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

Discuss +ve effect of BOT deficit on SOL

1. BOT deficit is due to greater levels of consumption of imported consumer goods = greater current SOL 

• If due to greater capital goods = greater future SOL

• Eval: Capital goods may be channelled into unproductive ventures → fail to generate future economic returns → unable to attract further FDI & fails to improve export competitiveness → ↓ Qdx → ↓ X revenue → jeopardises future material SOL

Discuss +ve effect of BOT deficit on inflation

BOT deficit → ↓ net exports → ↓ AD → ↓ demand-pull inflation (if economy near full employment) → firms cut production → ↓ competition for FOP → firms able to use more efficient combinations of FOP → ↓ UCOP → ↓ cost-push inflationary pressures

Discuss -ve effect of BOT deficit on EG

When a country’s BOT goes into a deficit due to falling (X-M) -> AD is falling -> real GDP falls by multiplier -> -ve AEG and PEG 

Discuss -ve effect of BOT deficit on forex rate

• (X-M) worsen = Rising imports → ↑ SS of local currency in forex market + falling export earnings → ↓ DD for local currency in forex market → depreciation 

• Central bank intervenes under managed float (buys domestic currency) → runs down foreign reserves → if deficit persists, CB forced to adopt depreciation stance → read as signal CB ran out of reserves → speculation against currency triggered → rapid & sharp depreciation → further loss of confidence in economy

• ↑ uncertainty over future currency fluctuations → C and I falls 

State effects of BOT deficit

-ve EG

Depreciation causing cost-push inflation

Higher SOL

Reduce demand pull inflation

Describe effect of BOT deficit on -ve EG

-ve EG

Starting from a balanced BOT, when a country’s BOT goes into a deficit due to falling X or rising M spending due to consumers switching from domestically produced goods to imports Eg. To finance BOT deficit, government will deplete foreign reserves or borrow from other countries or financial institutions -> -ve outlook on economy (households expect future income to fall + lower expected ROR)  AD will be falling as (X-M) is a component of AD

Describe effect of BOT deficit on forex rate and hence inflation under managed float

(X-M) worsen = Rising imports → ↑ SS of local currency in forex market + falling export earnings → ↓ DD for local currency in forex market → depreciation

• Central bank intervenes under managed float (buys domestic currency) → runs down foreign reserves → if deficit persists, CB forced to adopt depreciation stance → read as signal CB ran out of reserves → speculation against currency triggered → rapid & sharp depreciation → further loss of confidence in economy

• ↑ uncertainty over future currency fluctuations → C and I falls

Describe effect of BOT deficit on forex rate and hence inflation under free floating

• If BOT deficit is large and rises very quickly -> speculators betting against the currency -> freefall in the external value of the currency

• Depreciation -> cost-push inflation (need graph + some analysis!)

Describe eval of BOT deficit on forex rate

Eval: Extent of financial crisis depends on CB's foreign reserve buffers → speculators only attack when reserves perceived as nearly depleted → if large reserves: CB can continuously absorb excess SS of domestic currency → deters speculation

Describe effect of BOT deficit on current and future SOL

• BOT deficit is due to greater levels of consumption of imported consumer goods = greater current SOL 
  

• If due to greater capital goods -> AD increase -> (multiplier) + PC increase -> sustained EG -> greater future SOL

Effect of BOT deficit on SOL eval

Eval: Capital goods may be channelled into unproductive ventures → fail to generate future economic returns → unable to attract further FDI & fails to improve export competitiveness → ↓ Qdx → ↓ X revenue → jeopardises future material SOL

Effect of BOT deficit on inflation (from balanced to BOT deficit)

If from balanced to BOT deficit → ↓ net exports → ↓ AD → ↓ demand-pull inflation (if economy near full employment) → firms cut production → ↓ competition for FOP → firms able to use more efficient combinations of FOP → ↓ UCOP → ↓ cost-push inflationary pressures

Effect of BOT deficit on inflation eval

Eval: Depends on context 

• In overheated economies like the US in 2022, where spare capacity was non-existent -> deficit reduce inflation

• In recession-hit economies like Greece in 2012, where spare capacity was abundant, a worsening trade balance offers no inflationary relief and worsens fall in national output and employment