The Balance of Payments - Edexcel Economics Unit 4

8/3/2019 The Balance of Payments - Edexcel Economics Unit 4

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Balance of Paymentsc/w 24/11/11

Starter Are the following statements true or false

1)The UK currently has a current account deficit2)The UK currently has a financial account deficit

3)The UK is running a surplus in services4) The balance of payments must in the long run

always balance


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The Balance of Payments Must alwaysbalance

This is because we have to pay for everything we consume andfund it in some way to fund our current account deficit, we mustbe selling assets to foreign investors.

It is debatable whether this is sustainable in the long run, since if

people invest in the UK, at some point they will require a return ontheir investment and this will causes a deficit in the financialaccount

Additionally, because the data is never completely accurate , theaccounts also incorporate a net errors and omissions item which

will meake everything balance.


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Balance of Payments

CurrentAccount FinancialAccount

In the UK our current account is traditionally in deficitwhile our financial account is in surplus


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Balance of Payments

CurrentAccount

FinancialAccount

Net errors andaccounts/ statisticaldiscrepancy

Is used to

balance tozero asinevitablydue to thenumber oftransactio

ns this willnothappen ata specifictime


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What is the Uks current account

deficit?


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Does the Current Account deficitmatter?

There could be problems financing the deficit in the long term. A short termdeficit is not a problem, but if you have a deficit of over 6% of GDP then it isa problem if you rely on Capital flows. A significant part of the currentaccount deficit in US is finance by Chinese investors buying US securities,at relatively low interest rates.

A deficit on the current account increases foreign liabilities. In the beginninga current account deficit could be just a deficit on buying goods. Howeverover time the deficit will be increased by the interest payments on the capitalsurplus. Foreigners invest in the US. On these investments they receiveinterest payments or dividends. These dividends count as a debit on thecurrent account. Therefore the longer the deficit goes on the higher the level

of investment income debits will be accrued. This means that in the futurethe economy will need to attract capital flows just to pay off the investmentincome. As well as the deficit on goods and services.


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Why the deficit does not reallymatter?

1. If a current account deficit is financed from long termcapital inflows then this can be beneficial for theeconomy. Inward investment can increase the productivecapacity of the economy.

2. In an era of globalisation it is much easier to attractsufficient capital flows to finance the deficit.

3. If the deficit gets too large it will cause a devaluationwhich helps to reduce the deficit. Also when there is a

slowdown in consumer spending the deficit will fall.


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3 ways of correcting a deficit

Expenditure reducing

Expenditure Switching Policy

Supply-side policies


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Expenditure reducing policies

Expenditure reducing policies require thegovernment to cut the income of its citizens, sothat they spend less on imports (for example,

through deflationary fiscal policy); however, aside-effect of this is that spending on domesticgoods also decreases, so AD falls. This canreduce economic growth and cause recession.

It is an unpopular policy, especially politically,and therefore is unlikely to be used.


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Supply-side policies

Supply side policies such as spending oneducation and training in order to improve thequality and therefore competitiveness of exports,

aim to boost export demand rather than reduceimprt demand. Whilst they can incur anopportunity cost, they contribute positively toeconomic growth in the long run and can be anti-

inflationary in the long run


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Expenditure switching policies

Expenditure switching policies require thegovernment to find ways of reducing its citizensspending on imports using protectionist

measures such as tariffs or quotas, or even adevaluation of the currency under a fixedexchange rate regime. However, since this oftenleads to retaliation, exports will also fall and the

current account deficit may not be corrected


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Video Intro

http://www.youtube.com/watch?v=JKRBpJZ92QM

http://www.youtube.com/watch?v=yCjwXz7ZXwU

Current account deficits and exchangerates
http://www.youtube.com/watch?v=JKRBpJZ92QMhttp://www.youtube.com/watch?v=JKRBpJZ92QMhttp://www.youtube.com/watch?v=yCjwXz7ZXwUhttp://www.youtube.com/watch?v=yCjwXz7ZXwUhttp://www.youtube.com/watch?v=yCjwXz7ZXwUhttp://www.youtube.com/watch?v=yCjwXz7ZXwUhttp://www.youtube.com/watch?v=JKRBpJZ92QMhttp://www.youtube.com/watch?v=JKRBpJZ92QM


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http://tutor2u.com/

http://tutor2u.com/ PPT can be found on the above web site.

http://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xls

Click on the above link for economic data
http://tutor2u.com/http://tutor2u.com/http://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xlshttp://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xlshttp://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xlshttp://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xlshttp://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xlshttp://www.tutor2u.net/economics/mindmaps/inflation/LinkedDocuments%5CUK_Databank_Master.xlshttp://tutor2u.com/http://tutor2u.com/


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What does this increase in the current

account deficit mean?


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Current account

There was a current account deficit of20.0 billion in the third quarter, equivalentto -5.7 per cent of Gross Domestic Product

(GDP), compared with 13.7 billion,equivalent to -4.0 per cent of GDP, in theprevious quarter. The higher deficit was

due to an increase in the deficits on tradein goods and on investment income.


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Current Account

The deficit on trade in goods increased by3.1billion to 22.6 billion. The higher goodsdeficit resulted from a rise in net imports of oiland semi and finished manufactured goods.

Lower net earnings on foreign direct investmentand higher net payments on other investmentabroad led to a 3.6 billion increase in theincome deficit. These effects were slightly offsetby a small increase in the surplus trade in

services while current transfers were virtuallyunchanged from the previous quarter.


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The current account deficit

A deficit reflects an economy that is a net debtor to therest of the world. It is investing more than it is saving andis using resources from other economies to meet itsdomestic consumption and investment requirements. Forexample, let us say an economy decides that it needs to

invest for the future (to receive investment income in thelong run), so instead of saving, it sends the moneyabroad into an investment project. This would be markedas a debit in the financial account of the balance ofpayments at that period of time, but when future returns

are made, they would be entered as investment income(a credit) in the current account under the incomesection.


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The current account deficit

A current account deficit is usuallyaccompanied by depletion in foreign-exchange assets because those reserves

would be used for investment abroad. Thedeficit could also signify increased foreigninvestment in the local market, in whichcase the local economy is liable to pay the

foreign economy investment income in thefuture.


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The consequences of a currentaccount deficit

The effects of a current account deficit willbe influenced by its cause, its size andduration. A small, self-correcting deficit is

of less concern than one that is large andresults from poor performance. When acountry spends more than it earns, it is

enjoying higher living standards than it canafford. This may have to be financed byborrowing.


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Research

http://www.statistics.gov.uk/instantfigures.asp

Use the above website in order to obtaindata on the UK economy
http://www.statistics.gov.uk/instantfigures.asphttp://www.statistics.gov.uk/instantfigures.asphttp://www.statistics.gov.uk/instantfigures.asphttp://www.statistics.gov.uk/instantfigures.asp


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Summary

A deficit on the current account of the BOP mustalways be balanced by a corresponding surpluson the financial account;

A persistent deficit on current account meansthat in the long run domestic assets are beingsold to overseas buyers, or that foreignexchange reserves are being run down. Neithersituation can be sustained in the long run;

A key cause of a deficit on the current account isthe lack of competitiveness of domestic goodsand services.


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The implications of globalimbalances

Like the UK, the USA has experienced large currentaccount deficits, while China has experienced hugecurrent account surpluses. Whether such globalimbalances can be sustained in the long run is a major

question. On the one hand, if the deficits are easilyfinanced by inflows on the financial account, there maybe no cause for concern. Further, under a system offloating exchange rates over time, there should be anautomatic adjustment (i.e. deficit would cause the

exchange rate to fall). China!!! On the other hand,continuous deficits by the USA have in effect beenfinanced by China, which may not be sustainable in thefuture. Further exchange rate fluctuations must occur.


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Exchange Rates and Currency

Changes in the value of international currencies can affect

international trade.

The exchange rate is the price at which one currency can be traded

for another.For example:

AUKproduct cost10,000,when the exchange rate is1 = $2

If anAmericanbought this product, they would pay$20,000.

If the value of the pound rises, when1 = $2.5,then the cost ofthe product to the American would be $25,000.

a stronger poundmakes ithardertoexportgoods, but

easiertoimportgoods. Aweaker poundmakes goodseasierto

export,buthardertoimport.


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Balance of Payments

Aweaker poundmakes goodseasierto

export,butharderto import.

Exports are cheaper, but imports becomemore expensive.This means there is more

likely to be abalance of payments surplus.

The European Union EU is one of the UKs most important

trade areas.

Astronger poundmakes ithardertoexportgoods, but easiertoimportgoods. UK exports

become more expensive abroad, resulting in

fewer sales and smaller profits. This means

there ismore likely to be abalance ofpayments deficit.

TheExchange Ratecan affect theBalance of Payments.


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Examination questions

1. During 2002 the UK economyexperienced strong growth in retail sales,a decline in manufacturing output and a

rapidly rising trade deficit. Examine thefactors that might have led to theseimbalances. (40 marks)


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Essay Plan

What was the UK economy like in 2002? Consumer spending was rising fuelled by the housing

boom. Inflation was on target, 2.5%. The poundappreciated in value and the manufacturing industry wasin decline. Imports of finished manufactured goods were

rapidly increasing whilst exports of finishedmanufactured goods were declining. The balance oftrade in goods deficit significantly increased.

Why was consumer spending rising rapidly? How can a rise in house prices boost wealth?

Why did consumer credit increase and what effect didthis have on imports?

Why did low interest rates boost consumer spending?


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Essay plan

Remember the economy was growing andunemployment was falling; what impact did this have onconsumer spending?

During this time period there were a number of goodsfalling in price like DVD players, games consoles, TVs

etc due to supply side improvements such astechnological innovations and improvements inproductivity. Also, China and India low costmanufacturers.

The high pound What impact did this have on imports?

Conclusion have the above factors led to de-industrialisation? What impact will this have on the UKeconomy over time?


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Plenary

Does a deficit on the current account reallymatter?

http://www.economicshelp.org/2007/03/does-current-account-deficit-matter.html
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