Theme 4

• Balance of payments


  A big account/spreadsheet that measures the inflows and outflows of money into and out of a country, recording international transactions
• Components of the balance of payments

  • Current account (trade in goods, trade in services, primary income, secondary income)
  • Capital account
  • Financial account
• The capital account is a very small part of the balance of payments
• Capital account


  Records international transactions that are minor in nature, such as debt forgiveness, inheritance taxes, transfer of financial assets by migrants, sales of tangible and intangible assets
• Financial account


  The second biggest part of the balance of payments, records portfolio investment transactions (buying/selling of financial assets like bonds, shares, derivatives), foreign direct investment flows, and changes in reserves
• A country has a current account deficit

  It needs to have a financial account surplus to balance the overall balance of payments
• A country has a current account surplus

  It can have a financial account deficit to balance the overall balance of payments
• If the financial account and capital account cannot balance the current account deficit, the 'net errors and omissions' item is used as a balancing tool
• Countries with current account surpluses often invest their excess cash in countries with current account deficits, leading to financial account surpluses in deficit countries
• Countries with current account deficits often finance it by borrowing money through issuing bonds and shares, which is not sustainable in the long run
• Current account deficit


  A situation where a country's imports exceed its exports
• A country has a current account deficit

  It could lower aggregate demand in the economy
• Reduction in aggregate demand


  Leads to lower growth and higher unemployment in the economy
• A country has a current account deficit

  It often finances it by running financial account surpluses
• Financing a current account deficit


  Issuing more debt, such as selling government bonds, corporate bonds, or company shares to borrow from the rest of the world
• Accumulating large amounts of debt to finance a current account deficit

  Investors may lose confidence in the country's ability to pay back the debt
• Investors lose confidence in a country's ability to pay back its debt


  They may start to pull away from buying the country's debt
• Investors pulling away from buying a country's debt


  Leads to fears of the country defaulting on its debt, causing a currency crisis
• A country has a large current account deficit

  It puts downward pressure on the exchange rate of its currency
• A weaker exchange rate


  May not effectively correct a current account deficit, especially for countries without a strong exporting base
• If a country's current account deficit is a small proportion of GDP, financing it by issuing debt is not a major issue
• The issue arises when the current account deficit becomes a large percentage of GDP, leading to potential currency and economic crises
• Current account deficit


  A big issue in an economy
• Balanced trade


  Government objective to not have large current account deficits
• Policies available to governments to close a current account deficit

  • Expenditure reducing policies
  • Expenditure switching policies
• Expenditure reducing policies

  1. Reduce the amount of spending on imports in the economy

  2. Reduce aggregate demand

  3. Reduce incomes in the economy

  4. Reduce the marginal propensity to import
• Contractionary monetary and fiscal policies


  Shift aggregate demand to the left, make incomes lower in the economy, and thus reduce the marginal propensity to import
• Contractionary monetary policy


  • Raise interest rates
  • Reduce the money supply
• Contractionary fiscal policy


  • Reduce government spending
  • Increase taxation levels
• Expenditure switching policies

  1. Use protectionism such as tariffs, quotas, embargoes, domestic subsidies, non-tariff barriers

  2. Switch spending on imports towards domestic goods and services
• Protectionism can lead to retaliation from trading partners, which can worsen the current account deficit
• Protectionism can break World Trade Organization rules and lead to fines
• Protectionism can be inflationary and lead to a loss of efficiency
• Weaken the exchange rate

  1. Imports become more expensive

  2. Exports become cheaper

  3. Reduces demand for imports

  4. Increases demand for exports
• Policies to weaken the exchange rate

  • Reduce interest rates
  • Increase money supply through quantitative easing
  • Sell domestic currency reserves
• The Marshall-Lerner condition must be satisfied for a weaker exchange rate to improve the current account deficit
• In the short-run, a weaker exchange rate can worsen the current account deficit (J-curve effect)
• Weakening the exchange rate can be inflationary
• Weakening the exchange rate can lead to retaliation and currency wars
• Supply-side policies

  1. Boost international competitiveness of exports

  2. Improve price competitiveness

  3. Improve quality competitiveness