Topic 9: aggregate demand and aggregate supply Balance of payments

4.1.7 Balance of payments Students should be able to: Define the components of the balance of payments (the current account; the capital and financial accounts) Analyse causes of deficits and surpluses on the current account Analyse measures to reduce a country’s imbalance on the current account Evaluate the significance of global trade imbalances

What is the balance of payments? Microeconomics Topic 1: The Economic Problem The balance of payments is a record of all a ______________ financial dealings with the rest of the world over the course of a ______ What are the four components of the BoP? the ________________ account the ________________ account the international investment position Some textbooks have two components for BoP (current account and the capital account: financial and investment are included in the capital account)

What is the current account? Microeconomics Topic 1: The Economic Problem The current account is where payments for the purchase and sale of goods and services are recorded. It comprises the following: • Balance of trade which divides in to two groups: g________ and s__________ • I_________ i____________ • Current t_________

What is the balance of trade? Microeconomics Topic 1: The Economic Problem • Balance of trade refers to the difference between the ______________________________________ _________________________________________ Why do exports appear as a positive entry into the balance of payments? Imports appear as a negative entry into the balance of payments because money leaves the country. The balance of trade itself comprises two elements: the trade in g________ balance and the trade in s___________ balance.

What is investment income (in the current account)? Microeconomics Topic 1: The Economic Problem • Investment income: income earned by _________ citizens who own assets overseas minus income earned by ____________ citizens who own ___________ in this country. It includes profits, _______________ on investments abroad and interest. assets, dividends, domestic, foreign

What are current transfers? Microeconomics Topic 1: The Economic Problem • Current transfers: usually money transfers between central ____________________ (who lend and borrow money from each other) or ___________________, such as those that the UK receives as part of the CAP from the EU. governments, grants Notes from year 12: Also includes payments to British military personnel abroad and money migrants send home (i.e. to the UK)

What is a current account deficit? Surplus? Microeconomics Topic 1: The Economic Problem • If a country has a current ___________ deficit, then the _________ of money leaving the country _______ the value of money ________ the country. If a country has a current account surplus, then the value of _____________ entering the country exceeds the value of money _________ the country. account, entering, exceeds, leaving, money, value

What is the capital account? Microeconomics Topic 1: The Economic Problem • The capital account refers to transactions in fixed assets and is relatively small.

Current account deficits and capital & financial account Microeconomics Topic 1: The Economic Problem Current account deficits and capital & financial account Slide from year 12: If we have a deficit on the current account to buy goods from China, we need foreign currency to come from some other source to keep buying these imports. So Chinese banks and firms invest money back into UK investment trusts or buildings etc. in the UK. These lead to a credit on the financial account. Our current account deficit is being financed by a surplus on financial flows.

What is the financial account? Microeconomics Topic 1: The Economic Problem The financial account records almost all of the flows of financial capital into and out of the UK. It includes the following: • F__________ D_________ i_____________ (FDI) • Portfolio investment • Other investments e.g. financial derivatives

What is direct investment and portfolio investment? Microeconomics Topic 1: The Economic Problem • FDI: ________________ provided to an enterprise, by an ______________in another country. It includes taking over a _______________ firm or investing in property etc. • Portfolio investment: investments in equities and _______ issued by governments or firms. In the UK over 90% of portfolio investment is bonds. bonds, capital, foreign, investor

What are financial derivatives? Microeconomics Topic 1: The Economic Problem • Financial derivatives: financial instrument whose price is based upon the value of an underlying asset (typically another financial asset). Financial derivatives include options on currencies and commodities

The balance of payments must balance Microeconomics Topic 1: The Economic Problem The balance of payments must always balance. If a country has a current account deficit, it must have a surplus on the other elements of the balance of payments. Why?

Net errors and omissions Microeconomics Topic 1: The Economic Problem In addition, because the data is never completely accurate, the accounts also incorporate a ‘net errors and omissions’ item, which makes sure that everything will balance. This is sometimes called the balancing item.  

What causes a current account deficit? Microeconomics Topic 1: The Economic Problem What causes a current account deficit?

What causes a current account surplus? Microeconomics Topic 1: The Economic Problem What causes a current account surplus?

How can a current account deficit be corrected? Microeconomics Topic 1: The Economic Problem Measures to correct a deficit on the current account include: expenditure reducing expenditure switching supply-side policies NOTE: “Students should consider the option of doing nothing, in light of theory on floating exchange rates.” (See 4.1.8)

Expenditure-reducing policies Microeconomics Topic 1: The Economic Problem Expenditure-reducing policies relate to measures designed to reduce aggregate __________, such as deflationary __________ policy. As a result people spend less on _________ However, a side-effect of this is that spending on domestic goods also _________, causing ______________ and a fall in the rate of economic growth. decreases, demand, fiscal, imports, unemployment

Expenditure-switching policies Microeconomics Topic 1: The Economic Problem Expenditure-switching policies involve the use of protectionist measures such as _________ or quotas, or a devaluation of the currency under a fixed exchange rate regime. Such measures encourage people to buy ________ goods rather than imports. However, they may lead to ____________, causing ______________ to also fall so that the current account deficit may not be corrected. domestic, exports, retaliation, tariffs,

Microeconomics Topic 1: The Economic Problem Supply-side policies Microeconomics Topic 1: The Economic Problem Supply-side policies, such as spending on ______________ and ______________ in order to improve the quality and therefore competitiveness of exports, aim to boost _______________ While they can incur an opportunity cost, they contribute positively to economic growth and can be anti-inflationary in the _________ run. demand, education, long, training

Persistent current account deficits Microeconomics Topic 1: The Economic Problem Since a country’s balance of payments must always balance, any global imbalances are insignificant. But persistently large current account deficits may be unsustainable in the long run. This is because the expenditure on imports ahs to be financed, usually through loans from abroad. If people invest in a country, at some point they will require a return on their investment, and this will cause a deficit on the financial account.

Persistent current account surpluses Microeconomics Topic 1: The Economic Problem Why might large and persistent surpluses be a problem?