2. HL Balance of Payments IB Economics

3. The consequences of a current account deficit  If the current account is in deficit then the capital account will have to be in surplus to balance out the deficit  This means one of three things will have to happen 1.Foreign exchange reserves may be used to increase the capital account  However, no country is able to fund long term current account deficits with reserves – eventually they will run out 2.It may be that a high level of foreign buying of assets for ownership is financing the deficit  Foreign investors may be buying property, businesses, or stocks and shares  If it is based on foreign confidence in the domestic economy then this is not a problem  This is sometimes viewed as a threat to sovereignty  If there is a drop in confidence they move these assets to other countries  They could sell their assets resulting in an increase in the supply of the currency and a fall in its value 3.It may be that it is financed by high levels of lending abroad  High rates of interest will have to be paid  If governments lending the money decided to withdraw it this would lead to a massive selling of currency and a sharp fall in the exchange rate

4. The consequences of a current account surplus  If the current account is in surplus there will be other consequences 1.Allows a country to have a deficit on its capital account by building up its official reserve account or by purchasing assets abroad  However, one country’s surplus is another’s deficit and this may lead to protectionism by other countries 2.It will usually lead to an appreciation of the currency on the foreign exchange market as it implies an increase in demand for the currency  This will make imports cheaper so reducing inflationary pressures  It will also make exports more expensive harming exporters

5. How big is a ‘big’ current account deficit or surplus?  There are two ways to interpret the size of a country’s deficit or surplus  Total value  Or as a proportion of GDP  This is like having an overdraft on your bank account  If you earn $100,000 and you have a $10,000 overdraft this is manageable  If you earn $30,000 and have a $10,000 overdraft you may be in trouble  Big is only bad if you can’t pay it back

6. Methods of correcting a persistent current account deficit  There are two types of policy used to correct a persistent current account deficit  Expenditure-switching policies  If successful imports will fall and the current account deficit should improve  Examples  Depreciating or devaluing the currency – exports will become cheaper and imports more expensive  It depends how responsive domestic and foreign buyers are to the price change but the deficit should improve  Protectionist measures – restricting foreign imports will make domestic consumers switch spending from imports to domestic goods  Evaluation  Governments are often reluctant to use such measures because it may lead to retaliation and could be against WTO measures  Protecting domestic industries may also may them inefficient in the long run Expenditure switching policies – attempt to reduce spending on imports towards domestic goods and services

7. Methods of correcting a persistent current account deficit  Expenditure-reducing policies  Deflating the economy may reduce the current account but it is likely to lead to a fall in domestic employment and a fall in the rate of economic growth  Examples  Deflationary fiscal policy  increasing taxes and/or reducing government spending which will be politically unpopular  Deflationary monetary policies  increasing the rate of interest and/reducing money supply  Hot money would flow into the country’s capital account helping offset the deficit in the current account  Politically unpopular because payments on mortgages, loans and credit cards will increase  Investment may decrease  Overall  The economic costs of reducing a large current account deficit suggest why it is important to prevent it from happening  Governments will actively pursue export promotion policies – trade missions, govt advertising campaigns Expenditure reducing policies – attempt to reduce overall spending in the economy (shifting AD to the left)

8. The Marshall Lerner Condition  In theory when a country’s currency depreciates its exports will be cheaper and there will be an increase leading to an increase in the current account  This is not necessarily the case  How much the price change has an effect on the demand depends on the PED of imports and exports  The Marshall-Lerner condition is a rule that tells us how successful a depreciation or devaluation of a currency’s exchange rate will be  If the demand for exports was inelastic and the price fell there proportionate increase in demand would be less than the proportionate decrease in price  The same for imports  Complete student workpoint 24.3 Marshall-Lerner condition – reducing the value of the exchange rate will only be successful if the total value of the PED for exports and the PED for imports is greater than one PEDexports + PEDimports > 1

9. The Marshall Lerner Condition  The table below shows a study of trade elasticities in 2000  In almost all cases the short run values were lower than the long run values  This is to be expected because PED become more elastic over time (ability to look for alternatives)  Only the US would meet the Marshall Lerner condition in the short run but all meet the condition in the long run Marshall-Lerner condition – reducing the value of the exchange rate will only be successful if the total value of the PED for exports and the PED for imports is greater than one PEDexports + PEDimports > 1

10. The J-Curve effect  In the short term a depreciation of the exchange rate may not improve the current account deficit of the balance of payments  This is due to the low price elasticity of demand for imports and exports in the immediate aftermath of an exchange rate change  Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed  However, depreciation raises the sterling price of imports (that will also remain steady due to contracts with suppliers) causing total spending on imports to rise  Export demand will also be inelastic in response to the exchange rate change in the short term  Therefore the earnings from exports may be insufficient to compensate for higher spending on imports  The balance of trade may worsen (X to Y) in the immediate aftermath of a fall in the external value of the currency  This is widely known as the J-Curve effect as seen in the diagram  The PED for exports and imports increases with time until it meets the Marshall-Lerner condition and satisfied leading to a movement from Y to Z

11. Time for you to do some work!!  At home read through the chapter (make notes if you wish)  SL - Complete Exam Q’s 1 & 2 on P307  HL – complete 2 x HL Exam Q’s on P307