustainable to balance a deficit on the current account of the balance of payments by a surplus on the financial account in the long run?

A
  • may be a limit on foreign exchange rate reserves

- limit on extent to which it is desirable to fund current account by borrowing or selling UK assets

31
Q

What are the 3 basic routes a government could pursue to reduce the size of a current account deficit?

A
  • Demand management: YED for imports is high in UK ∴ by controlling level of AD you could limit demand for exports. However, this could damage other aspects of economy e.g. unemployment so depends on priority of objectives
  • Supply-side policies: policies to inc. competitiveness of domestic firms should inc. trade ∴ reduce imports
  • Exchange rate adjustment: not too sure how