Topic 9: aggregate demand and aggregate supply Balance of payments

4.1.7 Balance of payments Students should be able to: Define the components of the balance of payments (the current account; the capital and financial accounts) Analyse causes of deficits and surpluses on the current account Analyse measures to reduce a country’s imbalance on the current account Evaluate the significance of global trade imbalances

What is the balance of payments? Microeconomics Topic 1: The Economic Problem The balance of payments is a record of all a ______________ financial dealings with the rest of the world over the course of a ______ What are the four components of the BoP? the ________________ account the ________________ account the international investment position Some textbooks have two components for BoP (current account and the capital account: financial and investment are included in the capital account)

What is the current account? Microeconomics Topic 1: The Economic Problem The current account is where payments for the purchase and sale of goods and services are recorded. It comprises the following: • Balance of trade which divides in to two groups: g________ and s__________ • I_________ • Current t_________

What is the balance of trade? Microeconomics Topic 1: The Economic Problem • Balance of trade refers to the difference between the ______________________________________ _________________________________________ Why do exports appear as a positive entry into the balance of payments? Imports appear as a negative entry into the balance of payments because money leaves the country. The balance of trade itself comprises two elements: the trade in g________ balance and the trade in s___________ balance.

What is income (in the current account)? Microeconomics Topic 1: The Economic Problem • Income – this comprises income earned by ______________ citizens who own assets overseas minus income earned by ____________ citizens who own ___________ in this country. It includes profits, _______________ on investments abroad and interest. assets, dividend, domestic, foreign

What are current transfers? Microeconomics Topic 1: The Economic Problem • Current transfers – these are usually money transfers between central ____________________ (who lend and borrow money from each other) or ___________________, such as those that the UK receives as part of the CAP from the EU. governments, grants

What is a current account deficit? Surplus? Microeconomics Topic 1: The Economic Problem • If a country has a current ___________ deficit, then the _________ of money leaving the country _______ the value of money ________ the country. If a country has a current account surplus, then the value of _____________ entering the country exceeds the value of money _________ the country. Aacount, entering, exceeds, leaving, money, value,

What is the capital account? Microeconomics Topic 1: The Economic Problem • The capital account refers to transactions in fixed assets and is relatively small.

What is the financial account? Microeconomics Topic 1: The Economic Problem The financial account records almost all of the flows of financial capital into and out of the UK. It comprises transactions associated with changes of ownership of the UK’s foreign financial assets and liabilities. It includes the following: • F__________ D_________ i_____________ (FDI) • Portfolio investment • Other investments (financial derivatives and reserve assets)

What is direct investment and portfolio investment? Microeconomics Topic 1: The Economic Problem • FDI – this relates to _____ provided to or received from an enterprise, by an _________in another country. It refers to flows of money to purchase a “controlling interest” in a _______ firm (10% or more of the shares). Part of FDI is reinvested earnings. • Portfolio investment – this relates to investments in equities and _______ issued by governments or firms. It includes money to purchase foreign ______ where this is less than 10% of the company. In the UK over 90% of portfolio investment is bonds. bonds, capital, foreign, investor, shares

What are financial derivatives? Microeconomics Topic 1: The Economic Problem • Financial derivatives – these include any financial instrument the price of which is based upon the value of an underlying asset (typically another financial asset). Financial derivatives include options (on currencies, interest rates, commodities, indices), traded financial futures, warrants and currency and interest swaps.

What are reserve assets? Microeconomics Topic 1: The Economic Problem • Reserve assets – these refer to foreign financial assets that are available to, and controlled by, the monetary authorities such as the Bank of England for financing or regulating payments imbalances. Reserve assets comprise: monetary gold, Special Drawing Rights, reserve position in the IMF and foreign exchange held by the Bank. NOTE that the syllabus states “Students should focus especially on flows of FDI between countries.”

What is the international investment position? Microeconomics Topic 1: The Economic Problem • The international investment position is in the balance sheet of the stock of external assets and liabilities. NOTE that the syllabus states “Students should focus especially on flows of FDI between countries.” hence you don’t really need this detail

The balance of payments must balance Microeconomics Topic 1: The Economic Problem The balance of payments must always balance. If a country has a current account deficit, it must have a surplus on the other elements of the balance of payments. Why? It is debatable whether this is sustainable in the long run since, if people invest in a country, at some point they will require a return on their investment, and this will cause a deficit on the financial account.

Net errors and omissions Microeconomics Topic 1: The Economic Problem In addition, because the data is never completely accurate, the accounts also incorporate a ‘net errors and omissions’ item, which makes sure that everything will balance. This is sometimes called the balancing item.  

What causes a current account deficit? Microeconomics Topic 1: The Economic Problem Current account surpluses may arise from the reverse of these points

What causes a current account surplus? Microeconomics Topic 1: The Economic Problem What causes a current account surplus?

How can a current account deficit be corrected? Microeconomics Topic 1: The Economic Problem Measures to correct a deficit on the current account include: expenditure reducing expenditure switching supply-side policies NOTE: “Students should consider the option of doing nothing, in light of theory on floating exchange rates.” (See 4.1.8)

Expenditure-reducing policies Microeconomics Topic 1: The Economic Problem Expenditure-reducing policies relate to measures designed to reduce aggregate __________, such as deflationary __________ policy. As a result people spend less on _________ However, a side-effect of this is that spending on domestic goods also _________, causing ______________ and a fall in the rate of economic growth.

Expenditure-switching policies Microeconomics Topic 1: The Economic Problem Expenditure-switching policies involve the use of protectionist measures such as _________ or quotas, or a devaluation of the currency under a fixed exchange rate regime. Such measures encourage people to buy ________ goods rather than imports. However, they may lead to __________, causing _______________ to also fall so that the current account deficit may not be corrected.

Microeconomics Topic 1: The Economic Problem Supply-side policies Microeconomics Topic 1: The Economic Problem Supply-side policies, such as spending on ______________ and ___________ in order to improve the quality and therefore competitiveness of exports, aim to boost __________________ While they can incur an opportunity cost, they contribute positively to economic growth and can be anti-inflationary in the _________ run.

Global imbalances may be insignificant: Microeconomics Topic 1: The Economic Problem Some argue that, since a country’s balance of payments must always balance, any global imbalances are insignificant. However, the Global Financial Crisis of 2008 suggests that persistently large current account deficits may be unsustainable in the long run. Large and persistent deficits can be a problem because there is a need to finance the increasing expenditure on imports, usually through loans from abroad.

Global financial crisis and surpluses Microeconomics Topic 1: The Economic Problem In contrast, large and persistent surpluses can be a problem because resources are focused on producing to meet export demand rather than domestic demand, so consumer choice and resulting living standards could actually be low. Further, such imbalances may lead to large currency fluctuations which can have a destabilising impact of world trade.