Book 11C - Effects of BOT

Describe the effect of BOT deficit on SOL (Imported consumer goods) (SR AND LR)

• SR: temporary higher mSOL 

• LR: If there is BOT deficit, spending on imported consumer goods higher than what is earned from exports -> excess spending may be paid for by borrowing foreign lenders -> countries that run BOT deficits are net borrowers -> future generation have to cut consumption to repay past debt -> mSOL falls falls in future

Describe the effect of BOT deficit on SOL (Imported capital goods) (SR AND LR)

• SR: no change 

• LR: Increase capital stock -> increase PC and improve price competitiveness of G&S -> Qdx increase -> X increase -> generate EG in future 

• Country will have foreign currency to repay foreign loans it took to finance increase in imports -> no need to cut back on imports in future 

• AS also rises -> GPL falls + increase in equilibrium national output -> mSOL increase in future

Describe the effect of BOT surplus on SOL

• SR: temporary lower mSOL 

• LR: BOT surplus means country is a net lender (lending to trade partners to buy its exports) -> country receives loans and interest payments from abroad -> earnings adds to national income -> mSOL increase

Describe effect of worsening BOT on firms

Worsening BOT (BOT deficit larger OR reduced BOT surplus) 

• Supply of currency rises relative to its demand -> country currency depreciates in floating exchange rate system -> improve price competitiveness of domestic products 

• BOT imbalance = uncertainty in stability of currency -> negatively affect firm’s expectations

Extent of fall in national income from worsen BOT depends on… (worsening BOT)

Floating foreign exchange	Worsen BOT -> depreciation -> improve BOT which reduces contractionary impact on national output
Managed floating foreign exchange	Worsen BOT causes foreign exchange rate to fall below intervention band -> central bank intervene to prevent depreciation by buying up local currency -> domestic money in forex market supply falls -> C and I falls -> AD falls -> further contraction of national output, assuming economy initially below Yf

Extent of fall in national income depends on… (persistently large BOT)

Floating foreign exchange	Worsen BOT -> depreciation -> lowers expected ROR on investment -> I decrease
Managed floating foreign exchange	Central bank intervene to prevent depreciation by buying up local currency and selling foreign currencies -> reduce reserve of foreign currencies -> speculation against the currency and foreign investors call back loans, sell assets owned in the country and move funds out (capital flight) -> downward pressure on forex rate -> without sufficient foreign reserves, depreciation occurs

Explain effect of persistently large BOT on EG/UN

• Foreign lenders lose confidence in country’s ability to repay loans -> they cut off new loans -> country has to cut back on imports -> -ve EG 

• Negatively affect firm’s expectations 

Extent of rise in national income depends on… (improving BOT)

Floating foreign exchange	Appreciation -> worsen BOT which dampens rise in national output
Managed floating foreign exchange	Foreign exchange rate to appreciate beyond desired range -> central bank sell domestic currency -> increases supply of S$ in forex market and increase countries foreign reserves -> foreigner spend domestic currency on country G&S, local currency ends up in local bank accounts -> domestic money supply rise -> AD increase

Explain effect of worsening AND improving BOT on inflation

Worsening BOT 

• Depreciation -> Pimports increase -> UCOP increase -> cost-push inflation 

Improving BOT 

• Increase in AD -> demand-pull inflation 

• Appreciation -> UCOP falls -> reduce imported inflation