AS: E CONOMIC PERFORMANCE The balance of payments on current account Why do countries trade with each other?

2.3.4 T HE BALANCE OF PAYMENTS ON CURRENT ACCOUNT  The importance of international trade for an economy such as the UK  The current account comprises trade in goods, trade in services, income flows and transfers  The meaning of a deficit and a surplus on current account  The factors that influence a country’s current account balance such as productivity, inflation and the exchange rate and economic activity in other countries  You should be aware that the current account is only one part of the balance of payments but knowledge of the other parts of the account is not expected

D EFINITION “A record of a country’s trade/transactions with the rest of the world.”

M EASURING THE B ALANCE OF P AYMENTS  Three sections of the Balance of Payments 1. The Current Account o Trade in Goods o Trade in Services o Investment Income o Transfers 2. The Financial Account o Transactions in financial assets o Investment flows o Government transactions 3. The Capital Account o Transfer of assets by individuals This is the largest component of the Balance of Payments. Only knowledge of this section is required. These components are smaller and a detailed knowledge of them is not required.

S URPLUS OR D EFICIT A surplus is when the sum of exports of goods, services, investment income and transfers is greater than imports. > A deficit is when the sum of exports of goods, services, investment income and transfers is less than imports. >

T HE T RADE IN G OODS  Trade in goods measures the net exports (X - M) of visible goods  The UK has traditionally run a large deficit on the Trade in Goods component of the current account  There are a number of reasons for this:  An increase in the demand for consumer goods, many of which have to be imported  Decline in the UK manufacturing sector as secondary production is outsourced to low wage economies  Lower production of primary materials such as gas and oil  The UK now imports significant quantities of primary materials from other countries  A strong currency makes imports of goods more affordable and exports less attractive to foreign buyers

T HE T RADE IN S ERVICES  Trade in services measures the net exports (X - M) of invisible items e.g. banking, insurance and tourism  The UK has traditionally run a large surplus on the Trade in Services component of the current account  There are a number of reasons for this:  The UK has seen a shift away from primary and secondary sectors towards tertiary sector employment, thus specialising in the provision of services  This specialisation has meant that the UK is more competitive in the provision of these services, and can offer better services at lower cost  London has developed as one of the world’s prime financial centres and become a major source of income and wealth generation in the UK

I NVESTMENT I NCOME  Investment income is generated by UK owned overseas assets e.g. a UK firm might own a company abroad, or generate income from overseas investments  The profits and dividends that are received are sent back to the UK, and count as a credit item of Investment Income on the current account  However, debit items also occur as foreign investments into the UK may yield profits which are sent back to the country of investment origin

T RANSFERS Transfers are payments made (or received), usually by the government, to or from other countries. The main transfers include:  Payments for membership of the European Union  Foreign Aid Given its status in the European and global economy, the UK typically runs a deficit on the transfers section of the current account.

B ALANCE OF P AYMENTS IN THE UK Look at the chart above showing net balance of trade in the UK. Summarise the main trends and list the main causes of the persistent deficit that the UK is experiencing.

1) As consumer spending increases, so does our demand for goods. In the UK we have a high propensity to consume imported goods, thus improvements in economic growth and consumer spending feeds through to an increased and persistent deficit. W HY IS THERE A PERSISTENT DEFICIT ON THE CURRENT ACCOUNT ? IMPORTS EXPORTS 2) In terms of manufacturing, UK firms have become less competitive in the manufacture of goods. UK firms are unable to compete with low wage economies, and as globalisation has increased and widened, so has the UK’s reliance on imported goods. 3) It is also argued that our exchange rate is too strong, which makes our exports less competitive and makes imports relatively more affordable. 4) The deficit is also a sign of an unbalanced economy. Both primary and secondary business activity is shrinking over time, compared with significant growth in the tertiary sector.

1) Controlling consumer spending will reduce the demand for imports. Whilst this may improve the balance of payments, consideration should be given to other aspects of the economy if this occurred. R EDRESSING THE BALANCE IMPORTSEXPORTS 2) Investing in the supply-side of the economy should improve productivity of UK firms in terms of quality and price competitiveness. Enhanced productivity measures may give rise to higher exports through greater output. 3) Depreciation of the exchange rate may make our exports more price competitive. However, it will increase the relative price of imports, which may be problematic if we cannot produce alternatives domestically. 4) Improve overall macroeconomic conditions in the UK. This will encourage investment and domestic growth as well as reducing our reliance on imports.

Read the article and re-cap the previous slides to construct a table of key points to develop a balanced argument as to whether or not a persistent deficit on the current account of the balance of payments matters or not. Yes, it mattersNo, it doesn’t matter

F ACTORS INFLUENCING A COUNTRY ’ S C URRENT ACCOUNT BALANCE  Improving productivity is crucial in lowering unit costs and making the UK a competitive economy  Inflation reduces the competitiveness of an economy by raising prices and making exports less attractive  A strong exchange rate makes exports more expensive lowering demand for UK goods and services; at the same time, imports are cheaper lowering unit costs  Economic activity in other countries has a significant impact on open economies such as the UK The UK’s productivity challenge Problems in Brazil Soaring £ hits exports

M ULTIPLE C HOICE 1  All other things being equal, which of the following is most likely to reduce a balance of payments deficit on current account? An increase in a) the price level b) consumption c) productivity d) the money supply Can you explain your answer?

M ULTIPLE C HOICE 2  All other things being equal, which of the following is most likely to lead to an increase in imports? A fall in a) the exchange rate b) national income c) government expenditure d) the savings ratio Can you explain your answer?

M ULTIPLE C HOICE 3  The table shows the components of the balance of payments on current account for an economy. It follows that the balance of payments on current account is a) +£2150 bn b) +£200 bn c) -£200 bn d) -£50 bn Can you explain your answer? £bn Export of Goods500 Export of Services400 Import of Goods800 Import of Services300 Net Investment Income +50 Net Transfers+100

M ULTIPLE C HOICE 4  All other things being equal, which of the following combinations is most likely to lead to a deterioration in UK balance of payments on current account? Can you explain your answer? UK Inflation Rate Exchange Rate of £ UK Unemployment AIncreaseDecrease B Increase C Decrease D Increase