3.5 The Global Economy Balance of Payments GCSE Economics 3.5 The Global Economy Balance of Payments

Balance of Payments explain the contents of the balance of payments current account and make basic trade calculations; demonstrate understanding of the reasons for a UK current account deficit; evaluate policies that can be used to correct trade imbalances.

The balance of payments current account The current account measures flows of money into and out of the country as payments for goods, services, investments and other financial transfers. The 4 main components of the current account are: Trade in goods (visible balance) Trade in services (invisible balance) Investment incomes (also known as primary income) Net transfers (also known as secondary income)

Trade in goods (visible balance) Figure 1 -- Top 5 UK exports and import products November 2016 Imports £billion Machinery 5.2 Motor vehicles 4.8 Electronic equipment 4.3 Fuels & minerals 3.3 Precious metals 2.9 Exports £billion Machinery 4.1 Motor vehicles 3.9 Electronic equipment 2.4 Medicines 2.2 Precious metals 2.2 Source: ONS

Surpluses and deficits A balance is POSITIVE if more money flows IN from abroad than goes OUT to other countries. This is called a SURPLUS. A balance is NEGATIVE if more money goes OUT to other countries than flows IN from abroad. This is called a DEFICIT.

Trade in services (invisible balance) e.g. payments for banking, insurance, business services, transport Figure 2 -- UK trade in services 2015 Source: ONS

Trade balance This is the balance of trade in both goods and services Trade balance = visible balance + invisible balance Figure 3 – UK trade balance 1995-2015 Source: ONS

Investment incomes (sometimes called primary income) the difference between the income received for UK investments overseas and income paid abroad for foreign investments in the UK. e.g. dividends paid to foreigners from the UK, interest and dividends paid to UK residents, money sent back by immigrants to their home countries Table 1 -- UK Investment balance as % of GDP 2005 2.4 2006 1.1 2007 2008 0.3 2009 0.4 2010 1.3 2011 1.2 2012 -0.1 2013 -0.6 2014 -1.3 2015 -2.0 The balance in investment income has changed from positive to negative in recent years. The UK has traditionally made more from investment abroad than foreign residents take from Britain. This changed after 2010, partly because UK businesses have been less successful abroad. Source: ONS

Net transfers (sometimes called secondary income) e.g. EU contributions, development aid for poorer countries The UK usually pays out more than it receives back from abroad Figure 4 – UK Net Transfers 2013-2015 Source: ONS

Current balance This is the sum of all the balances. It has been negative (a deficit) for most of the last 30 years Figure 5 – UK Current Balance 1995-2015 Source: ONS

Calculating the current account balance Assuming a country has the following 4 balances Visible balance + £60 bn Invisible balance - £45 bn Investment (primary) balance - £30 bn Net transfers (secondary) balance + £10 bn The current balance = 60 -45 - 30 + 10 = minus £5 billion i.e. a current account deficit

Exercise – calculating the current account balance A country has the following figures in its balance of payments accounts. Calculate the current balance and say whether it is in surplus or deficit. Use the table on the next slide to show your calculations. All figures are in £ billion. Exports of goods 55 Transfers (secondary) paid abroad 70 Investment income from abroad 120 Transfers (secondary) from abroad 10 Investment income paid to other countries 120 Exports of services 80 Imports of services 55 Imports of goods 75

Current balance Visible balance + Invisible balance + Investment (primary) balance + Net transfers (secondary) balance = Current balance

Figure 6 -The UK’s current account deficit Current balance £million Source: ONS

Reasons for a UK current account deficit High inflation making UK exports of goods and services more expensive and imported products relatively cheaper High exchange rate for sterling making exports dearer and imports cheaper Lack of investment and research & development by UK firms World recession reducing demand for UK exports Low-quality goods and services Wage costs are higher than those of competitors

Policies to correct a current account deficit Protectionism Devaluation of sterling Deflation Supply-side policies © thinkstockphotos.co.uk

Protectionism Protectionism describes restrictions upon free trade between countries. The Government tries to increase exports and/or reduce imports. Protectionist methods include: Tariffs – special taxes on imports to make them more expensive; Quotas – limits on the quantity of goods which can be imported; Subsidies – money given to exporters to help them sell abroad or to UK firms facing competition from imports; Government policy of giving preference to UK firms when it is buying goods and services; Exchange controls – restrictions on the amount of foreign currency UK residents and businesses can buy to pay for imports

Evaluation of protectionist policies UK currently has agreements e.g. with the European Union and World Trade Organisation which limit its use of protectionist policies; Other countries may retaliate e.g. by putting tariffs or quotas on UK exports; Reduces consumer choice; Leads to higher prices; Protects inefficient domestic producers. © thinkstockphotos.co.uk

Devaluation of sterling Government may lower the value of the pound on the foreign exchange market e.g. by selling sterling on the foreign exchange market. This should make exports cheaper and imports dearer, so that the value of exports INCREASES and the value of imports DECREASES

Evaluation of devaluing sterling It will only work if demand for exports and imports is price elastic so that changes in prices significantly increase demand for exports and significantly reduce demand for imports; Higher import prices will increase costs for UK firms who buy products from abroad e.g. retailers, airlines, metal refiners. This will cause IMPORTED INFLATION.

Deflation Deflation means reducing aggregate demand i.e. the total demand for goods and services in the UK economy. This may be done using FISCAL POLICY and/or MONETARY POLICY Deflationary fiscal policy involves increasing taxes (especially direct taxes such as income tax) to reduce disposable income AND cutting Government spending on goods and services. Deflationary monetary policy involves reducing or restricting money supply AND increasing interest rates to make it more difficult and expensive for people and firms to borrow money.

Evaluation of deflationary policies By reducing aggregate demand the Government will reduce revenue for businesses, therefore possibly causing lower economic growth and higher unemployment; Higher taxes may discourage people from working and firms from investing; Lower Government spending may lead to job losses in the public sector and businesses which sell to the public sector; Higher interest rates may increase households costs e.g. for mortgages and reduce their standard of living; Higher interest rates may encourage capital flows into the UK, thus rising the exchange rate and making exports dearer and imports cheaper.

Supply-side policies Supply-side policies are designed to make the economy more efficient and productive so that UK producers can compete against foreign competition. Supply-side polices include; Income tax cuts; Corporation tax cuts; Grants and tax-free allowances for firms for capital investment and R & D; High-quality education and training; Government spending on infrastructure.

Evaluation of supply-side policies They are mainly long-term policies which therefore take a long time to have an effect e.g. education and training can take years to increase productivity and make UK goods and services more competitive; Some policies such as those aimed at making labour more flexible can result in job insecurity and poverty; Policies such as cutting income and corporation tax don’t necessarily lead to people working harder or firms investing more. © thinkstockphotos.co.uk