6.3 The Balance Of Payments

Question 1

Balance of payment definition

Answer 1

A record of all the financial transactions taking place between one country and any other country

Question 2

What three sections are the balance of payments broken down into

Answer 2

• capital account
• financial account
• current account

Question 3

What is the capital count?

Answer 3

Capital account includes capital transfers as well as purchases and sales of some non-financial assets

Question 4

What is the financial account?

Answer 4

Measures the flows of financial capital into and out of the country. It consists of FDI, portfolio investment and short-term speculative money (hot money)

Question 5

Foreign direct investment definition

Answer 5

The buying of productive assets (businesses, CELL) located outside the country of ownership

Question 6

Portfolio investment definition

Answer 6

Refers to the buying of financial assets located outside the country of ownership. (Stocks and shares)

Question 7

Current account definition

Answer 7

Measurement of the net income from trade in goods and services and primary and secondary income

Question 8

What are the four components of the current account?

Answer 8

• trade in goods
• trade in services
• primary income
• secondary income

Question 9

Primary income definition

Answer 9

The net income earned from investments abroad or outside the country of origin

Question 10

Why has recently the UK net investment income become a deficit in recent years?

Answer 10

Rapid growth in countries such as China and India has led to invests INTO the Uk, thus creating floes of investment income back to those countries

Question 11

Secondary income definition

Answer 11

Related to the transfers of money between countries

Question 12

What are four examples of secondary incomes

Answer 12

• remittances
• foreign aid
• grants
• gifts

Question 13

Is the current account for the Uk in surplus or deficit, and why?

Answer 13

Deficit, because the trade on goods is in deficit and outweighs the surplus on the trade of services

Question 14

What are the factors that determine the current account

Answer 14

• foreign GDP
• productivity
• inflation

Question 15

How does foreign GDP affect the current account?

Answer 15

As foreign GDP rises, spending in those countries will also rise and this will lead to greater demand for imports = UK goods and services = UK current account surplus

Question 16

How does productivity affect the current account?

Answer 16

If UK productivity rises relative to foreign productivity, this means UK firms can produce more output for less inputs = decrease cost of production = firms can be more price competitive compared with foreign substitutes = increase in UK exports = surplus on current account

Question 17

How does inflation affect the current account?

Answer 17

If UK inflation is relatively higher than foreign inflation it means the prices of UK goods are rising faster than those produced overseas = less price competitive = lower exports = current account deficit

• not the rate of inflation but the level of relative inflation

Question 18

What are expenditure reducing policy’s?

Answer 18

Deflationary policies

Question 19

What are expenditure switching polices?

Answer 19

Protectionist policies and devaluation

Question 20

Expenditure reducing policies definition

Answer 20

Policies to improve the current account balance by reducing spending in the economy

Question 21

Expenditure switching policies definition

Answer 21

Policies to encourage a switch away from imports and to encourage a growth in exports

Question 22

What are the types of expenditure reducing policies?

Answer 22

• higher taxation
• lower government expenditure
• higher interest rates

Question 23

What do expenditure reducing policies aim to do?

Answer 23

Reducing Uk consumer spending on imports by reducing the ability of Uk consumers to spend money

Question 24

What is the aim of expenditure switching policies?

Answer 24

To reduce the quantity of imports accompanied by a rise in the quantity of exports

Question 25

Explain how devaluation is an expenditure switching policies

Answer 25

• Devaluation leads to exports being cheaper to foreign customers = increase in exports
• imports become more expensive = more domestic goods used instead as cheaper = less imports

Question 26

What are the issues with devaluation?

Answer 26

It may improve the current account balance but will depend on the elasticity of demand for both exports and imports

Question 27

Devaluation definition

Answer 27

A sudden and significant fall in the value of the exchange rate

Question 28

Marshall-Lerner condition definition

Answer 28

The requirement that devaluation will improve the current account balance only if the total of the price elasticity was for imports and exports is greater than 1

Question 29

What is the J curve?

Answer 29

The observation that after a devaluation. The current account balance worsens initially before improving

Question 30

Describe how the J curve works

Answer 30

Demand usually becomes more price elasticity over time as more substitutes are found
- exports prices falls but does not immediately lead to higher exports. An increase occurs over time as demand becomes more price elastic
- imports become more expensive but demand dosent fall much as demand is price inelastic but over time, it changes as substitutes are found
= current account worsens in the short-term but gets better in the long-term after the devaluation

Question 31

What are the types of expenditure switching policies?

Answer 31

• devaluation
• protectionist polices
• supply-side polices

Question 32

How do supply-side policies help the balance on the current account?

Answer 32

• improves the productivity of the economy = reduces cost of production per unit = lower prices = more price competitive = more exports

Question 33

Why are current account deficits to be avoided?

Answer 33

• they mean a net outflow of money leaving the UK economy = withdrawals
• may signify a weakness in the country’s export industries e.g poor technology
• if the exchange rate is fixed, a deficit may persist
• more expensive costs for Uk businesses = inflation

Question 34

Why may a current account deficit not matter?

Answer 34

• could signify higher incomes = economic growth

- depends on the size of the deficit based on the countries GDP