c/w

Balance of Payments

24/11/11

Starter Are the following statements true or false 1)The UK currently has a current account deficit 2)The UK currently has a financial account deficit 3)The UK is running a surplus in services 4) The balance of payments must in the long run always balance

The Balance of Payments Must always balance

This is because we have to pay for everything we consume and fund it in some way to fund our current account deficit, we must be 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 on their investment and this will causes a deficit in the financial account Additionally, because the data is never completely accurate , the accounts also incorporate a net errors and omissions item which will meake everything balance.

Balance of Payments

Current Account

Financial Account

In the UK our current account is traditionally in deficit while our financial account is in surplus

Balance of Payments
Is used to balance to zero as inevitably due to the number of transactio ns this will not happen at a specific time

Net errors and accounts/ statistical discrepancy

Current Account

Financial Account

What is the Uks current account deficit?

Does the Current Account deficit matter?

There could be problems financing the deficit in the long term. A short term deficit is not a problem, but if you have a deficit of over 6% of GDP then it is a problem if you rely on Capital flows. A significant part of the current account 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 beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. Foreigners invest in the US. On these investments they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.

Why the deficit does not really matter?

1. If a current account deficit is financed from long term capital inflows then this can be beneficial for the economy. Inward investment can increase the productive capacity of the economy. 2. In an era of globalisation it is much easier to attract sufficient capital flows to finance the deficit. 3. If the deficit gets too large it will cause a devaluation which helps to reduce the deficit. Also when there is a slowdown in consumer spending the deficit will fall.

3 ways of correcting a deficit

Expenditure reducing Expenditure Switching Policy Supply-side policies

Expenditure reducing policies

Expenditure reducing policies require the government to cut the income of its citizens, so that they spend less on imports (for example, through deflationary fiscal policy); however, a side-effect of this is that spending on domestic goods also decreases, so AD falls. This can reduce economic growth and cause recession. It is an unpopular policy, especially politically, and therefore is unlikely to be used.

Supply-side policies
Supply side policies such as spending on education and training in order to improve the quality and therefore competitiveness of exports, aim to boost export demand rather than reduce imprt demand. Whilst they can incur an opportunity cost, they contribute positively to economic growth in the long run and can be antiinflationary in the long run

Expenditure switching policies

Expenditure switching policies require the government to find ways of reducing its citizens spending on imports using protectionist measures such as tariffs or quotas, or even a devaluation of the currency under a fixed exchange rate regime. However, since this often leads to retaliation, exports will also fall and the current account deficit may not be corrected

Video Intro
http://www.youtube.com/watch?v=JKRBpJ Z92QM http://www.youtube.com/watch?v=yCjwXz 7ZXwU Current account deficits and exchange rates

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

http://www.tutor2u.net/economics/mindmaps/infl ation/LinkedDocuments%5CUK_Databank_Mast er.xls Click on the above link for economic data

What does this increase in the current account deficit mean?

Current account
There was a current account deficit of 20.0 billion in the third quarter, equivalent to -5.7 per cent of Gross Domestic Product (GDP), compared with 13.7 billion, equivalent to -4.0 per cent of GDP, in the previous quarter. The higher deficit was due to an increase in the deficits on trade in goods and on investment income.

Current Account
The deficit on trade in goods increased by 3.1billion to 22.6 billion. The higher goods deficit resulted from a rise in net imports of oil and semi and finished manufactured goods. Lower net earnings on foreign direct investment and higher net payments on other investment abroad led to a 3.6 billion increase in the income deficit. These effects were slightly offset by a small increase in the surplus trade in services while current transfers were virtually unchanged from the previous quarter.

The current account deficit

A deficit reflects an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. For example, let us say an economy decides that it needs to invest for the future (to receive investment income in the long run), so instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments 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 income section.

The current account deficit

A current account deficit is usually accompanied by depletion in foreignexchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future.

The consequences of a current account deficit

The effects of a current account deficit will be influenced by its cause, its size and duration. A small, self-correcting deficit is of less concern than one that is large and results from poor performance. When a country spends more than it earns, it is enjoying higher living standards than it can afford. This may have to be financed by borrowing.

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

Summary
A deficit on the current account of the BOP must always be balanced by a corresponding surplus on the financial account; A persistent deficit on current account means that in the long run domestic assets are being sold to overseas buyers, or that foreign exchange reserves are being run down. Neither situation can be sustained in the long run; A key cause of a deficit on the current account is the lack of competitiveness of domestic goods and services.

The implications of global imbalances

Like the UK, the USA has experienced large current account deficits, while China has experienced huge current account surpluses. Whether such global imbalances can be sustained in the long run is a major question. On the one hand, if the deficits are easily financed by inflows on the financial account, there may be no cause for concern. Further, under a system of floating exchange rates over time, there should be an automatic adjustment (i.e. deficit would cause the exchange rate to fall). China!!! On the other hand, continuous deficits by the USA have in effect been financed by China, which may not be sustainable in the future. Further exchange rate fluctuations must occur.

Exchange Rates and Currency

Changes in the value of international currencies can affect international trade.
A UK product cost 10,000, when the exchange rate is 1 = $2 If an American bought this product, they would pay $20,000. If the value of the pound rises, when 1 = $2.5, then the cost of the product to the American would be $25,000. The exchange rate is the price at which one currency can be traded for another. For example: a stronger pound makes it harder to export goods, but easier to import goods. A weaker pound makes goods easier to export, but harder to import.

Balance of Payments
The Exchange Rate can affect the Balance of Payments. A stronger pound makes it harder to export goods, but easier to import goods. UK exports become more expensive abroad, resulting in fewer sales and smaller profits. This means there is more likely to be a balance of payments deficit. A weaker pound makes goods easier to export, but harder to import. Exports are cheaper, but imports become more expensive.This means there is more likely to be a balance of payments surplus. The European Union EU is one of the UKs most important trade areas.

Examination questions
1. During 2002 the UK economy experienced strong growth in retail sales, a decline in manufacturing output and a rapidly rising trade deficit. Examine the factors that might have led to these imbalances. (40 marks)

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 pound appreciated in value and the manufacturing industry was in decline. Imports of finished manufactured goods were rapidly increasing whilst exports of finished manufactured goods were declining. The balance of trade 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 did this have on imports? Why did low interest rates boost consumer spending?

Essay plan
Remember the economy was growing and unemployment was falling; what impact did this have on consumer spending? During this time period there were a number of goods falling in price like DVD players, games consoles, TVs etc due to supply side improvements such as technological innovations and improvements in productivity. Also, China and India low cost manufacturers. The high pound What impact did this have on imports? Conclusion have the above factors led to deindustrialisation? What impact will this have on the UK economy over time?

Plenary
Does a deficit on the current account really matter? http://www.economicshelp.org/2007/03/do es-current-account-deficit-matter.html