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IB ECONOMICS SECTION 3.3 THE BALANCE OF PAYMENTS.

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1 IB ECONOMICS SECTION 3.3 THE BALANCE OF PAYMENTS

2 1. Outline the role of the balance of payments. The balance of payments (BOP) records financial transactions made between consumers, businesses and the government in one country with others. The BOP figures tell us about how much is being spent by consumers and firms on imported goods and services, and how successful firms have been in exporting to other countries. The balance of payments accounts record all flows of money in and out of a country. These flows might result from the sale of exports (an inflow or credit) or from the domestic country purchasing imports from overseas (an outflow or debit). They might also arise from other countries investing in the domestic country (inward investment - a credit), or from domestic country companies investing abroad (a debit).

3 1. Outline the role of the balance of payments. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance. But in practice this is rarely the case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and from which part of the economy the discrepancies are stemming.  All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country  Usually, the Balance of Payments is calculated every quarter and every calendar year.

4 2. Distinguish between debit items and credit items in the balance of payments. Debit and credit are the two fundamental aspects of every financial transaction in the double-entry bookkeeping system in which every debit transaction must have a corresponding credit transaction(s) and vice versa.  Debit: an expense, or money paid out from an account. (-)  Credit: is used to mean positive cash entries in an account. (+)

5 3. Explain the four components of the current account, specifically the balance of trade in goods, the balance of trade in services, income and current transfers. The current account includes four components : Trade in goods: visible account consists of physical items. Trade in services: invisible account consists of transport, tourism and insurance etc. Net Income flows: Income flows consist of wages, interest and profits flowing into and out of the country. Current transfers of money: Government contributions to and receipts from international organizations and international transfers of money by private individuals and firms.

6 4.Distinguish between a current account deficit and a current account surplus.current account deficit A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

7 4.Distinguish between a current account deficit and a current account surplus.current account deficit A current account surplus occurs when the country’s exports are more than its imports. This is a desirable condition, however it has its own problem associated with it. A surplus in the long run will lead to the appreciation of the country’s currency which will reduce its export competitiveness. Relatively stronger currency will induce people to go in for imported goods, thus harming the domestic consumption and investment. In the long run, it will harm the domestic industry and increase unemployment.

8 5. Explain the two components of the capital account, specifically capital transfers and transaction in non-produced, non-financial assets. Capital transfers are transactions, either in cash or in kind, in which the ownership of an asset (other than cash and inventories) is transferred from one institutional unit to another, or in which cash is transferred to enable the recipient to acquire another asset, or in which the funds realized by the disposal of another asset are transferred. Non-financial assets are entities, over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them over a period of time, that consist of tangible assets, both produced and non-produced, and most intangible assets for which no corresponding liabilities are recorded. Non-produced assets are non-financial assets that come into existence other than through processes of production; they include both tangible assets and intangible assets and also include costs of ownership transfer on and major improvements to these assets.

9 6. Explain the three main components of the financial account, specifically, direct investment, portfolio investment and reserve assets. Direct investment is a category of international investment made by a resident entity in one economy (direct investor) with the objective of establishing a lasting interest in an enterprise resident in an economy other than that of the investor (direct investment enterprise). Portfolio investment is the category of international investment that covers investment in equity and debt securities, excluding any such instruments that are classified as direct investment or reserve assets. Reserve assets - capital held back from investment in order to meet probable or possible demands

10 7. Calculate elements of the balance of payments from a set of data. Calculate the following balances: I. Current account II. Financial account III. Capital account IV. Reserve assets V. Balance of payments Does the country have a trade deficit or surplus? Determine the amount needed for the reserve assets if any and explain why its either positive or negative.

11 7. Calculate elements of the balance of payments from a set of data. CategoryBalance / billions of $ Imports of goods550 Import of services400 Export of goods380 Export of services550 Income-130 Current transfers70 Direct investment40 Portfolio investment-80 Capital transfer90 Transaction in non-produces, non-financial assets -25 Reserve assets? Balance of payments?

12 7. Calculate elements of the balance of payments from a set of data. Calculate the Current account: Current account balance = Export of goods380 Export of services550 Import of goods550 Import of services400 Income balance-130 Current transfer70 Current account balance =-$80 billion

13 7. Calculate elements of the balance of payments from a set of data. Calculate the Financial account: Financial account balance = Direct investment40 Portfolio investment-80 Financial account balance =-$40 billion

14 7. Calculate elements of the balance of payments from a set of data. Calculate the Capital account: Capital account balance = Capital transfers90 Transaction in non-produces, non- financial assets -25 Capital account balance =$65 billion

15 7. Calculate elements of the balance of payments from a set of data. Current account + financial account + capital account + change in reserve assets = 0, therefore: reserve assets = 55 Change in reserve assets is $55 billion. Balance of payments = current account + financial account + capital account + change in reserve assets BOP = = 0

16 7. Calculate elements of the balance of payments from a set of data. The country has a trade deficit. It purchased more goods and services from the rest of the world than the rest of the world bought of its goods and services. The country’s reserve assets must have changed by $55 billion. This number is positive because the country overall had a net deficit in its current, capital and financial accounts of $55 billion, meaning that more money left the country for all its international transactions than came into the country.

17 8. Explain that the current account balance is equal to the sum of the capital account and financial account balances. Current account Balance of trade in goods Balance of trade in services Income Current transfers Capital account Capital transfers Transactions in non-produced, non-financial assets Financial account Direct investment Portfolio investment Reserve assets

18 8. Explain that the current account balance is equal to the sum of the capital account and financial account balances. Current account + financial account + capital account + change in reserve assets = ZERO Another way to look at this is to notice that a nation’s current balance equal the inverse of the capital, financial and reserve account balance. Current account = - (capital account + financial account + change in reserve assets)

19 9. Examine how the current account and the financial account are interdependent. The current, capital, and financial accounts are interdependent  Current account measures flow of goods and services  Capital and financial accounts measure flow of financing  Therefore, sum of capital account and financial accounts equal to current account with opposite sign

20 10. Explain why a deficit in the current account of the balance of payments may result in downward pressure on the exchange rate of the currency. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit.deficit in the current account In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

21 What are the main causes of a current account deficit?  High income elasticity of demand for imports – when consumer spending is strong, the volume of imports grows quickly  Long-term decline in the capacity of manufacturing industry because of de-industrialization. There has been a shift of manufacturing to lower-cost emerging market countries who then export products back into the developed country. Many businesses have out-sourced assembly of goods to other countries whilst retaining other aspects of the supply chain such as marketing and research within the home country.  The trade balance is vulnerable to shifts in world commodity prices and exchange rates.

22 11. Discuss the implications of a persistent current account deficit, referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international credit ratings and demand management. The effect of a current account deficit on the exchange rate: Under a floating exchange rate system, deficits in the current account should be automatically corrected due to adjustments in exchange rates.floating exchange rate When households and firms in one nation demand more of other countries’ output than the rest of the world demands of theirs, there is upward pressure on the value of trading partners’ currencies and downward pressure on the importing nation’s currency. In this way, a movement towards a current account deficit should cause the deficit country’s currency to weaken. The downward pressure on exchange rates resulting from an increase in a nation’s current account deficit should have a self-correcting effect on the trade imbalance. In this way, a flexible exchange rate system should, in the long-run, eliminate surpluses and deficits between nations in the current account.

23 11. Discuss the implications of a persistent current account deficit, referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international credit ratings and demand management. The effect on interest rates: A persistent deficit in the current account can have adverse effects on the interest rates and investment in the deficit country. As explained before, a current account deficit can put downward pressure on a nation’s exchange rate, which causes inflation in the deficit country as imported goods, services and raw materials become more expensive. In order to prevent massive currency depreciation, the country’s central bank may be forced to tighten the money supply and raise domestic interest rates to attract foreign investors and keep demand for the currency and the exchange rate stable. Additionally, since a current account deficit must be offset by a financial account surplus, the deficit country’s government may need to offer higher interest rates on government bonds to attract foreign investors. Higher borrowing rates for the government and the private sector can slow domestic investment and economic growth in the deficit nation.

24 11. Discuss the implications of a persistent current account deficit, referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international credit ratings and demand management. Foreign ownership of domestic assets: By definition, the balance of payments must always equal zero. For this reason, a deficit in the current account must be offset by a surplus in the capital and financial accounts. If the money spent by a deficit country on goods from abroad does not end up returning to the deficit country for the purchase of goods and services, it will be re-invested into the county through foreign acquisition of domestic real and financial assets, or held in reserve by surplus nations’ central banks. Essentially, a country with a large current account deficit, since it cannot export enough goods and services to make up for its spending on imports, instead ends up “exporting ownership” of its financial and real assets. This could take the form of foreign direct investment in domestic firms, increased portfolio investment by foreigners in the domestic economy, and foreign ownership of domestic government debt, or the build up of foreign reserves of the deficit nation’s currency.

25 11. Discuss the implications of a persistent current account deficit, referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international credit ratings and demand management. The effect on indebtedness: A large current account deficit is synonymous with a large financial account surplus. One source of credits in the financial account is foreign ownership of domestic government bonds (i.e. debt). When a central bank from another nation buys government bonds from a nation with which it has a large current account surplus, the deficit nation is essentially going into debt to the surplus nation. On the one hand, foreign lending to a deficit nation is beneficial because it keeps demand for government bonds high and interest rates low, which allows the deficit country’s government to finance its budget without raising taxes on domestic households and firms. On the other hand, every dollar borrowed from a foreigner has to be repaid with interest. Interest payments on the national debt cost US taxpayers over $400 billion in 2010, making up around 10% of the federal budget. Nearly half of this went to foreign holders of US debt, meaning almost $200 billion of US taxpayer money was handed over to foreign interests, without adding a single dollar to aggregate demand in the US.

26 11. Discuss the implications of a persistent current account deficit, referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international credit ratings and demand management. The effect on international credit ratings and demand management: Over time, budget deficits financed through foreign borrowing reduce the attractiveness of the deficit country’s government bonds to foreign investors, harming its international credit rating, forcing the government to offer ever increased interest rates to foreign lenders. Higher interest rates that must be offered reduce the government’s ability to manage the level of aggregate demand in that nation through fiscal policy to promote its macroeconomic objectives.

27 11. Discuss the implications of a persistent current account deficit, referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, international credit ratings and demand management. What does a current account deficit mean? Running a deficit on the current account means that an economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending. Spending on imported goods and services exceeds the income from exports. Balance of payments and the standard of living In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference In the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables. Balance of Payments and Aggregate Demand When there is a current account deficit – this means that there is a net outflow of demand and income from a country’s circular flow. In other words, trade in goods and services and net flows from transfers and investment income are taking more money out of the economy than is flowing in. Aggregate demand will fall. When there is a current account surplus there is a net inflow of money into the circular flow and aggregate demand will rise.

28 Reasons why a country’s balance of payments on current account may at times be in deficit and at other times be in surplus changes in exchange rates which alter the relative prices of imports and exports  the impact of the level of economic activity in overseas markets on exports  the impact of the level of domestic economic activity on imports  relative domestic and foreign rates of inflation  changes in the pattern of comparative advantage and overseas competition  the impact of changes in barriers to trade  changes in investment income and transfers  changes in the terms of trade  the impact of fiscal and monetary policies

29 Does the existence of a current account deficit represent an economic problem? not a problem if:  deficit is small and/or temporary  it is counterbalanced by capital inflows  other countries are continuously willing to finance the deficit  it reflects a growing economy and higher living standards  automatic correction of a deficit under a floating exchange rate system

30 Does the existence of a current account deficit represent an economic problem? reasons why it may be a problem:  need to finance deficit may lead to depletion of foreign exchange reserves/overseas borrowing/greater indebtedness  a reflection of trading uncompetitiveness / overvalued exchange rate  overseas creditors decide to “turn off the taps”  the impact on the exchange rate and inflation  the need for domestic deflation and the conflict with the goals of full employment and economic growth

31 12. Explain the methods that a government can use to correct a persistent current account deficit, including expenditure switching policies, expenditure reducing policies and supply-side policies, to increase competitiveness. Expenditure switching policies These are policies implemented by the government that attempt to switch the expenditure of domestic consumers away from imports towards domestically produced goods & services.  devaluating currency: Fixing the domestic currency value at a lower price and thus making exports more attractive. Moreover, imports will become more expensive, thus diverting consumption to domestic goods. However, expensive imports will lead to imported inflation  Protectionist measures: Reducing imports by levying tariffs and setting up quotas.

32 12. Explain the methods that a government can use to correct a persistent current account deficit, including expenditure switching policies, expenditure reducing policies and supply-side policies, to increase competitiveness. Expenditure reducing policies These are policies implemented by the government that attempt to reduce overall expenditure in the economy, so shifting the AD to the left. deflationary fiscal policies: Increasing taxes and reducing government spending. deflationary monetary policies: Increasing Interest rates. However, contractionary fiscal and monetary policies will lead to fall in Aggregate Demand, which is not desirable. This will result in compromising economic growth and higher unemployment.

33 12. Explain the methods that a government can use to correct a persistent current account deficit, including expenditure switching policies, expenditure reducing policies and supply-side policies, to increase competitiveness. Supply Side policies The main objective of the supply side policies is to improve the quantity and quality of factors of production. By achieving efficiency in the production of goods and services, the economy can improve its international competitiveness and increase its exports. This would include  Improvement in technology  Improving the education and skill level of its workforce  Providing better infrastructure  Privatization  deregulation All of the above measures will also attract foreign investment in the economy, which will lead to inflow of foreign currency and improve balance of payment. Supply-side policy can provide a highly effective policy framework for long term improvement in competitiveness and current account performance. The main problem is that supply-side policy may take decades to work and is not a quick-fix.

34 12. Explain the methods that a government can use to correct a persistent current account deficit, including expenditure switching policies, expenditure reducing policies and supply-side policies, to increase competitiveness.

35 13. Evaluate the effectiveness of the policies to correct a persistent current account deficit. Evaluation of Expenditure reducing policies: The main criticism of deflationary policy is that, as spending-power must fall, personal incomes and standards of living will also fall, and this can trigger demand deficient unemployment. However, different deflationary policies may result in different effects. For example, raising interest rates may work more quickly than raising tax rates. For the above reasons, deflation is a politically unpopular policy option. Voters are much more likely to be concerned with recession and unemployment than with a balance of payments deficit, hence politicians are unlikely to priorities the reduction of a deficit. It is also difficult to predict the precise effect of a fall in spending on imports, which requires an accurate calculation of the marginal propensity to import.

36 13. Evaluate the effectiveness of the policies to correct a persistent current account deficit. Evaluation of Expenditure switching policies: Devaluation relies on the assumption that the sum of price elasticity of demand for imports and exports is elastic (>1), the so-called Marshall-Lerner condition. However, this may not be satisfied in the short run, or even the longer run. Devaluation may also trigger cost-push inflation, where a fall in the value of a currency will increase the price of imported goods, in terms of the domestic currency. Devaluation could be interpreted as a hostile move against other countries and may lead to retaliation by competitors, so that no long term benefit is derived by the devaluing country.

37 13. Evaluate the effectiveness of the policies to correct a persistent current account deficit. Evaluation of Expenditure switching policies: In the short run, trade barriers may help to reduce imports and help improve the current account. However, retaliation is a likely response, and any short-term gains will be eroded away. Therefore, direct controls are not generally considered an effective long-term solution to a current account deficit.

38 13. Evaluate the effectiveness of the policies to correct a persistent current account deficit. Evaluation of Supply-side policies: Supply-side policy can provide a highly effective policy framework for long term improvement in competitiveness and current account performance. The main problem is that supply-side policy may take decades to work and is not a quick-fix.

39 14. State the Marshall-Lerner condition. The Marshall–Lerner condition has been cited as a technical reason why a reduction in value of a nation's currency need not immediately improve its balance of payments.Marshall–Lerner condition The condition seeks to answer the following question: When does a real devaluation (in fixed exchange rates) or a real depreciation (in floating exchange rates) of the currency improve the current-account balance of a country? The Marshall-Lerner condition states that a real devaluation (or a real depreciation) of the currency will improve the trade balance if the sum of the elasticity's (in absolute values) of the demand for imports and exports with respect to the real exchange rate is greater than one, Exports ped +Imports ped > 1

40 15. Apply the Marshall-Lerner condition to the effect of depreciation/devaluation on the current account. Immediately following the depreciation or devaluation of the currency, the volume of imports and exports may remain largely unchanged due in part to pre- existing trade contracts that have to be honored. Moreover, in the short run, demand for the more expensive imports (and demand for exports, which are cheaper to foreign buyers using foreign currencies) remain price inelastic. This is due to time lags in the consumer's search for acceptable, cheaper alternatives (which might not exist).

41 15. Apply the Marshall-Lerner condition to the effect of depreciation/devaluation on the current account. Over the longer term a depreciation in the exchange rate can have the desired effect of improving the current account balance. Domestic consumers might switch their expenditure to domestic products and away from expensive imported goods and services, assuming equivalent domestic alternatives exist. Equally, many foreign consumers may switch to purchasing the products being exported into their country, which are now cheaper in the foreign currency, instead of their own domestically produced goods and services.

42 16. Explain the J-curve effect, with reference to the Marshall- Lerner condition. A country's trade balance experiences the J-curve effect if its currency becomes devalued. At first, the country's total value of imports (goods purchased from abroad) exceeds its total value of exports (goods sold abroad), resulting in a trade deficit. But eventually, the currency devaluation reduces the price of its exports. Consequently, the country's level of exports gradually recovers, and the country moves back to a trade surplus.

43 16. Explain the J-curve effect, with reference to the Marshall- Lerner condition. Following the depreciation or devaluation of the currency, the volume of imports and exports will remain level due in part to pre-existing contracts for imported goods that have to be honored. However, the depreciation will cause the price of imports to rise and the price of exports to fall. Therefore, total spending on imports will subsequently increase and total spending on exports will decrease. It is this that causes the worsening of the current account.

44 16. Explain the J-curve effect, with reference to the Marshall- Lerner condition. Moreover, in the short run, demand for the more expensive imports remain price inelastic. This is due to time lags in the consumer's search for acceptable, cheaper alternatives. As a result, the quantity demanded for imports remain the same, although consumers are now paying a higher price for it. Ceteris paribus, a worsening of the current account, and hence the balance of payments, is to be expected in the short run. Over the longer term a depreciation in the exchange rate can have the desired effect of improving the current account balance. Demand for exports picks up and domestic consumers will switch their expenditure to domestic products and away from expensive imported goods and services. Equally, many foreign consumers may switch to purchasing cheaper imported products instead of their own domestically produced goods and services.

45 16. Explain the J-curve effect, with reference to the Marshall- Lerner condition.

46 17. Explain why a surplus in the current account of the balance of payments may result in upward pressure on the exchange rate of the currency. If a nation consistently sell more of its output to foreigners than it demands of foreign output, demand for the exporting nations currency will eventually rise and appreciate. In addition, since the surplus nation demands relatively little of foreign goods, the supply of its currency in foreign exchange markets will fall, contributing to the currency’s appreciation.

47 18. Discuss the possible consequences of a rising current account surplus, including lower domestic consumption and investment, as well as the appreciation of the domestic currency and reduced export competitiveness. Over time, an appreciation currency will reduce the export industry’s competitiveness with the rest of the world and force domestic producers to become more efficient or shut down as foreign demand for their goods eventually falls. Under a floating exchange rate, current account surpluses should be kept in check by the appreciation of the surplus nation’s currency and the corresponding decrease in demand for its exports and the increasing appeal of imports among domestic consumers.

48 18. Discuss the possible consequences of a rising current account surplus, including lower domestic consumption and investment, as well as the appreciation of the domestic currency and reduced export competitiveness. Many countries operate with a trade and current account surplus Many countries operate with a trade and current account surplus – good examples are China, Germany, Norway and emerging market countries with strong export sectors. There are several causes and each country will have a unique set of circumstances: Export-oriented growth: Some countries have set out to increase the capacity of their export industries as a growth strategy. Investment in new capital provides the means by which economies of scale can be exploited, unit costs driven down and comparative advantage can be developed. Foreign direct investment: Strong export growth can be the result of a high level of foreign direct investment where foreign affiliates establish production plants and or exporting. Undervalued exchange rate: A trade surplus might result from a country attempting to depreciate its exchange rate to boost competitiveness. Keeping the exchange rate down might be achieved by currency intervention by a nation’s central bank, i.e. selling their own currency and accumulating reserves of foreign currency. One of the persistent disputes between the USA and China has revolved around allegations that the Chinese have manipulated the Yuan so that export industries can continue to sell huge volumes into North American markets.

49 18. Discuss the possible consequences of a rising current account surplus, including lower domestic consumption and investment, as well as the appreciation of the domestic currency and reduced export competitiveness. High domestic savings rates: Some economists attribute current account surpluses to high levels of domestic savings and low domestic consumption of goods and services. China has a high household saving ratio and a huge trade surplus; in contrast the savings ratio in the United States has collapsed and their trade deficit has got bigger. Critics of countries with persistent trade surpluses argue they should do more to expand domestic demand to boost world trade. Closed economy – some countries have a low share of national income taken up by imports – perhaps because of a range of tariff and non-tariff barriers. Strong investment income from overseas investments: A part of the current account that is often overlooked is the return that investors get from purchasing assets overseas – it might be the profits coming home from the foreign subsidiaries of multinational businesses, or the interest from money held on overseas bank accounts, or the dividends from taking equity stakes in foreign companies.

50 CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS

51 Balance of payments balance of payments - principally because the total of outflows must be equivalent to the total of inflows. The BOP is made up of the Current account, Capital account and the Official Reserve account. (Financial account)

52 The Balance of Payments

53 Current account CHAPTER 9 APPLICATION: INTERNATIONAL TRADE Current account : It is the account where all of one country's international transactions in goods and services are recorded. A record of a country's earnings from the sale of visible and invisible items minus its expenditure on visible and invisible items from abroad.  The balance of trade in goods (Visible)  The balance of trade in services (Invisible)  Net income flows - Net investment income (profits, interest and dividends) - Net transfers of money (foreign aid, grants, remittance, pensions)

54 Explain the four components of the current account, Specifically:  the balance of trade in goods,  the balance of trade in services,  income and  current transfers.  Current account deficit: A deficit on the trade account means that imports are larger than exports.  Current account surplus: A surplus on the trade account means that imports are less than exports.

55 The current account is made up of the following payments: Trade in goods: These items include the import and export of finished goods, such as cars, and computers; semi-finished goods, such as parts and components for assembly, and commodities, such as oil, tea and coffee. Trade in services: Trade services include financial services, tourism, and consultancy. Investment income: Investment income, which includes overseas profits, such as those from business activities of subsidiaries located abroad; interest received from UK financial investment and loans abroad and; dividends from owning shares in overseas firms. Transfers: Transfers in items such as gifts, donations to charity, remittance and overseas aid

56 Capital Account  The capital account (financial account) is a measure of the buying and selling of assets between countries.  Foreign direct investment  Portfolio investments (stocks & bonds)  Other investments (currency transactions and bank and savings account deposits)

57 The Capital and Financial Account records the flows of capital and finance between the UK and the rest of the world. Types of flow include the following: 1. Real foreign direct investment (FDI), such as a UK firm setting up a manufacturing plant in South Africa. 2. Portfolio investment, such as UK citizens buying shares in an overseas firm in anticipation of a long term return. 3. Short-term speculative flows, called hot money, where speculators invest abroad in order to obtain the highest return in the short run. For example, a UK fund manager working for a major UK investment bank may buy shares in a US hi-tech firm in the hope of making a fast return. Speculators may quickly sell shares and other financial assets if a short-term profit has been made. 4. Official financing, which occurs when governments, or their agents, buy or sell currencies, securities and other assets to create an inflow or outflow in the balance of payments accounts. For example, when a deficit occurs it may be financed through the Bank of England acting for the government. In an accounting sense the Bank of England must ensure that the account balances – the bottom line of the account must always equal zero.

58 Capital Account  The Capital Servicing account: Includes the interest, profits and dividends paid to and by foreigners. For developing countries, this section is usually negative. More is paid out to foreign investors than is received as interest and dividends.  For industrialized countries like the US and Japan, this account is typically positive because of the large amount earned on foreign investments.

59 4.5 Balance of payments CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS  Capital account: if the Japanese invest in US treasury bills, it is the US that gets the money, and the Japanese that get the TB's.  It counts as negative on the Japanese balance of payments (and their GDP).  This is how the balance of payments is always balanced: if there are negatives on the current account, they must be balanced by a plus on the capital account.  Short term capital is held mainly in money market instruments such as treasury bills or bank accounts (portfolio as opposed to direct investment).  Long term capital movements:  Portfolio: generally involve the purchase of stocks or bonds.  Direct: investments in capital in the country or joint venture agreements.

60 Capital account  Capital account: That part of the balance of payments accounts that measures the flows of capital in and out of the country.  Capital inflows: The movement of money into the domestic country in the form of e.g. the purchase of shares, the purchase of companies and loans by overseas companies.  Capital flight (outflows): The movement of financial assets out of a country in response to an unfavorable domestic circumstances.

61 Official Reserve Account  Central Bank controls to balance the BOP accounts with foreign currencies, gold and SDR’s.  Depends on the level of flexibility of the currency.

62 Official Reserve account  Reserves: monetary assets held by central banks to intervene in foreign exchange markets and to settle international debts.  Reserve currency: A currency held by central banks to intervene in foreign exchange markets and to settle international debts.

63 balance of trade  The balance of trade (or net exports, sometimes symbolized as NX) is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports.  A positive balance is known as a trade surplus if it consists of exporting more than is imported;  a negative balance is referred to as a trade deficit or, informally, a trade gap.

64 Factors influencing the balance of payments include:  Income: as national income rises the demand for imports rise shifting the current account toward a deficit.  Changes in relative prices: as domestic prices rise relative to foreign prices, imports appear cheaper and exports more expensive and the current account will move toward a deficit.  Changes in relative investment prospects: as return on investment rises, foreign capital will be attracted into the country and the capital account will move toward a surplus.  Changes in relative interest rates: as domestic interest rates rise, short term capital is attracted moving the capital account toward a surplus.  If the foreign exchange rate is rising (domestic currency appreciating), the central bank may intervene by selling more domestic currency.  If the foreign exchange rate is falling (domestic currency is depreciating), the central bank may intervene by buying domestic currency with the reserve of foreign currency.

65 Factors influencing the balance of payments  Changes in exchange rates which alter the relative prices of imports and exports  The impact of the level of economic activity in overseas markets on exports  The impact of the level of domestic economic activity on imports  Relative domestic and foreign rates of inflation  Changes in the pattern of comparative advantage and overseas competition

66 Factors influencing the balance of payments  The impact of changes in barriers to trade  Changes in investment income and transfers  Changes in the terms of trade  The impact of fiscal and monetary policies

67 Causes of a current account deficit  Excessive growth If the economy grows too quickly and rises above its own trend rate, which in the UK is around 2.5%, then domestic output (AS) may not be able to cope with domestic aggregate demand. When national income rises above its trend rate it is likely that income elasticity of demand for luxury imports such as motor cars is relatively high, so that imports rise relative to exports.  De-industrialization An increasing trade deficit may be a symptom of long-term de-industrialization. The UK started to lose its manufacturing base in the 1970s, and this process has continued over the last 30 years.  High export prices High export prices will occur if a country's inflation is higher than its competitors, or if its currency is over-valued which will reduce its price competitiveness.

68 Causes of a current account deficit  Non-price competitiveness Non-price factors can discourage exports, such as poorly designed products, poor marketing or a worsening reputation for reliability.  Low levels of investment in human capital This involves a lack of investment in education and training, which reduces skill levels relative to competitor countries and forces countries to produce low value exports.  Poor productivity An economy might not be producing enough from its scarce factors of production. Labor productivity, which is defined as output per worker, plays an important role in a country’s competitiveness and trade performance, and the UK has suffered from poor productivity. The productivity gap is the gap between the UK’s relatively poor productivity performance and that of the UK’s leading competitors.

69 Causes of a current account deficit  Low levels of investment in real capital This could be caused by excessive long-term interest rates, or low levels of research and development.  Low levels of investment in human capital This involves a lack of investment in education and training, which reduce skill levels relative to competitor countries and force countries to produce low value exports.  The rise of alternative global suppliers While the UK has slowly deindustrialized, emerging economies like China and India have increased their share of world trade, with their firms benefitting from access to new technology and from economies of scale. This has reduced the likelihood of smaller UK manufacturers selling abroad, while at the same time increased the likelihood of UK households and firms importing from these economies.

70 Is a current account deficit a problem? A deficit can be a problem under certain circumstances, including the following: 1. It is a persistent deficit that does not self-correct over time. 2. The deficit forms a large share of GDP. 3. There are no compensating inflows of investment income or inward capital account flows. 4. The central bank has low reserves. 5. The economy has a poor record of repaying debt.

71 Reasons why a country’s balance of payments on current account may at times be in deficit and at other times be in surplus  changes in exchange rates which alter the relative prices of imports and exports  the impact of the level of economic activity in overseas markets on exports  the impact of the level of domestic economic activity on imports  relative domestic and foreign rates of inflation  changes in the pattern of comparative advantage and overseas competition  the impact of changes in barriers to trade  changes in investment income and transfers  changes in the terms of trade  the impact of fiscal and monetary policies

72 Does the existence of a current account deficit represent an economic problem? not a problem if:  deficit is small and/or temporary  it is counterbalanced by capital inflows  other countries are continuously willing to finance the deficit  it reflects a growing economy and higher living standards  automatic correction of a deficit under a floating exchange rate system

73 Does the existence of a current account deficit represent an economic problem? reasons why it may be a problem:  need to finance deficit may lead to depletion of foreign exchange reserves/overseas borrowing/greater indebtedness  a reflection of trading un-competitiveness /overvalued exchange rate  overseas creditors decide to “turn off the taps”  the impact on the exchange rate and inflation  the need for domestic deflation and the conflict with the goals of full employment and economic growth

74 Methods of correcting a persistent current account deficit Expenditure-switching policies, are policies implemented by the govt. that attempts to switch the expenditure of domestic consumers away from imports toward domestically produced goods and services.  Devaluation/ depreciation of the currency  Protectionist measures  Policies to reduce inflation below that of competitors  Policies that reduce cost of domestic firms. (Ex. Subsidies & increases in productivity)

75 Methods of correcting a persistent current account deficit Expenditure-reducing policies, are policies implemented by the govt. that attempt to reduce overall expenditure in the economy, so shifting AD inward.  Contractionary Fiscal policy  Contractionary Monetary policy

76 Methods of correcting a persistent current account deficit Supply-side policies to increase competitiveness.  Lower input prices  Increase productivity  LIE policies: Taxes Govt Spending Govt Regulations

77 Policies to reduce a deficit Deflating demand  Deflating demand means deliberately reducing consumer spending, or reducing its rate of growth, through fiscal contraction, such as raising direct taxes, or by monetary contraction, such as raising interest rates or reducing the availability of credit.  As a by-product of this, imports are also likely to fall, hence deflating demand is said to work by a process called expenditure reduction. This policy targets general household spending, and given that imports are dependent on spending, then imports will fall as spending falls.

78 Devaluation The second policy option to improve the current account is devaluation, which involves the deliberate reduction in the value of a country’s currency. It works by expenditure switching, which means that the policy encourages consumers to alter the distribution of their spending, rather than the total level of spending. An ‘equilibrium’ exchange rate is the specific rate where export revenue and import spending are equal. A fall in the exchange rate will, ceteris paribus, reduce export prices encouraging overseas consumers to switch to lower price products. This is likely to lead to a rise in export demand. Devaluation will also lead to an increase in import prices, encouraging domestic consumers to switch away from imports to domestically produced products. This will lead to a fall in import demand.

79 Direct controls A third option to help reduce a current account deficit is to impose direct controls on imports by erecting barriers against imports or by providing assistance to exporters. Specific measures include:  Tariffs  Non-tariff barriers, such as quotas, subsidies to domestic firms and discrimination against imports and in favor of domestic firms.

80 Supply-side policy Finally, supply-side policy could be used to help improve an economy’s ability to produce. There are several actions that a government can take to improve supply-side performance. These measures include improving labor productivity and labor market flexibility.

81 Current account surpluses A surplus on the current account component of the Balance of payments indicates that the country is exporting more goods and services than importing. This means they are gaining foreign currency they can use to buy foreign assets such as government bonds and invest in foreign factories. It is not clear that a surplus on the current account is a bad thing. It has certain advantages such as being able to invest in foreign countries and build up foreign exchange reserves. It may also indicate that the country is quite competitive relative to other countries.

82 Current account surpluses However, a large current account surplus may indicate an unbalanced economy. For example, it may indicate the country is relying too heavily on exports and consumer spending is relatively too low. In the case of China, one reason for large current account surplus is their decision to keep their currency undervalued. This makes their exports more competitive and imports more expensive, increasing domestic demand. However, this undervaluation of the currency is arguably contributing to inflation. China is at risk of allowing their economy to grow too quickly and cause a boom and bust.


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