AS Macro Revision - The Balance of Payments

AS Macro Revision

The Balance of Payments

Spring 2014

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The Balance of Payments (BoP)

The Balance of Payments

For AS economics emphasis is on the current account of the BoP and in particular the balance in trade in goods and services

• The balance of payments (BOP) records all financial transactions made between consumers, businesses and the government in one country with other nations

• Inflows of foreign currency are counted as a positive entry (e.g. exports sold overseas)

• Outflows of foreign currency are counted as a negative entry (e.g. imported goods and services)

• The current account of the balance of payments is the main measure of external trade performance

Items in the Current Account of the BoP

• Finished manufactured goods, components, raw materials

• Energy products, Capital technology

Trade Balance in Goods

• Banking, Insurance, Consultancy• Tourism, Transport, Logistics• Shipping, Education, Health,• Research, Cultural Arts

Trade Balance in Services

• Overseas aid / debt relief• Private money transfers e.g. From migrants

Net Money Transfers

• Profits, interest and dividends from investments in other countries e.g. The profits from transnational businesses

Net Investment Income from

Overseas Assets

Worked Example of the BoP Current Account

Item of the Balance of Payments Net Balance$ billion

Current Account (1) Balance of trade in goods -25

(2) Balance of trade in services +10(3) Net investment income -12(4) Net overseas transfers +8

Sum of 1+2+3+4 = Current account balance -19

The current account comprises the balance of trade in goods and services net investment incomes and net transfers.If a country is running a current account deficit, there is a net outflow of demand and income from the circular flow.

Causes of a Balance of Payments Deficit

• Higher inflation than trading partners• Low levels of capital investment and research• Weaknesses in design, branding, performance

Poor price and non-price competitiveness

• High currency value increases prices of exports• Appreciating currency also makes imports cheaper

causing switch of demand to them

Strong exchange rate affecting exports and

imports

• Recession lowers exports to countries affected• Might be barriers to switching to other markets

Recession in one or more major trade partner countries

• Exporters of primary commodities might be hit by a fall in world prices of their major export products

• Importing nations could be hit by higher prices for essential goods

Volatile global prices (e.g. Commodities)

The Export Multiplier Effect

A fall in exports will reduce AD and the final impact on GDP, jobs and investment is amplified by multiplier and accelerator effects

Real GDP

GPL1

Y1

AD1

AS

Y2

AD2

GPL2

GPL The Export Multiplier Effect

Many industries rely heavily on key export industries remaining competitive – these include:

• Transportation / freight / logistics businesses

• Trade finance businesses e.g. Insurance and trade credit

• Service businesses that operate in ports and airports

Exports particularly important for regional economic performance

Balance of Payments Deficit and Surplus CountriesExamples of Countries that run

Current Account Deficits

Current account, % of GDP, data is 2012, Source: World Bank

Mongolia -49.5

Cyprus -22.3

Jamaica -11.4

Ghana -8.6

Portugal -5.0

South Africa -4.6

Sri Lanka -4.4

India -3.6

Examples of Countries that run Current Account surpluses

Current account, % of GDP, data is 2012, Source: World Bank

Kuwait +39.7

Saudi Arabia +31.8

Norway +18.2

Singapore +17.7

Switzerland +13.9

Taiwan (China) +8.1

Germany +5.3

China +3.1

Economic Problems from Persistent Trade Deficits

Loss of aggregate demand which causes slower real GDP growth and reduced living standards

Loss of jobs in home-based industries, may contribute to regional decline and structural unemployment problems

Can lead to currency weakness and higher inflation and a country may run short of vital foreign currency reserves

Trade deficit might be a reflection of lack of competitiveness / supply-side weaknesses

Possible Problems from Running Trade Surpluses

If GDP is close to capacity, a rise in the trade surplus might cause demand –pull inflation

Persistent trade surpluses might lead to threat of protectionism from trade deficit nations

If the surplus is due to high saving / low consumption, living standards might be too low

Surplus might be result of exporting high-priced commodities – prices are volatile/unpredictable

Economic Policies to Reduce a Trade Deficit• Demand management: A tightening of fiscal and/or monetary

policy reduces real spending power of consumers and leads to lower spending on imports (fall in M improves trade balance)

• Lower exchange rate reduces the overseas price of exports and makes imports more expensive – causes changes in demand

• Supply-side improvements: • Policies to raise labour productivity and encourage start-

ups with export potential e.g. Life sciences, digital etc• Investment in human capital to boost productive capacity

and competitiveness in high-value industries such as bio-technology, engineering, medicine, tourism

• Protectionist measures such as import quotas and tariffs (NB: limited by global trade agreements e.g. EU and WTO rules)

Economic Effects of a Currency Depreciation

This will have an effect on a number of economic indicators

Domestic production Trade deficit Domestic jobs

Changes in import and export prices will affect demandImport sales will CONTRACT Export sales will EXPAND

When the pound depreciates against the US dollarIt makes UK import prices RISE It makes UK export prices FALL

Will an Exchange Rate Depreciation improve the BoP?

Time period after depreciation

Trade surplus

Trade deficit

Currency depreciation

here

Trade deficit may grow in initial period after depreciation

Net improvement in trade provided certain conditions

are met

The diagram below shows the “J Curve effect” – it shows the time lags between a falling currency and an improved trade balance

Some Reasons for the UK’s Persistent Trade Deficit

High income elasticity of demand (Yed) for imported goods and services

Some weaknesses on supply-side of the economy (i.e. Low research / investment)

Many UK businesses finding it hard to finance a rise in exports (effects of credit squeeze)

The majority of our exports go to slower-growing countries in Europe e.g. Ireland, Spain and also the USA. Less successful in exporting to BRICs.

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