Balance of Payments

• Define balance of payments


  the record of financial transactions between the UK and the rest of the world
• What are the different components of the Balance of Payments


  1) Current Account

  2) Capital account

  3) Financial account
• What are the components of the current account


  1) Trade in goods and services

  2) Investment Income

  3) Current transfers
• What is meant by Trade in goods and services and how does it affect the CA

  imports (withdrawals) - decrease ca

  exports (injections) - increase ca
• What is meant by Investment income and how does it affect the current account


  Investment income earned by a UK investor abroad will appear in the current account as a positive transaction because money is injected into the UK - improves the ca.

  Payments by British firms to foreign investors will appear as a negative transaction on the current account - worsen the ca
• What is meant by current transfers and how does it affect the current account


  When UK workers transfer money from abroad into the UK, it will appear as a positive transaction on the current account as money is entering the UK e.g. Remittances
• What is meant by the capital & financial accounts


  Capital and financial accounts track investments such as:

  1) FDI - Investments made by a firm in one country into a firm in another country to gain control over the foreign firm)

  2) Hot money flows - When foreign investors place their spare cash into foreign banks that have the highest interest rates
• what factors can affect the current account


  1) Exchange rates

  2) Relative inflation

  3) Productivity and costs

  4) Quality

  5) Economic growth

  6) Protectionism
• How can exchange rates affect the current account


  SPICED:

  imports are cheaper so import expenditure increases and exports are more expensive and decreases export revenue - this will worsen the current account

  
  

  WIDEC:

  imports are more expensive so import expenditure decreases and exports are cheaper so export revenue increases - this will improve the current account
• How can relative inflation affect the current account


  If the inflation rate is higher in country A than country B, then the price level of goods is increasing by more in A than B. This means foreign consumers more likely to move towards buying goods from country B as the products in B are cheaper relative to country A.

  - This will increase export revenue for country B and decrease for country A

  - Country B's current account will improve and country A's will worsen
• How can productivity and costs affect the current account


  Low productivity:

  High per unit cost - increase export prices - decrease export revenue - worsen the current account

  
  

  High productivity:

  Low per unit cost - decrease export prices - increase export revenue - improve the current account
• How can quality affect the current account


  high quality - increased international competitiveness - increase in exports - increase in export revenue - improve the current account
• How can economic growth affect the current account


  increased growth - increase in national income - increase in import expenditure as the UK has a high MPI and increase in normal good imports - worsen the current account
• How can Protectionism affect the current account


  Protectionism include policies to protect domestic producers e.g. tariffs and quotas

  
  

  A tariff is a tax on imports so a tariff will increase the price of imports, reduced the demand for imports as well as import expenditure - this will improve the current account

  Removal of a tariff will decrease import prices - increasing import expenditure and worsening the current account
• Evaluate the impact of a current account deficit on AD


  a negative trade balance will decrease AD as X-M are a component of AD - this will decrease real GDP. A fall in real GDP will increase unemployment and decrease standards of living.

  
  

  Ev: affect on AD may not be significant if the current account is only a small component of AD. Furthermore, depends on the position of the economy, a fall in AD will not have an effect on real GDP
• Evaluate the impact of a current account deficit on exchange rates


  A deficit means M>X so there is an increase in the supply of £s; if exports are low, demand for £s are low.

  Therefore an increase in supply and decrease in demand will collectively result in a depreciation and a worsened ca. Furthermore, a depreciation will mean foreign investors sell their pounds for a different current - increases supply even further so the currency will depreciate even further - this may create a cycle and result in a severe depreciation of the pound

  - Living standards will fall as M falls

  
  

  Ev: Exports may become cheaper so demand for exports and the demand for the pound will increase - appreciation
• Evaluate the impact of a current account surplus on AD


  Positive trade balance - ca surplus - increase in AD - increase in real GDP - increase in living standards and a decrease in unemployment

  
  

  Ev: Reduced domestic competition as firms start to focus more on produing goods demanded by foreign consumer - less choice, less satisfaction etc.
• What measures can be sued to reduce ca trade imbalances


  1) Expenditure reducing policies

  2) Expenditure switching policies

  3) Supply-side policies
• Give examples of expenditure reducing policies


  1) Raising income tax

  2) Cutting welfare payments

  Both will decrease imports
• Give examples of expenditure switching policies

  1) Trade barriers

  2) Low interest rates

  Both will lower import expenditure