Saturday, March 06, 2010

Unit 2: Revision: The Balance of Payments

Now that economics student has gone off line, I've brought together some posts to form this revision document for the Balance of Payments

The Balance of Payments

The Balance of Payments (BoP) records economic transactions between residents of a country and the rest of the world. There are two sections:
The Current Account records money flows between UK & overseas residents arising from trade in goods & services, flows of income from owning overseas assets and overseas transfers
The Capital & Financial Account records money flows between UK & overseas residents from the purchase of fixed or financial assets eg factories or shares or bank deposits/loans
Note that the two accounts are interlinked: Interest profits and dividends from owning overseas assets (ie income in the current account) result from investing overseas (which would appear in the capital and financial account)

At AS the focus is on the current account. Be careful to use the terms current account and balance of payments carefully – they have different meanings. The current account is just one section of the balance of payments covering international transactions which have no impact on the country beyond the current year; ie the next 12 months.
Next, be sure you understand each element in the current account. Hopefully you understand trade in goods and trade in services, but the other 2 items are not as straightforward.
Put simply, total income is the difference between income earned by UK residents from owning overseas assets ( in the form on interest, profits and dividends; IPD) and income paid out to overseas residents owning UK assets.
Current transfers are mainly transfer payments made by government (eg receipts from (and payments to) the European Union) and payments made by expatriate workers back to their home country.

One potential area of confusion are the + and – signs. Any money entering the country will have a positive sign in the BoP accounts. Likewise, money flowing out of the country will have a negative sign

Task: Use the table below to assess the performance of the UK economy over the 4 years. Look at the trends in goods and services. Ask yourself whether the trade in services more than outweighs the deficit on trade in goods.

Trade in Goods
Trade in services
Balance of trade
Total income
Current transfers
Current balance
The causes of a current account deficit

The current account is one element of the balance of payments. The main cause of the deficit in the current account is a country’s trade in goods and services where the value of imports is higher than the value of exports.
In 2007, the UK ran a £89.2bn deficit on trade in goods and a £41.7bn surplus on trade in services giving an overall Balance of trade of -£47.5bn.

What factors cause the trade deficit? Put simply: a lack of international competitiveness. If UK made products are more expensive or of a lower quality than EU & USA rivals then UK imports rise and our exports fall
There are three main factors at work which can explain why UK products are relatively more expensive than their overseas rivals:
1 Lower productivity. Productivity is output per worker. If, on average, UK workers produce less than the international average then it follows that UK unit costs are higher. Price competitiveness is lost
2 The strength of sterling. Exchange rates affects the price of UK imports and the price of UK exports in terms of foreign currency. a sustained appreciation of the pound over time lowers the price of imports while raising the price of exports, causing the loss of price competitiveness
3 Relative inflation rates. where the UK has higher inflation rates than its overseas rivals, then UK prices are accelerating faster than their competitors, so reducing UK price competitiveness

The role of quality should not be underestimated. Price is just one factor determining the demand for imports and exports. Globalisation and the emergence of developing economies such as China with low labour costs and an advantage in the mass production of low-priced products, encourages the UK to specialise in high value added industries. UK goods compete on quality design and exclusive brand image.

Policies to improve a current account deficit

The current account is an element of the balance of payments. So how would you define a current account deficit? It occurs when exports revenue, income and current transfers from abroad are less than expenditure on imports, income and current transfers going abroad. More money is leaving the country than entering it.

The government can make use of various policy instruments to improve the current account position, focusing on the balance of trade in goods and services. This involves taking measures that increase the demand for exports or lower the demand for imports

Demand side measures
1 Lower the exchange rate; this will bring about an increase in the price of imports, and reduction in the price of exports in terms of foreign currency. The effectiveness of the depreciation of sterling depends upon the demand for exports and imports being price elastic and ceteris paribus. Bringing about a reduction in the exchange rate is rendered ineffectual if other countries follow suit and engineer a depreciation of their own currency or retaliate with import restrictions
2 Introduce import restrictions such is tariffs or quotas that increase the price of imports, lowers demand and so – given demand is price elastic - reduces spending on imports. Note import restrictions have an inflationary side effect and so conflict with the objective of stable prices (low inflation). More importantly scope for introducing tariffs and quotas is limited by UK membership of the EU and World Trade Organisation. Import restrictions may simply encourage retaliation lowering the volume and value of UK exports.
3 Reduce aggregate demand. The demand for imports depends on the level of national income reducing aggregate demand causes lower levels of imports. This reduction in AD could be achieved via fiscal or monetary policy. The effectiveness of this policy depends upon the value of the marginal propensity to import and the extent to which aggregate demand is reduced. Note the objectives of low unemployment and economic growth are compromised.

Supply side measures
A current account deficit is brought about by a lack of international competitiveness; ie UK products are either relatively more expensive or of poorer quality than items produced overseas. Improving the quality of UK products require supply side policies. For example, offering tax breaks and/or grants to firms that encourage research and development, enterprise and innovation. Many supply-side policies take a relatively long time to have an impact and can be expensive.

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