2.13 The Balance of Payments on Current Account Why do countries trade with each other?

2.13 What you need to know The different components of the current account The meaning of a deficit or surplus on the current account How the strengths and weaknesses of the domestic economy may impact upon the balance of payments of the current account

2.13 You should be able to: Identify and explain the different components of the current account; trade in goods, trade in services, investment income and transfers Understand and explain the meaning of a deficit or surplus on the current account Explain and analyse how strengths and weakness in the domestic economy can impact upon the balance of payments on current account

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

Measuring the Balance of Payments 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.

Surplus or Deficit 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. >

The Trade in Goods 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

The Trade in Services 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

Investment Income 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 & 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

Transfers 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.

Balance of Payments 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. Source: tradingeconomics.com

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. Why 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. Redressing the balance IMPORTS EXPORTS 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

Multiple Choice 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?

Multiple Choice 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?

Multiple Choice 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

Multiple Choice 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 RateExchange Rate of £UK Unemployment AIncreaseDecrease B Increase C Decrease D Increase

2.13 You should be able to: Identify and explain the different components of the current account; trade in goods, trade in services, investment income and transfers Understand and explain the meaning of a deficit or surplus on the current account Explain and analyse how strengths and weakness in the domestic economy can impact upon the balance of payments on current account