Balance of Payments

What is the balance of payments?

A record of all financial transactions made between consumers, businesses and the government with other nations

What is counted as a positive entry into the BoP?

Inflows of foreign currency

What is counted as a negative entry?

Outflows of foreign currency

What are the three components of the current account?

1. Trade in goods and services

2. Net income flows from abroad

3. Current trasnfers

What is the Balance of Trade?

Value of X - Value of M

What form of income in the current account is the net income flows?

Primary Income

What are examples of this?

Profits / dividends / interest (e.g from foreign investment)

What is the secondary income of the current account?

Current Transfers

What are some examples of this?

Foreign grants / subsidies (e.g foreign aid or EU contributions)

What are the three components of the capital account?

1. Sale / transfer of transferable contracts

2. Debt forgiveness / cancellation

3. Capital transfers of ownership of fixed assets

What are some examples of transferable contracts?

Patents, copyrights, franchises and leases (e.g a business buying foreign land)

What does the financial account focus on?

Investment

What are the two key forms of investment?

• FDI flows

• Portfolio Investment (inward / outward investment in stocks and shares)

What are credits?

Money flows into the economy

What are debits?

Money flowing out of the economy

What must the balance of payments be equal to?

0

What are foreign currency reserves?

Assets held by the central bank which can be used to buy its own currency to stabilize it

What happens if these reserves are run down?

The economy might need to borrow from the IMF leading to external debt

What are reserve assets recorded on?

Capital account

Who owns them and what can they be used for?

• The Uk gov

• Correct BoP positions

What are the 3 main examples of reserve assets?

• Gold

• SDRs

• Foreign Exchange

What is are SDRs?

• Special Drawing Rights created by the IMF

• Claims for currencies which can be exchanged for US dollars, Euros, Chinese yuans, Japanese yens, and British pounds.

What is the financial account?

A record of the transactions that result in a change of ownership of financial assets between UK and non Uk residents

What 4 things does it include?

1. Net balance of FDI flows

2. Net balance of portfolio investment

3. Balance of banking flows (e.g hot money in / out)

4. Changes to the value of gold reserves and foreign currency

What are hot money flows?

Short-term international capital movements that quickly move between countries in search of the highest returns

How does FDI resolve itself in the BoP?

• Inflow of FDI - surplus on financial account

• Firms profits given back to original country (Salaries etc) - deficit on current account (net primary income)

What is a current account deficit?

When the value of exports is less than the value of imports

How does a current account deficit impact growth?

• Leakage from circular flow

• Decrease in AD

What do external deficit countries need to run?

A financial account surplus

What percentage of the UK’s GDP is exports?

28%

How is employment improved by exports?

• Derived demand

• Multiplier effect (e.g regional effect on local businesses)

Why are different regions effected differently by exports?

Some regions are more dependent than others on demand for exports (e.g regions with a strong manufacturing industry)

What stat shows the UK’s strength in service exports?

2nd largest exporter of services in the world

What are the two main types of service exports from the UK?

• Creative - architecture, marketing, film

• Financial - trading, accounting

Why does Britain have an advantage in selling financial services?

• London is 1 of 3 main world financial centres (Banks set up there and 1/3 of all currency dealings take place in its trading platforms)

• Largest share of trading in international markets

What are the 4 main causes of a current account deficit?

1. Poor price and non - price competitiveness

2. Strong exchange rate

3. Recession in trading partner countries

4. Volatile global prices

How are importer and exporter countries affected differently by volatile global prices?

• Prices fall - exporters of primary commodities are hit

• Prices rise - importers hit by higher prices

What is external competitiveness?

The ability to sell goods and services at competitive prices in a foreign country

What effects cost competitiveness?

Differences in unit labour costs (wages, pensions NI etc) and non - labour costs

What are some examples of non - labour costs?

• Costs of meeting environmental/health regulations

• Environmental taxes

Why might a country have poor price competitiveness?

Higher inflation than trading partners

Why might a country have poor non - price competitiveness?

• Weakness in design and branding

• Low levels of capital investment

What is non - price competitiveness?

Product quality, design, reliability and performance.

How does a stronger exchange rate effect the current account?

Stronger pound makes imports cheaper and exports more expensive worsening the deficit

How does decreased interest rates help a deficit?

• People dont want to save in uk

• Less demand for pound

• Currency depreciates - exchange rate weakens

• Imports more expensive and exports are cheaper

• Deficit is improved

What are 4 negative effects of a fall in exports on growth?

• Fall in AD - fall in output - negative multiplier

• Fall in company profits - less investment

• Firm cutbacks - cyclical and structural employment

• Gov finances worsen - less tax revenue and more welfare spending

What are 6 negative effects of a current account deficit?

1. Structural weakness (persistent deficit)

2. Unbalanced Economy

3. Net leakage of income

4. Structural unemployment

5. Problems financing deficit

6. Large currency depreciation

What wider structural economic problem might be causing a trade deficit?

Innovation / productivity gap causing poor competitiveness

How does a trade deficit cause structural unemploymnt?

• Low demand for exports - less demand for labour (derived)

• Less low skilled manufacturing jobs - regional inequality

• Skills gap - structural unemployment

What might a government have to do if the deficit is not fincanced?

Sell its assets or borrow (increasing debt)

What are 3 potential problems for countries running a current account surplus?

1. Vulnerable to external shocks - downturns in markets for exports can decrease GDP

2. Lack of domestic consumption might limit growth (if no external demand)

3. Lack of sustainability if it relies on non - renewables

What are 4 reasons for why a deficit may not be a problem?

1. Imports might be capital goods

2. Deficit may be cyclical

3. Capital / financial account may finance it

4. Could increase international competitiveness

What strength might a cyclical deficit show?

Strong AD and short term boost of living standards

How would a deficit increase international competitiveness of UK exports?

• Deficit - more imports which need foreign currency

• £ is sold to buy foreign currency

• More supply of £ - currency depreciates

• Exports become cheaper

What are the 4 key methods to reduce a current account deficit?

• Supply - side policies

• Improving macro - economic stability

• Expenditure reducing policies

• Expenditure Switching Policies

How do supply side policies work?

They are designed to improve competitiveness of UK exports by increasing efficiency (price) and quality (non - price)

What are 3 examples of supply side policies to improve a deficit?

• Investment in human capital (education etc) to boost productive capacity and quality

• Investment in infrastructure (cost effective)

• Encourage business investment (cut corp tax)

How would improving macro economic stability reduce a deficit?

More attractive for FDI - better technology = more competitive exports

What are two policies to improve macro economic stability?

• Monetary policy (interest rates) to keep inflation at 2% (low and stable)

• Fiscal policy to maintain stable gov finances

What are expenditure reducing policies?

Policies designed to reduce demand for imports

What is the YED for imports in the UK and what does this mean?

• YED = 2 (very income elastic)

• If income rises demand for imports doubles so the UK is very consumer based

What are deflationary/contractionary policies and how can they reduce a deficit?

Policies that reduce AD:

• Reduced gov spending

• Higher interest rates (deflationary)

• Higher taxes

These policies reduce consumer confidence and spending (less imports etc)

How else does low domestic demand improve a deficit?

Creates an incentive (profit motive) for businesses to export overseas

What are two negative effects of this type of policy?

• Discretionary fiscal policy may slow growth and increase unemployment

• Does not address structural factors that reduce competitiveness

What is expenditure switching policies?

Designed to change the relative price of exports and imports (mainly by devaluing the currency)

What does devaluing the currency to reduce a trade deficit rely on?

• For the PED of X + M > 1 (elastic)

• So that when the price of these goods changes countries can respond quickly and buy less or more of them

What is this called?

The Marshall Lerner Condition

What are 3 examples of expenditure switching policies?

• Raising interest rates - devalues currency

• Introducing tariffs - makes imports expensive

• Subsidies for domestic firms - makes exports more competitive

What does the J - curve effect look like?

What is the actual PED of X + M?

Inelastic

Why is it inelastic?

• Foreign traders are often fixed into contracts

• They still have to buy or sell the good after a devaluation meaning they cant respond to it

How does this worsen the current account?

• Domestic buyers have to pay higher import prices rather than switching (value of M rises)

• Demand for exports may not increase so devaluation just decreases X