MODULE: MACROECONOMICS BB106

Unit 9: Balance of PaymentsTUTORIAL 9

Question 1:What are the major components of the current account in the balance of payments? How is the current account balance determined?

(The current account shows the position of the United States in terms of trade in goods and services. Two major components of this account are U.S. goods exports and imports. The difference between these two components gives the balance on goods. Two other components are U.S. exports and imports of services. The difference between these two components gives the balance on services, which is added to the balance on goods to give the balance on goods and services. The fifth component is net investment income. It shows excess of interest and dividend payments foreigners paid to U.S. individuals or companies for the services of U.S. exported capital over what the U.S. paid to foreign individuals or companies. The sixth item is net transfer payments. This is the difference between U.S. public and private transfer payments to the rest of the world and foreign private and public transfer payments to the United States. Adding net investment income and net transfer payments to the balance on goods and services gives the balance on the current account

Question 2:

What are the major components of the capital and financial account?

( The capital and financial account breaks down into the capital account and the financial account. The capital account can be either positive or negative and measure debt forgiveness.( It is the net of how much debt owed by foreigners was forgiven by Americans and how much debt owed by Americans was forgiven by foreigners.

( The financial account records the sale and purchase of real and financial assets and the direction in which the resulting funds flow(. If a foreigner buys a U.S. asset, it would be recorded as a plus (+) to the financial account, while U.S. purchases of foreign goods are recorded with a minus ().Question 3:

What is the official reserves account and how is it used in the balance of payments?

( The official reserves are the foreign currencies owned by the central bank( These reserves decrease when they are used to finance a net deficit on the combined current account and capital and financial account.( The reserves increase when a nation has a net surplus on its current account and capital and financial accountQuestion 4:

Answer the next five questions on the basis of the following hypothetical data for a nation Malthusia. All numbers are in billions of dollars.

Goods exports+$45

Goods imports51

Service exports+15

Service imports6

Net investment income10

Balance on capital account+3

Net transfers+12

Foreign purchases of Malthusia assets+25

Malthusia purchases of assets abroad33

(a)What was the balance on goods?

(b)What was the balance on goods and services?

(c)What was the balance on the current account?

(d)What is the balance on the financial account?

(e)What is the balance on the capital and financial account?

(a)Goods exports were +$45 billion and goods imports were $51 billion, so the balance on goods was $6 billion.

(b)Goods and service exports ($45 + $15 billion). Goods and service imports ($51 + $6 billion). Balance on goods and services was +$3 billion ($60 $57 billion).

(c)Balance on goods and service ($3 billion) plus net investment income ($10 billion) plus net transfers (+$12 billion) equals the current account balance. The sum is $5 billion.

(d)The balance is $8 billion. Outflow of $33 billion and inflow of only $25 billion.

(e)The balance is $5 billion. The balance on the capital account is +$3 billion. The balance on the financial account is $8 billion. The net difference is $5 billion.Question 5:

Why is a balance-of-payments deficit not necessarily good or bad if it occurs in one given year, but potentially very harmful if maintained over a number of years?

( Balance of payments as a single event is neither good nor bad, they simply occur given the current economic conditions.( However, persistent deficits result in the drawing down of official reserves( Since reserves are a finite amount, a country with persistent balance deficits may have to take drastic measures to equalize its economyQuestion 6:

Explain how the exchange rate gets determined in a flexible exchange rate system

( If the foreign exchange rate floats freely, the demand for and the supply of foreign currency determine foreign exchange rates( If the demand for a nations currency increases, other things equal, the currency of that nation will appreciate( Conversely, if the demand for a nations currency decreases, other things equal, the currency of that nation will depreciate( If the supply of a nations currency decreases, other things equal, the currency of that nation will appreciate( Conversely, if the supply of a nations currency increases, other things equal, the currency of that nation will depreciate.Question 7:

Describe how changes in tastes affect the value of a nations currency

( If consumer preferences for the products of a foreign nation change, then the demand for and supply of that countrys currency will change( If the demand for British clothing increases, then the demand for British pounds will increase causing the pound to appreciate( If the demand for British clothing declines, then the demand for British pounds will decrease causing the pound to depreciateQuestion 8:

Explain how changes in relative income affect the value of a nations currency

( If nations income rises more rapidly than other nations incomes, then its expenditures on imports are likely to grow along with expenditures on everything else. This will probably cause the currency to depreciate as other nations are not growing as rapidly, and therefore, their demand for the nations currency is not keeping pace with the change in supply. The reverse would be true if the nations income grew more slowly than other nations incomes.(Income increase-(increase DD to Imported products-(increase DD to foreign currency(foreign currency appreaciate,nation currency depreciate )

Question 9:

How are flexible exchange rates used to eliminate a balance-of-payments deficit or surplus?

( Flexible exchange rates can be used to eliminate a balance-of-payments deficit or surplus( When a nation has a balance-of-payments deficit, foreign exchange rates will decrease, thus making foreign goods and services more expensive and decreasing imports (less DD to nation goods,services and financial assest(less DD to nation currency(cause nation currency depreciate(make nation people feels foreign goods and services more expensive(decreasing imported products )

( These events will make a nations goods and services less expensive for foreigners to buy, thus increasing exports.( With a balance-of-payments surplus, the exchange rates will increase, thus making foreign goods and services less expensive and increasing imports. This situation makes a nations goods and services more expensive for foreigners to buy, thus decreasing exports.

Question 10:

Describe the three major disadvantages of flexible exchange rates.

( First, flexible exchange rates are subject to great volatility, and thus create uncertainty in exchange rate markets( creates more risks for those businesses that import and export goods and services( Second, a fall in the international value of a nations currency will worsen the terms of trade for that nation( Third, changes in exchange rates create instability in the domestic economy( Appreciation of a nations currency reduces exports and increases imports possibly creating unemployment in export-related industriesQuestion 11:

How does a fixed exchange rate system work? How can a nation maintain its fixed exchange rate?

( In the fixed exchange rate system a nation might fix its exchange rate with another nation.( In this case, the governments of these nations must intervene in the foreign exchange markets to prevent shortages and surpluses caused by shifts in demand and supply for foreign currencies.

(One way for a nation to stabilize foreign exchange is for its government to sell its reserves of a foreign currency in exchange for its own currency (or gold) when there is a shortage of the foreign currency(when value of foreign currency appreciate due to high DD,gov will sell)

( Conversely, a government would buy a foreign currency in exchange for its own currency (or gold) when there is a surplus of the foreign currency(when value of foreign currency appreciate due to high DD,gov will buy)

Question 12:

What is the managed float?

The managed float is a way of describing the eclectic system of exchange rates that evolved after the demise of the Bretton Woods system. The managed float allows for long-term changes in exchange rates that occur because of persistent balance-of-payment surpluses or deficits. The system also permits some short-term changes in exchange rates that are the result of changing demand and supply conditions; however, central banks may intervene in the short-term to manage or to stabilize fluctuations in exchange rates that might occur because of speculative buying and which may disrupt international tradeQuestion 13:

Why might a government intervene in the foreign exchange markets to try to increase or decrease the value of its currency?

( The U.S. economy generally benefits from a depreciation( It can stimulate the U.S. economy when foreign purchases of U.S. goods and services increase because foreign currency has risen in value(found it good cheaper than their nation,services cheap due to low labor cost)( If the government wanted to stimulate the economy, it would want to intervene in foreign exchange markets to prevent a rise in the international value of the dollar( It could do this by selling dollars for another foreign currency such as the Japanese yen.

( Some countries may let its currency appreciate to reduce the burden of foreign debtsQuestion 14:

What are two positive roles that speculators play in currency markets?

( Speculators buy foreign currency in hopes of reselling it later at a profit( They also sell foreign currency in hopes of re-buying it later when it is cheaper( One positive function of speculators is that they smooth out temporary fluctuations in the value of foreign currencies( If there is a temporary decline in the demand for a foreign currency, speculators take advantage of the lower value and buy the currency, thus increasing demand and supporting its value.(If there is a temporary strong demand that raises the value of a currency higher than economic conditions suggest the price should be should be, then speculators can sell their holdings of foreign currency to take advantage of the high price, thus reducing its value( Another positive role speculators play in currency markets is that they bear risks that others do not want.( International transactions can be risky because exchange rates change minute by minute( Buyers and sellers can decrease this by hedgingan action a buyer or seller takes to protect against an unfavorable change in exchange rates in the future.(. It is speculators who will often assume the risk of delivering the specified amount of foreign exchange at the contract price on the date of delivery