Theme 4 - Balance of payments Flashcards
(34 cards)
what is the balance of payments
a spreadsheet that measures the inflows and outflows of money in and out of a country
- consists of the current account, capital account, and financial account
what does the current account consist of
trade in goods(visible trade) - Exports and imports of physical goods such as machinery, vehicles, food, and raw materials.
trade in services - Exports and imports of intangible services like banking, tourism, insurance, and consultancy.
investment income - Earnings from overseas investments, such as dividends, interest, and profits from foreign-owned assets.
transfers - Payments made without receiving goods or services in return, like foreign aid, remittances, and contributions to international organizations.
what does the capital account consist of
- debt forgiveness
- inheritance taxes
- sales of tangible and intangeable assets
- death duties
what does the financial account consist of
- portfolio investment - the buying and selling of financial assets, eg bonds,shares
- foreign direct investment flows - Long-term investment where investors acquire a significant degree of control in a foreign company, such as building new facilities or acquiring substantial stakes in foreign firms.
- reserves - The central bank’s holdings of foreign currencies, gold, and Special Drawing Rights (SDRs).
what is a current account deficit
when countries are buying more from the world than it is selling. when imports exceed exports
why does the balance of payments need to be balanced
- A balanced BoP ensures that a country’s transactions with the world are sustainable. If there’s a persistent imbalance, it may lead to issues like accumulating foreign debt, currency devaluation, or economic instability.
how do countries with a current account deficit gain a financial account surplus from a country with a high current account surplus
- A country with a current account deficit imports more goods and services than it exports, leading to an outflow of funds.
- To finance this deficit, it must attract financial inflows, such as investments or loans from other countries. These inflows appear as a financial account surplus (e.g., through foreign direct investment or the purchase of domestic assets by foreign investors).
- Countries with current account surpluses, like China or Germany, often provide the needed capital by investing in the deficit country’s assets. This investment fills the gap created by the current account imbalance, ensuring the overall balance of payments is maintained.
- While China receives some foreign investment, its outward investment exceeds these inflows, leading to a financial account deficit.
role of the balancing item
- there can be discrepancies in the BOP data (e.g., unreported or misclassified transactions).
- The balancing item corrects these statistical discrepancies by ensuring that the sum of the current, capital, and financial accounts equals zero
consequences of a current account deficit
- LOWER AD
- A current account deficit means imports (M) exceed exports (X), so net exports (X-M) are negative.
- This reduces aggregate demand (AD), leading to slower economic growth and potentially higher unemployment.
- The economy may face a negative output gap, worsening economic performance. - DEBT BURDENS
Current account deficit → increased foreign debt servicing costs → reduced government spending and investment → potential crowding out of productive investment → slower economic growth - Lower Exchange Rate
- A current account deficit increases the supply of the domestic currency in foreign exchange markets, leading to currency depreciation.
- However, if the deficit is due to poor competitiveness, a lower exchange rate may not boost exports sufficiently, leading to stagflation (low growth with rising inflation), as import prices would still be high - Cost-push inflation
- A depreciating exchange rate can make imported goods more expensive, causing cost-push inflation.
- This raises production costs, especially in economies reliant on imports for raw materials, leading to higher inflation with stagnant growth.
Reduced investor confidence
- A significant and sustained current account deficit may signal an economy that is dependent on foreign capital and borrowing.
- Foreign investors might become concerned about the country’s ability to service its debt or manage its external liabilities.
- This could lead to a reduction in investment inflows or even capital flight, which could destabilize the economy.
- The outflow of capital can increase the deficit further and weaken economic growth prospects.
what are expenditure reducing policies
policies used to reduce the amount of spending on imports in the economy
- they work by reducing AD, reducing income and therefore reduce the marginal propensity to import
- contractionary monetary and fiscal policy are examples
evaluation points for expenditure reducing policies
- conflict of macro objectives
- contractionary policies like increasing taxes/ lowering govt spending can lower aggregate demand and reduce imports but also slow down economic growth
- this could lead to higher unemployment, low growth, maybe a recession and potentially deflation - Business and consumer confidence
- if consumer and business confidence is high, households and firms may continue spending and investing despite government policies aimed at reducing expenditure
- this could undermine the effectiveness of policies and worsen the deficit - Elasticity of imports
- If imports are demand inelastic,reducing consumer spending may not significantly decrease import demand
- therefore import expenditure may remain high and the deficit may worsen - size of the output gap
- if the economy has a large output gap(below full capacity), expenditure reducing policies may have a stronger impact on reducing demand without significant inflationary pressure
- however, if the output gap is small, these policies could push the economy into a recession
what are expenditure switching policies
policies that aim to switch expenditure away from imports and towards domestic consumption
- eg protectionist barriers like quotas and tariffs
evaluation points for expenditure switching policies
- retaliation
- protectionist measures could lead to retaliatory measures from trading partners, reducing export opportunities
- this could harm domestic industries and escalate into trade wars, potentially worsening the trade balance instead of improving it - WTO laws
- Many forms of expenditure switching pouches may violate WTO rules, which promote free trade and discourage protectionism
- countries could face penalties, disputes and sanctions, limiting the effectiveness and sustainability of these policies - inflationary pressures
- restricting imports can lead to higher domestic prices and demand shifts to local goods, which may have limited supply or higher production costs
- this could create inflationary pressure, reducing consumer purchasing power and leading to lower economic growth - loss of efficiency
- protectionist policies can shield inefficient domestic firms from international competition, reducing the incentive for them to innovate or cut costs
- this can lead to long term inefficiency, misallocation of resources, and lower overall productivity in the economy
how could expenditure switching policies lead to a weaker exchange rate
💷 1. Reduced Demand for Imports → Lower Demand for Domestic Currency
Tariffs or import quotas increase price of imports → consumers and firms buy fewer foreign goods → demand for foreign currency falls → foreign firms receive less domestic currency in exchange → demand for domestic currency falls → exchange rate depreciates
📉 2. Lower Supply of Foreign Currency (from reduced imports)
Fewer imports mean less need to exchange domestic currency for foreign currency → supply of domestic currency on forex markets falls → downward pressure on the exchange rate → domestic currency weakens
🔁 Expectations of Protectionism May Worry Investors
Introduction of tariffs signals move towards protectionism → foreign investors may lose confidence in the economy → capital flight or reduced capital inflows → lowers demand for domestic currency → exchange rate depreciates
evaluation points for expenditure switching policies leading to a weaker exchange rate
- marshall lender condition - states that a depreciation of the exchange rate will only improve the current account balance if the sum of the price elasticities of demand for exports and imports is greater than 1
- if the condition is not met(eg if demand for exports and imports is inelastic), a weaker exchange rate might worsen the trade balance. imports will become more expensive but export demand won’t rise enough to compensate - inflation
- a weaker exchange rate makes imports more expensive, increasing production costs for firms reliant on foreign goods, which could lead to cost push inflation
- higher inflation reduces real income and purchasing power, potentially leading to stagflation, which can undermine the benefits of a weaker currency - retaliation/currency wars
- countries might respond to a deliberate weakening of the exchange rate by devaluing their own currency(currency wars) where nations compete to maintain export competitiveness
- this could lead to global instability in exchange rates, reduce global trade volumes, and further harm long-term economic growth for all countries involved
general evaluation points for policies on trade - expenditure switching and reducing
❓ 1. Depends on the Cause of the Deficit
If the deficit is due to lack of competitiveness → expenditure-switching (e.g. devaluation or tariffs) may help → but if it’s caused by high domestic demand or structural issues → these policies may be ineffective → identifying the root cause is key for success
📉 2. Time Lags Before Improvement Occurs
Marshall-Lerner condition must be met for devaluation to work → in the short run, demand for imports/exports may be inelastic → current account may worsen first (J-curve effect) → improvements in trade balance may only emerge over time
💸 3. Possible Retaliation or Trade Wars
Tariffs and protectionist measures may provoke retaliatory tariffs → reduces export revenue and harms international relations → global trade contracts → long-term growth and current account could worsen
🧍 4. Negative Impact on Domestic Households
Expenditure-reducing policies (e.g. higher interest rates or taxes) → reduce disposable income and domestic demand → may lower imports but also increase unemployment → sacrifices growth and living standards for external balance
🏭 5. Structural Reforms May Be More Effective
Improving productivity, skills, and quality of domestic goods → boosts export competitiveness more sustainably → long-term improvements without harming consumption → better than short-term demand suppression
causes of a current account surplus (demand side causes)
Increase in foreign demand for domestic goods and services
Higher foreign demand increases exports, leading to an increase in the current account surplus.
This leads to more revenue flowing into the domestic economy.
The domestic currency strengthens due to increased export activity.
This further encourages exports, contributing to the sustained current account surplus.
Improvement in domestic competitiveness
If domestic industries become more efficient or innovative, their goods and services become more attractive to foreign consumers.
This leads to an increase in exports.
As exports rise, the current account balance improves.
The stronger export performance helps the economy accumulate more foreign currency, contributing to the surplus.
Lower domestic consumption of foreign goods
If domestic consumers reduce their demand for imported goods, imports decrease.
With reduced imports, the current account deficit shrinks or a surplus may form.
As domestic demand is satisfied by domestic producers, the economy’s current account balance improves.
This reflects a shift toward more local production and consumption, reinforcing the surplus.
Exchange rate depreciation
A depreciation of the domestic currency makes exports cheaper for foreign buyers and imports more expensive for domestic consumers.
As a result, exports increase and imports decrease.
The resulting higher exports and lower imports lead to an improvement in the current account surplus.
This effect tends to be more pronounced if the demand for exports is price-elastic.
causes of a current account surplus(supply side)
🏭 1. High Productivity and Efficiency
Improved labour or capital productivity → lowers unit labour costs for domestic firms → goods become more price competitive internationally → exports increase relative to imports → current account moves into surplus
🤖 2. Technological Advancements
Adoption of advanced technology in production → improves efficiency and innovation → boosts output and quality of export goods → increases foreign demand for domestic products → export revenue rises, creating a surplus
🎓 3. Investment in Human Capital
Better education and training systems → improves workforce skillset → supports production of high-value goods and services → increases competitiveness of exports → leads to a trade surplus
🧾 4. Strong Industrial Policy or Export Incentives
Government promotes certain sectors through subsidies or tax breaks → lowers costs and boosts scale of production → increases supply of exports in global markets → contributes to a trade surplus
🚢 5. Competitive Exchange Rate due to Supply-Side Strengths
Supply-side reforms improve productivity → currency remains relatively undervalued due to low inflation → exports become more competitive globally → surplus in trade in goods and services increases
🌍 6. Gains in Comparative Advantage
Economy becomes more specialised in sectors with comparative advantage → lower opportunity cost in producing certain goods → export sector becomes more competitive globally → higher volume of exports relative to imports → current account moves into surplus
🛢️ 7. Discovery of Natural Resources
Discovery of valuable natural resources (e.g. oil, gas, rare earth metals) → increases the supply of tradable goods with strong global demand → exports rise sharply → surplus in the trade balance boosts the current account
consequences of a current account surplus
Increase in foreign reserves
A current account surplus means that a country is exporting more than it imports.
This leads to an inflow of foreign currency.
As a result, the central bank may accumulate more foreign reserves.
This provides the country with a buffer for future economic shocks or external debts.
Appreciation of the currency
A current account surplus results in high demand for a country’s currency (because of export transactions).
This increases the value of the currency relative to others.
An appreciating currency makes imports cheaper.
This could reduce export competitiveness in the long run if the currency becomes too strong.
Increased national savings
A surplus reflects that domestic savings exceed domestic investment.
This can signal an increase in national savings.
The extra savings can be used for investment in infrastructure or domestic business development.
However, it could also imply under-investment in the domestic economy if too much capital is directed abroad.
Impact on global trade relations
A persistent surplus may lead to trade tensions with other countries.
Countries with deficits may pressure the surplus country to reduce its exports or increase imports.
This can lead to the imposition of tariffs or trade restrictions.
Such actions may disrupt international trade relations and impact global economic stability.
how to reduce a current account deficit
Reduce Domestic Consumption:
Reducing domestic consumption lowers the demand for imported goods.
This leads to a decrease in the volume of imports.
As imports fall, the current account deficit narrows.
Lower consumption can also reduce domestic inflationary pressures.
Encourage Exports:
Governments can incentivize exports through subsidies or improved trade agreements.
This boosts the country’s exports, increasing export revenue.
As exports rise, the current account balance improves.
Increased exports lead to higher employment in export-oriented industries.
Depreciate the Currency:
A weaker currency makes imports more expensive and exports cheaper.
Consumers are less likely to buy imports due to higher prices.
Foreign demand for cheaper exports rises.
This leads to a more favorable balance of trade and reduces the current account deficit.
Attract Foreign Investment:
Encouraging foreign direct investment (FDI) can increase financial inflows.
FDI creates income from dividends and profits that offset the current account deficit.
The influx of capital strengthens the currency and helps balance payments.
Increased investment can lead to higher production and export potential, reducing the deficit further.
Reduce Domestic Consumption and Spending on Imports
Tight fiscal policies, such as increasing taxes or reducing government spending, can lower disposable income and domestic demand. With less purchasing power, consumers and businesses may cut back on imports, reducing the current account deficit. However, this approach may slow economic growth, leading to potential trade-offs between addressing the deficit and maintaining economic stability.
Supply-Side Policies to Improve Competitiveness
Enhancing the productivity and efficiency of domestic industries can increase their ability to compete globally. Policies like investing in education, research, infrastructure, and innovation can help improve the quality and cost-effectiveness of exports. While this reduces reliance on imports and boosts export revenues, these policies require time to take effect and significant upfront investment.
Protectionist Measures
Imposing tariffs, quotas, or other trade barriers can reduce the volume of imports by making them more expensive or less accessible. This helps protect domestic industries and shifts demand toward locally produced goods. However, such measures may lead to retaliation from other countries, disrupting international trade relationships and potentially offsetting the gains in the current account.
How can a current account deficit affect macroeconomic objectives?
📉 1. Economic Growth
Current account deficit → indicates net outflow of money due to higher imports than exports → domestic industries lose demand to foreign producers → reduced output and employment in tradable sectors → lower economic growth
📊 2. Inflation
Current account deficit → caused by strong consumer demand for imports → imports act as a leakage from the circular flow → reduces pressure on domestic prices in the short run → could dampen demand-pull inflation
Alternatively:
Persistent deficit → leads to currency depreciation → imported goods become more expensive → cost-push inflation may rise
👷♀️ 3. Employment
Current account deficit → signals weak export performance or strong import penetration → domestic firms may downsize due to falling competitiveness → job losses in manufacturing/export sectors → higher unemployment
💷 4. Fiscal Balance
Large deficit → may require government to intervene to support industries or devalue the currency → increased public spending or reduced tax revenue due to lower output → worsens the budget deficit
💰 5. Exchange Rate Stability
Sustained current account deficit → increases supply of the domestic currency on forex markets (to buy foreign goods) → downward pressure on exchange rate → causes volatility and uncertainty for investors and importers
How can a current account surplus affect macroeconomic objectives?
Economic growth: A surplus can indicate a competitive export sector, contributing to economic growth.
Unemployment: A surplus is usually associated with a stronger domestic industry, potentially leading to more jobs, especially in export-oriented sectors.
Inflation: A surplus can keep inflation in check by balancing aggregate demand with supply.
Exchange rates: A surplus may lead to an appreciation of the currency, which could reduce export competitiveness and increase imports.
How does international trade connect economies?
International trade allows countries to specialize in the production of goods and services in which they have a comparative advantage, leading to increased efficiency, lower costs, and greater variety for consumers. Countries depend on each other for goods, services, and financial capital.
disadvantages of a current account surplus
📉 1. Lower Domestic Consumption and Living Standards
A surplus may arise from low domestic spending → consumers face low wages or high taxes to suppress imports → reduced consumption lowers living standards → economic welfare may decline despite a surplus
🛑 2. Risk of Retaliation and Protectionism
Persistently large surplus → trading partners suffer deficits → may accuse the country of unfair trade practices (e.g. currency manipulation) → could lead to tariffs or trade restrictions on exports → harms long-term trade and growth
🏦 3. Currency Appreciation Pressures
Surplus leads to higher demand for domestic currency (to buy exports) → exchange rate appreciates → exports become more expensive and less competitive → surplus may erode over time, reducing export-led growth
⚖️ 4. Unbalanced Growth Model
Excess reliance on exports → neglect of domestic demand and investment in services or social welfare → growth becomes narrowly focused → economy becomes vulnerable to external shocks or global demand changes
🔁 5. Reflects Under-Consumption and Inequality
Large surpluses may indicate households are saving excessively → possibly due to income inequality or lack of social safety nets → economy not operating at full domestic demand potential → limits inclusive and sustainable growth
