Balance of Payments Exam Notes PDF

BALANCE OF PAYMENTS Background: o The presentation examines the UK's economic crisis and international perspective on the balance of payments (BoP), as highlighted by a notable event during Liz Truss's term as UK Prime Minister. o A decision to i...

BALANCE OF PAYMENTS Background: o The presentation examines the UK's economic crisis and international perspective on the balance of payments (BoP), as highlighted by a notable event during Liz Truss's term as UK Prime Minister. o A decision to implement unfunded tax cuts led to a devaluation of the British pound, driven by a lack of investor confidence in the UK’s financial stability. Bond: government sell bonds to raise funds. They are borrowing money internationally from the savings of the citizens, domestic banks… Key Components of the Balance of Payments (is based on two accounts) 1. The Current Account o Records transactions involving goods and services (exports and imports), not money (payment). o Example: UK’s trade balance could show a deficit if imports exceed exports, indicating a net outflow. As it raises the graph it means trade deficit. 2. The Financial (Capital) Account o Tracks financial asset (money) transactions between residents and non-residents. o Includes investments, bonds, and currency transactions. o It can reflect borrowing from other countries to balance out trade deficits. 3. Balance of Payments Equation o BoP identity: Current Account + Financial Account = 0. If the equation is not 0 it means that o This relationship ensures that every international transaction has an offsetting entry to balance the accounts. o If a country imports more than it exports, it must compensate by selling financial assets or borrowing internationally. Detailed Mechanisms  Understanding Net Borrowing and Lending: o A country with a current account deficit finances its imports by “borrowing” from foreign entities, leading to increased foreign liabilities. o This borrowing can be through various forms like foreign investment in stocks, bonds, or physical assets.  Double Entry Accounting in BoP: o Every international transaction enters the balance of payments twice. - For example, a Spanish firm imports a €40,000 car from a US firm, and in exchange it exports a €40,000 bank deposit. The first transaction is debited from Spain’s current account and credited to the financial account. - If every international transaction gives rise to two offsetting entries, then the balance of payments must “balance”. That is, current account + financial account = 0. That is, in absolute terms the current account balance = financial account balance Real-World Examples and Exercises 1. Current Account Practice Problem: o Example: If Spain imports €500 in goods and exports €100, it has a deficit. Spain would need to borrow or sell assets to cover this deficit. 2. US Trade Imbalance Scenario:  o The US, as of 2021, exports $2 trillion and imports $3 trillion. This creates a $1 trillion current account deficit. o To fund this imbalance, the US might:  Sell bonds to foreign investors.  Increase foreign investment in US assets.  Use currency reserves or increase domestic savings. Advantages and Disadvantages of Being a Net Importer (imports greater than exports)  Disadvantages: o May need to cut public spending or raise taxes to cover imports. o The need for economic growth intensifies as reliance on foreign investments increases. o Potentially undesirable political or economic dependencies if investments come from countries with conflicting interests. o Need to use savings or sell assets: To increase savings a country could raise taxes or reduce spending on public services. If taxes are raised to pay for imports, then they are not being used for investment in physical capital. o Pressure to ensure economic growth: Could be that you rely on investments from countries you would rather not be associated with.  Advantages: o Consumers benefit from a broader selection of products from global markets. o Large importing countries can leverage their buying power over smaller exporting nations. If large importing country doesn't want to buy from smaller exporting country, the smaller exporting country could suffer strong effects. THE GLOBAL FINANCIAL CRISIS What Happened? The Global Financial Crisis was a major economic problem that started in 2007–2008. It caused big problems for banks, businesses, and governments around the world. The crisis had two main parts: 1. Global Crisis (2007–2008): o Started in the United States. o The U.S. dollar is very important for the global economy, so when America had trouble, the world felt it. 2. European Crisis (2010): o Some European countries, like Greece and Spain, couldn’t pay their debts. o This created a banking crisis and economic uncertainty. Which Countries Suffered the Most?  Hardest Hit: Countries like Greece, Spain, and Portugal, which relied on borrowing money from other nations.  Less Affected: Wealthier European countries like Germany and the Netherlands. They had strong economies and were lending money instead of borrowing. How Did Europe Respond?  The European Union (EU) told all countries to spend less and save more (austerity).   This meant: o Cutting government spending (fewer services, fewer jobs). o Raising taxes.  But this raised a question: Is saving money always the best idea during a crisis? o Critics argued that this made things worse because people had less money to spend, which slowed the economy further. 2007: The Sudden Stop  Before the crisis, countries like Spain and Greece borrowed money from richer European countries (Germany, Netherlands).  In 2007, this borrowing stopped suddenly, causing: o A credit crunch (it became hard to get loans). o Recessions in countries that depended on loans.  The EU and the International Monetary Fund (IMF) helped with loans and bailouts to stop the crisis from spreading. However, countries that received help had to: o Reduce their debt. o Spend less. Spain’s Choices During the Crisis (2007) Spain had three options to fix its economy: 1. Leave the Eurozone and Devalue Its Currency: o If Spain left the Eurozone, it could lower the value of its currency. This would make its exports cheaper and help its economy. o However, leaving the euro was politically risky and very complicated. 2. Internal Changes (Internal Devaluation): o Spain chose to:  Cut wages.  Improve productivity. o This made Spanish goods cheaper without leaving the Eurozone but caused years of hardship. 3. Ask Germany and Others to Spend More: o Wealthy countries like Germany could have bought more from Spain, helping its economy grow. o This idea was mostly ignored. What Happened After the Crisis?  Spain and other countries fixed some of their economic problems. For example, they stopped relying so much on borrowing money.  But new problems appeared: o Germany and other rich countries saved too much, creating trade surpluses (selling more goods than they buy). o This imbalance makes it hard for other countries to recover. Global Savings Problem  Many countries (like in Europe and Asia) want to save more than they spend.  This creates a big question: Who will spend if everyone is saving? o In the past, the United States was the "global buyer," importing goods and spending a lot. But now, the U.S. cannot keep doing this alone. o Europe needs to spend more to help the global economy. Solutions for Too Much Saving (what to do in a world with excess desired savings?) 1. Businesses Invest More: o Companies can use the savings to build new factories or products, but this only happens if they believe they can make a profit.  2. Consumers Spend More: o People need to save less and buy more goods and services. 3. Governments Invest More: o Governments can use savings to build infrastructure, create jobs, and stimulate the economy. Problems with European Policies 1. Monetary Policy: o The European Central Bank (ECB) didn’t print enough money to keep the economy growing. 2. Fiscal Policy: o There’s no single budget for all of Europe, so each country had to follow rules that required spending cuts (austerity). This reduced demand and slowed recovery. What Needs to Change? 1. Increase Spending: o Europe needs to spend more to boost demand. When there’s more demand, businesses will invest and create jobs. 2. Support Businesses: o Governments should create a stable economy, so companies feel confident investing. 3. Improve Productivity: o Structural reforms (like better training for workers or improving technology) can make economies stronger. We need more demand  The biggest challenge is low demand. Europe must spend more, invest in growth, and take responsibility for its role in the global economy.  Eurozone should assume more responsibility for sustaining domestic and global demand  If policymakers backstop demand, then businesses will invest and innovate  If structural reforms improve the supply side, all the better  But key challenge now is deficient demand THE FOREIGN EXCHANGE MARKET What Are Exchange Rates?  Definition: Exchange rates tell us how much one currency is worth compared to another. o Example: $1.20/€1 means 1 euro costs 1.20 U.S. dollars. Why Do Countries Exchange Currencies? Countries exchange currencies to: 1. Trade: Buying goods and services from other countries. 2. Invest: Purchasing assets (like property or stocks) in other countries. History of Exchange Rates 1. 1870s–1914: Gold Standard: o Each country’s currency was tied to gold. o Central banks stored gold to back their currency. o Example: $1 could be exchanged for a specific amount of gold. 2. 1914–1939:  oEvents like World War I and the Great Depression caused people to lose trust in currencies, leading to a preference for gold. But there wasn’t enough gold for everyone. 3. 1944–1973: Bretton Woods System: o Currencies were linked to the U.S. dollar, and the dollar was linked to gold. o Example: £1 = $4, and $1 = 1/35th of an ounce of gold. o New institutions, like the IMF and World Bank, were created to stabilize the global economy. 4. 1973 Onwards: Floating Exchange Rates: o Currencies are no longer tied to gold or another currency. o Their value depends on supply and demand in the foreign exchange market. Types of Exchange Rate Quotations  Direct Quotation: The price of the foreign currency in terms of the domestic currency (e.g., 1.20 USD/EUR).  Indirect Quotation: The price of the domestic currency in terms of the foreign currency (e.g., 0.83 EUR/USD). How Do Exchange Rates Work?  Depreciation: o When a currency loses value. o Example: If €1 changes from $1.20 to $1.10, the euro has depreciated. o Effect:  Exports become cheaper (good for businesses that sell abroad).  Imports become more expensive (bad for consumers buying foreign goods).  Appreciation: o When a currency gains value. o Example: If €1 changes from $1.20 to $1.30, the euro has appreciated. o Effect:  Exports become more expensive (harder to sell abroad).  Imports become cheaper (better for consumers). New communications networks mean that there can be no significant arbitrage opportunities. The dollar/euro exchange rate quoted in New York must be the same as the rate quoted in London. If not, an arbitrage trader would simultaneously buy a currency in one market and sell it in the other, making a riskless, guaranteed profit. Trade Volume in the Foreign Exchange Market  1989: $600 billion per year.  2001: $1.6 trillion per day.  2005: $2.4 trillion per day.  2020: $6 trillion per day.  Main reason: Improved communication networks, eliminating arbitrage opportunities. Participants in the Foreign Exchange Market 1. Commercial banks (account for most transactions). 2. International companies. 3. Non-bank financial institutions (pension funds, etc.).  4. Central banks. Factors Affecting Currency Supply and Demand Supply of a Currency: 1. Imports (purchasing foreign goods). 2. Outward foreign investment (purchasing foreign assets). 3. Central bank purchases of foreign reserves. Demand for a Currency: 1. Exports (foreigners need the domestic currency to buy goods). 2. Inward foreign investment (foreigners need the domestic currency to buy assets). 3. Central bank sales of foreign reserves. Practical Exercise  Example of euro supply and demand in terms of dollars: o Initial equilibrium exchange rate: 1.10 USD/EUR. o If Europe increases its imports from the US, demand for dollars increases, and the euro depreciates. o If Europe increases its exports to the US, demand for euros increases, and the euro appreciates. Relation to the Balance of Payments 1. Example: France buys a US car for $5000. o France must exchange euros for dollars, increasing the demand for dollars. o The US current account balance will be positive (+$5000). o According to the balance of payments:  If the current account is positive, the financial account will be negative.  This may cause a dollar appreciation, affecting US export competitiveness. Central Bank Intervention  Typically, central banks do not intervene directly.  However, they may intervene in specific cases to: 1. Avoid appreciation: Buy foreign assets, depreciating their currency. 2. Avoid depreciation: Sell foreign assets, appreciating their currency.  Note: A central bank can never run out of its own currency, but it can exhaust its foreign reserves. Example Question  Spain imports a mobile phone from China (100 euros, paid in dollars): 1. The demand curve for dollars shifts to the right. 2. Spain’s current account will show a deficit (negative balance). 3. Spain’s financial account will show a surplus (positive balance). The Foreign Exchange Market  This is where currencies are bought and sold. The value of currencies is determined by supply and demand. What Increases the Supply of a Currency? 1. Imports: If a country buys goods from another country, it sells its currency to buy the foreign currency. 2. Investing Abroad: Buying assets in another country requires selling your currency to buy theirs. 3. Central Bank Actions: A central bank might sell its currency to buy foreign currency. What Increases the Demand for a Currency? 1. Exports: Foreigners need your currency to buy your goods. 2. Foreign Investments: Foreigners buying assets in your country need your currency. 3. Central Bank Actions: A central bank might buy its currency, increasing its value. Practice Example: How Supply and Demand Affect Exchange Rates  Scenario 1: Europe increases imports from the U.S. o Europe sells euros to buy dollars. o This increases the supply of euros and demand for dollars. o Result: The euro depreciates, and the dollar appreciates.  Scenario 2: Europe exports more to the U.S. o Americans buy more euros to pay for European goods. o This increases the demand for euros and supply of dollars. o Result: The euro appreciates, and the dollar depreciates. Balance of Payments Example Imagine France buys a U.S. car for $5,000: 1. France needs dollars to pay, so it increases demand for the U.S. dollar. 2. This affects the Current Account (trade balance): o The U.S. has a surplus (it sold the car), and France has a deficit (it bought the car). 3. To balance this, the Financial Account must adjust: o Dollars earned by the U.S. are reinvested or saved, keeping the accounts balanced. What Influences Exchange Rates? 1. Trade: Countries that export a lot may see their currency appreciate due to demand. 2. Investments: High investment inflows (money coming into the country) can raise demand for a currency. 3. Central Bank Actions: o To depreciate a currency: The bank buys foreign assets, increasing the supply of its currency. o To appreciate a currency: The bank sells foreign assets, increasing the demand for its currency. Central Banks and Currency  Why Do Central Banks Intervene? o To control inflation, exports, or economic stability. o Example: China kept its currency low for years by selling it and buying foreign currencies to make Chinese goods cheaper.  Limitations: o Central banks can print unlimited domestic money to depreciate it.  o But they can run out of foreign reserves, limiting their ability to stop depreciation. Global Trade and Currency Movement  Why Does Currency Trading Matter? o The foreign exchange market is huge:  In 1989: $600 billion was traded daily.  By 2020: $6 trillion was traded daily. o Improved communication networks mean prices are the same across markets (e.g., New York and London). Key Takeaways 1. Exchange rates are influenced by supply, demand, trade, and investments. 2. Depreciation can boost exports but raise import costs, while appreciation does the opposite. 3. Central banks can intervene, but their power is limited by foreign reserves. 4. Currency markets are critical for global trade, with massive volumes traded daily. The Gold Standard It didn’t happen inflation, as the price was fixed. Is stable People lose faith in the bank function Before we had the Gold Standard monetary system, nowadays we have the Fiat money. Bank Runs People convert the money into gold. They throw out the money from the bank and buy gold. GLOBAL TRADE IN THE ERA OF DIGITALISATION AND AUTOMATION Automation: The use of machines and computers that operate without human control (e.g., robots in manufacturing). Reduce labor. Automation started with the invention of the wheel. Digitalization: The adoption of digital technology (e.g., the internet and software) for tasks like communication, production, music, films and service delivery. Historical Drivers of Globalization  Technological Advances: Innovations like railways, steamships, and telecommunication enhanced goods and services trade in the 20th century.  Comparative Advantage: o Based on David Ricardo's theory: Countries trade by focusing on goods/services they can produce efficiently. o Resources and capabilities determine trade patterns (e.g., technology-rich vs. raw-material-abundant nations). Changing Dynamics in Goods Trade Before Automation and Digitalization: In the second half of the 20th century, important developments have taken place that changed the geography of trade flows: o Lower transport costs o The easier to export capital was due to the reduce of protectionism (less taxes, tariffs…) and the gold standard. Monetary system, the national bank for every bank they issue they took a piece of gold of that bank. That system last until 1950.  Why are transport costs lower: o Lower transport costs (90% of goods transported by ships).  o Easier capital flows and reduced protectionism enabled industrial production to shift to low-wage regions. o Trade blocs and geographical proximity (think about the end of empires and integration of local markets) o Insurance costs lowered o Some automation of shipping  Low transport costs, the transferability of technology and capital and the availability of cheap labour in developing countries meant that a substantial share of industrial production was moved away from the developed world.  Around the millennium, the conventional wisdom seemed to be that developed countries need to specialise in skilled services as they cannot compete with the low wages in the developing world for industrial production but can exploit their advantage in the skill intensive provision of service. However, automation and digitalisation are starting to affect the relationship with the richer world and the other side (comparative advantage). What automation does it taken the labour out of that process. Means the production process requires less labour and more capital to invest. Post-Automation and Digitalization:  Reindustrialization in Developed Economies: o Theory that industrial production is returning to the developed world. Why? o Automation and Digitalisation offer increased proximity between production and consumption: o Automated machines can produce many goods. Therefore, labour costs are no longer decisive to determine the location of production. o Instead, other factors become more important. Time to market is probably the most important one, since most of the consumption of goods takes place mostly in developed economies. Changing Dynamics in Services Trade (digitalization of services)  Classical economics has argued that many services are globalisation proof – I probably wouldn’t choose to see a dentist in Barcelona if I was living in Wales. This has to do with the need for geographic proximity. Nevertheless, digitalization has allowed some services to be performed at a location a large geographical distance from where they are commissioned.  Digitization’s Impact: o Services like customer support and accountancy now outsourced globally (e.g., UK call centers in India). o Digital platforms reduce local monopolies, enhance competition, and allow consumers to access global markets. Risks and Challenges in Digital Trade Monopoly Risks:  High Initial Costs: Digital platforms often require significant upfront investments but have near-zero marginal costs, favoring large players.  Network Effects: Popular platforms grow more attractive as user bases expand, leading to "winner-takes-all" scenarios.  Information Asymmetry: o Companies use big data to implement personalized pricing. o Results in reduced consumer surplus and higher profits for providers. Effect on Consumers:  Higher prices due to monopolistic control.   Reduced market competition stifles innovation and cost reduction. Impact on Employment  Work without Workers? o Contrary to fears of mass unemployment, data-gathering platforms (e.g., Amazon Mechanical Turk) create low-paid digital labor. o These roles support critical tasks like algorithm training and data management. In Developing Countries:  Digital labor platforms expand opportunities but often lack fair wages and protections. Broader Implications for Globalization  Technologies Enhancing Globalization: o Advanced production methods and digital tools continue to integrate global markets. o Services globalization reduces regional barriers.  Challenges to Globalization: o Rising automation and geopolitical factors may limit outsourcing trends. o "Reindustrialization" could reduce the reliance of developed nations on developing economies for goods. Economic and Social Questions  Winners and Losers: o Developed economies may benefit from near-market production. o Developing countries risk losing manufacturing jobs but gain in digital service roles.  Ricardo’s Vision of Prosperity: o Digitalization challenges classical free-trade models. o While efficiencies increase, equity and wealth distribution become central concerns. TRADE AND PROTECTIONSIM  Free trade is a system without restrictions on imports or exports.  Ricardo’s Argument: Free trade benefits nations due to comparative advantage, where each country specializes in what it produces most efficiently.  Potential Problems: 1. Economic inequality between countries. 2. Loss of jobs in industries unable to compete with imports. 3. Environmental degradation due to relaxed regulations. WORLD TRADE ORGANIZATION (WTO)  Overview: The only global organization handling trade rules between nations.  Goals: o Ensure smooth, predictable, and free trade. o Create agreements negotiated and ratified by member nations.  Membership: o 164 countries are members. o Notable non-members: North Korea, Kosovo, and others.  Key Principles: o Non-discrimination, transparency, and promoting fair competition. PROTECTIONISM  Policies restricting international trade to protect domestic industries.  Rationale for Protectionism: 1. Job Protection: Safeguards local industries and prevents unemployment. 2. Infant Industries: Protects emerging sectors until they are competitive. 3. National Security: Protects vital industries like defense and technology. 4. Consumer Protection: Ensures imported goods meet safety and quality standards. Types of Protectionist Measures 1. Tariffs: Taxes on imports to raise their prices, making domestic goods more competitive. 2. Quotas: Direct limits on the quantity of goods that can be imported. 3. Subsidies: Government financial support to domestic producers to lower production costs. Examples  The Doha Round of WTO talks aimed at reducing trade barriers largely failed due to the US and UK’s refusal to cut agricultural subsidies. CASE STUDIES China vs. USA  Concerns: o US nervous about China’s rapid economic growth. o Trade imbalances and currency manipulation allegations.  China’s Economic Strategies: o Export-driven growth, currency intervention, and state-led policies. Mexico vs. Vietnam  Despite free trade agreements and proximity to the US, Mexico’s growth (~1% annually) has lagged behind Vietnam’s (~5% annually).  Vietnam’s Strategy: o “Doi Moi” reforms (1986): Combined state control with selective free- market policies. o Protected domestic industries while slowly integrating into global markets. ARGUMENTS FOR PROTECTIONISM 1. Job Protection: o Protects workers’ livelihoods and industries essential to national growth. o Prevents unemployment and the decline of GDP by safeguarding established industries. o Example Reference: Arthur Guarino’s The Economic Effects of Trade Protectionism (2018). 2. Infant Industry Argument: o Supports new industries until they can compete globally. o Helps developing nations diversify their economies.  oExample References:  William Ashworth’s Customs and Excise: Trade, Production, and Consumption in England, 1640–1845.  Arthur Guarino’s The Economic Effects of Trade Protectionism. 3. National Security: o Protects critical sectors like defense, communication (e.g., Huawei and 5G), and advanced electronics. o Ensures strategic self-reliance during conflicts. 4. Consumer Protection: o Protects against imported goods that don’t meet domestic standards (e.g., food regulations). o Example: Brexit and the “Bendy Bananas” controversy. DISADVANTAGES OF PROTECTIONISM 1. Domestic prices rise due to less competition. 2. Reduced consumer choice. 3. Slower technological progress. 4. Risk of government errors in selecting industries to protect: o May nurture uncompetitive industries. 5. Increased likelihood of retaliatory tariffs, reducing trade benefits. BIGGEST DANGER WITH PROTECTIONIST POLICIES? 1. High risk other countries will impose tarrifs on goods from your country. 2. This is turn will reduce the terms of trade, making it more expensive to import goods from other countries. 3. Risk that government is bad at choosing which industries to protect. What happens if they nurture a failure? 4. Home country may not have a large enough market support consumption levels. ECONOMIC IMPLICATIONS Terms of Trade (ToT)  Definition: The ratio of a country's export prices to its import prices.  Formula: (Export Prices/Import Prices)×100(Export Prices/Import Prices)×100.  Example: o Spain exports $100 worth of wine for $200 worth of beer. o Spain’s ToT = (100/200)×100=50%(100/200)×100=50%. Spain’s Trade Profile (1995-2022) Top Exports:  Cars: $34.5B.  Refined Petroleum: $12.3B.  Vehicle Parts: $10.6B.  Key Markets: France, Germany, Portugal, Italy, UK. Top Imports:  Crude Petroleum: $27.8B.  Cars: $21.6B.   Vehicle Parts: $13.2B.  Main Sources: Germany, France, China, Italy, Netherlands. EFFECTS OF TARIFFS ON SPAIN 1. Scenario 1: No Retaliation. o Spanish ToT improves. o Higher import costs encourage domestic production. o Global supply of affected goods rises, lowering world prices. 2. Scenario 2: Retaliation. o Spanish exports decrease. o Domestic industries in retaliating countries produce alternatives. o World prices fall, worsening Spain’s ToT. Case Study: Mexico vs. Vietnam Mexico:  Proximity to the US and a free trade agreement.  Significant foreign investment.  Longstanding WTO membership.  Growth: Barely ~1% annually. Vietnam:  Devastated by war (1955-1975) and a US trade embargo (lifted in 1994).  WTO membership since 2007.  Adopted "Doi Moi" reforms (1986): o Mixed state control with limited free-market policies. o Maintained tariffs on key sectors (energy, ICT, defense). o Gradual skill and technology development.  Growth: Around 5% annually, with poverty reduction and rising wages. Conclusion:  Vietnam’s tailored policies, including selective protectionism, outperformed Mexico’s liberal trade policies.  Reference: Economists like Ha-Joon Chang and Dani Rodrik argue for customized approaches over strict adherence to free-market principles. Comparison: Asia vs. Latin America  Asia: Embraced unorthodox strategies (e.g., China’s two-track system) and experienced rapid growth.  Latin America: Liberalized trade, privatized industries, and deregulated economies, yet grew slower. Example:  Senegal’s manufacturing sector was wiped out by foreign competition due to liberalization.