3.4.3 The International Economy Globalisation Trade The Balance of Payments Exchange Rate Systems The European Union (EU)

Balance of Payments Current account Capital & Financial account

Terms Current account –Part of the balance of payments that records trade in goods and services mainly Capital and financial account –Part of the balance of payments that records capital flows in and out of the country Current account deficit –When imports of goods and services exceed exports

Terms Current account surplus –When exports of gods and services exceed imports Balance of trade in goods –Visible imports minus visible exports Balance of trade in services –invisible imports minus invisible exports Net income flows –The difference between inward and outward flows of interest, profits and dividends

Terms Net current transfers –The difference between government transfers to and from overseas organisations Hot money –Volatile capital movements in foreign exchange markets due to interest rate changes Direct investment –The purchase of productive assets (factories, offices etc) –These can be foreign direct investment (FDI) or outward direct investment Portfolio investment –The purchase of financial assets (shares etc)

Current account revisited The balance of payments accounts include: Trade in goods (visible trade) Trade in services Income –Compensation of employees –Investment income Current transfers –Central government transfers –Other sectors

Capital and financial accounts –FDI Long term –Portfolio investment Shares, financial assets Long term –Hot money Short term Interest rate

Problems of deficit It is persistent. It forms a large share of GDP. There are no compensating inflows of investment income or inward capital account flows. The Bank has low reserves. The economy has a poor record of repaying debt.

Causes Excessive growthgrowth 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. High export prices High export prices will occur if a country's inflation is higher than that of its competitors, or if its currency is over-valued which will reduce its price competitiveness.inflation competitiveness Non-price factors Non-price factors can discourage exports, such as poorly designed products, poor marketing or a worsening reputation for reliability.

Poor productivity An economy might not be producing enough from its scarce factors of production. Labour 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. Low levels of investment in real capitalinvestment 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.

RNI and BoP

Policy options Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand reducing the demand for imports When domestic demand is low, this creates an incentive and the spare capacity for businesses to export overseas to replace low spending in the home economy Natural effects of the economic cycle: One would expect to see a trade deficit fall during a recession – so some of the deficit is partially self- correcting. A lower exchange rate: A lower exchange rate provides a way of improving competitiveness, reducing the overseas price of exports and making imports more expensivecompetitiveness For those countries operating with a managed exchange rate, the government may decide to authorise intervention in the currency markets to manipulate the value of the currency Supply-side improvements: Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. The time-lags for supply-side policies to have an impact are long.innovation Policies to encourage business start-ups – successful small businesses with export potential Investment in education and health-care to boost human capital and increase competitiveness in fast- growing and high value industries such as bio-technology, engineering, finance, medicine Investment in modern critical infrastructure to support businesses and industries involved in international markets Protectionist measures such as import quotas and tariffs

Expenditure Reducing Policies These are policies that aim to reduce the real spending power of consumers Fiscal policy can be used (e.g. a rise income tax that reduces disposable income) Higher interest rates would dampen consumer spending and reduce economic growth Expenditure Switching Policies These are policies that attempt encourage consumers to switch their spending away from imports towards the output of domestic firms. ‘Expenditure-switching’ occurs if the relative price of imports can be raised, or if the relative price of UK exports can be lowered. Measures might include: A depreciation of the exchange rate which has the effect of increasing the UK cost of imports and reduces the foreign price of UK exported goods and services. A lower exchange rate also increases the profitability of exporting products overseas, and this profit signal should, over time, act an as incentive for UK businesses to reallocate factor resources towards potential export markets Tariffs or other import controls can occasionally be used – but the UK is bound by its commitments to the World Trade Organisation. Protectionist policies are not a viable option for an economy wishing to control its total trade deficit Policies that reduce the rate of inflation in the economy below that other international competitors leading to a gradual improvement in price competitiveness

Good or bad? Promotes world trade Generates finance Transfers technology –Supply side benefits Downturn can be global –Credit crunch Global domination Destabilise exchange rates

BoP Equilibrium Short run – not a problem Long run – can be, depends on the size and cause

Worksheet Export and Import Volumes - the importance of Elasticity of Demand Original exchange rate£1 = $1.80 Exports of Pocket tablets from the UK Imports of US i-pads UK price (£)£350 USA price ($)$450 US price ($)$630 UK price (£)£250 Demand40,000 Demand60000 Export revenue (£)  Import spending (£)  New exchange rate£1 = $1.60 Ped for UK exports =  Ped for US imports =  UK price (£)£350 USA price ($)$450 US price ($)$560 UK price (£)£ Demand46,220 Demand56670 Export revenue (£)  Import spending (£)  % change in ex rate   % change in demand   Net trade balance Original exchange rate£1 = $1.80 Deficit / surplus?  New exchange rate£1 = $1.60 Deficit / Surplus ?  Combined elasticity of demand for X and M = 

Answers Export and Import Volumes - the importance of Elasticity of Demand Original exchange rate£1 = $1.80 Exports of Pocket PCs from the UK Imports of US DVD players UK price (£)£350 USA price ($)450 US price ($)630 UK price (£)250 Demand40,000 Demand60000 Export revenue (£)14,000,000 Import spending (£)15,000,000 New exchange rate£1 = $1.60 Ped for UK exports = 1.4 Ped for US imports = 0.5 UK price (£)£350 USA price ($)450 US price ($)560 UK price (£) Demand46,220 Demand56670 Export revenue (£)16,177,000 Import spending (£)15,938,438 % change in ex rate11.1 % change in ex rate11.1 % change in demand15.55 % change in demand5.55 Net trade balance Original exchange rate£1 = $1.80-1,000,000Deficit New exchange rate£1 = $ ,562.50Surplus Combined elasticity of demand for X and M = 1.9

To what extent would a significant fall in the exchange rate of the pound sterling achieve a sustained reduction in unemployment in the UK? (25 marks)