Session 4Balance of Payments and Exchange Rates

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The Balance of Payments (BOP)

• A record of all financial transactions between the UK and rest of the world

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The Current Account + Financial Account + FX ReservesThe current account

Financial account

FX reserves

Trade in goods (visibles)

Trade in services

(invisibles) Trade balance (X-M)

Net factor income from abroad

Net unilateral transfers

Portfolio capital flows (e.g. buying/selling of govt debt)

Direct capital flows (FDI)

The Basics

• An export refers to a UK PRODUCED good or service being sold overseas. This results in an INFLOW of money TO the UK economy and is a CREDIT on the UK Current Account which ADDS to UK GDP.

• An import refers to an OVERSEAS PRODUCED good or service being purchased by UK consumers or firms. This results in an OUTFLOW of money FROM the UK economy and is a DEBIT on the UK Current Account which REDUCES UK GDP.

• A Balance of Trade SURPLUS occurs when the VALUE of EXPORTS exceeds the VALUE of IMPORTS

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The Basics

• An export refers to a UK PRODUCED good or service being sold overseas. This results in an INFLOW of money TO the UK economy and is a CREDIT on the UK Current Account which ADDS to UK GDP.

• An import refers to an OVERSEAS PRODUCED good or service being purchased by UK consumers or firms. This results in an OUTFOW of money FROM the UK economy and is a DEBIT on the UK Current Account which REDUCES UK GDP.

• A Balance of Trade SURPLUS occurs when the VALUE of EXPORTS exceeds the VALUE of IMPORTS

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Precise terminology is key:

– “The Balance of Payments is exports minus imports and is a deficit”……WRONG, VAGUE

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VALUE not QUANTITY…

– “The Trade Balance is a component of the Current Account of the Balance of Payments. It is calculated by the value of exports minus the value of imports. The UK's Current Account balance is approximately -£60bn, of which -£32bn is accounted for by the Trade Balance.”…CORRECT, CLEAR!

What fits where in the UK Balance of Payments Current Account?

David Cameron buys a Mercedes Import, Debit, Trade in Goods

UK government provides aid to Syria

US citizen flies to the UK on British Airways

Wealthy UK landlord income on property he rents out in Spain

Austrian hotel buys a Dyson vacuum cleaner

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Import, Debit, Transfers

Export, Credit, Trade in Services

Export, Credit, Net Investment/Factor Income

Export, Credit, Trade in Goods

Import: Money flows OUT; Export: Money flows IN Import: Debit; Export: Credit

Explain 4 reasons why the UK runs a current account deficit

Exam Tips:• This is an ‘explain’ question which is common across exam

boards.

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• Marks are awarded for definitions, analysis and sometimes application (if there is data) and knowledge…if it is relevant - check your syllabus!!

• THIS DOES NOT REQUIRE EVALUATION OR A CONCLUSION

• The answers should use a logical chain of progression

Explain 4 reasons why the UK runs a BOP deficit on current account

1. Supply-side deficiencies impacting on price and non-price competitiveness of UK products

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Productivity gap… low Investment… Feeds through to low R&D… and

low innovation…

Lacking new areas of comparative advantage / dynamic inefficiency

Vs Germany/US

Explain 4 reasons why the UK runs a BOP deficit on current account 33

Poor productivity and lack of innovation………..

Price level

Real GDP and employment

AD

YIDEAL

P

P1

33

LRAS1LRAS

Y

LRAS2

Over a 10 year period, the UK

has failed to deliver the

productivity and innovation

improvements that would aid

growth and allow us to compete and hence sell

more exports…… P2

YUK

Other causes of the UK Current Account deficit

High levels of disposable income ‘sucks in’ imports

High labour costs and EU regulation inc H&S

Strong Exchange Rate

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Marginal Propensity to Import

NMW; Bureaucracy; Red-tape

Historically strong on a trade-weighted basis

Evaluate effectiveness of policies to reduce a deficit on the Current Account34

Evaluate the effectiveness of policies to reduce the UK Balance of Trade deficit

Deflate the economy….really?

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Imports depend on the level of income…

EXPENDITURE REDUCING POLICIES…

CONRACTIONARY MP/FP

Reduce disposable income…

Reduces MPM

E.g. foreign cars/holidays… BUT… has consequences…

Effects of deflating the economy

Price level

Real GDP and employment

AD

Y

P

P1

35

AD1

AS

Y1

UNINTENDED CONSEQUENCES

CONFLICT OF MACROECONOMIC OBJECTIVES

PRIORITISATION

Overt Protectionism…

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Evaluate the effectiveness of policies to reduce the UK Balance of Trade deficit

Tariffs are taxes on imports…

Raise the price of imports…

Some expenditure-SWITCHING…

Value of M should fall

(X-M) rises, current account rises… Back it up with a DIAGRAM

Tariff

Price

Quantity

Domestic demand

P

36 Q

No trade

Domestic supply

Price

Quantity

Domestic demand

P

36 Q

Domestic supply

World P

QdQs

IMPORTS

Too many imports: QD>QS

Tariff

Tariff

Price

Quantity

Domestic demand

P

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Domestic supply

World P

Qs

World P+Tariff

Qs1 QdQd1

Govt tax revenue…

Inflationary pressure…

Domestic industry benefits…

Allocative efficiency lost…

Retaliation… EU Customs union…

WTO…

PM rises in domestic currency terms

Currency depreciates

PX falls in foreign currency terms

XD rises

Value of X rises

Trade balance increases

MD falls

Value of M falls

Depreciation of the exchange rate….

MARSHALL-LERNER CONDITION

PM rises in domestic currency terms

Currency depreciates

PX falls in foreign currency terms

XD rises

Value of X rises

Trade balance increases

MD falls

Value of M falls

If Price X falls; and Demand for X rises; for

VALUE of X to RISE; need demand for X to be

ELASTIC

If Price M rises; and Demand for M falls; for

VALUE of M to FALL; need demand for M to

be ELASTIC

In SHORT RUN however, Demand for X and M is likely to be INELASTIC

Marshall-Lerner condition: if PED of exports + the PED for imports > 1, a depreciation will help resolve a trade deficit

Reasons for a possible J curve effect

Low price elasticity of demand for exports

Low price elasticity of demand for imports

Supply constraints for exporters

Long-term contracts

Wait-and-see approach

Cheaper pound – a boost to competitiveness of UK economy

Non-price factors

Global supply chains

Financial sector

Import intensity

Overseas demand

Currency Wars

BrazilPeru

Colombia

Korea

South Africa

Russia

Switzerland

Japan

U.S

Chile

Discuss the view that a depreciation is always beneficial to an economy

• Exam tips:

– Strategy: ‘build up a case with theory (analysis) and then knock it down (analysis and evaluation)!!

– Use examples

– Remember to address: ‘to whom’ is depreciation beneficial and the word ‘always’

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Try to spot key words in the question that can help your

evaluation…

Positive effects of a depreciation

• Exports Increase

•Growth and job creation

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The Theory………Export led growth

Price level

Real GDP and employment

AD

Y1

P2

P1

AS

AD 1

Y2

Stimulates exports, injection into CFoY, higher AD

Derived demand

Positive multipliers

Negative effects of a depreciation

INFLATIONARY PRESSURES

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Demand-pull inflation…

Cost-push inflation…

The reality……….Imported Inflation

Price level

Real GDP and employment

AD

Y1

P2

P1

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AS

AS 1

Y2

Value judgement: Likelihood? Undesirability?

Currency depreciation can harm inflation

objectives…