2.5 Balance of Payments 1.pdf

2.5 The Balance of Payments 1 YEAR 12 MACROECONOMICS 2023-24 There has been a huge increase in the amount of international trade, especially since WW2. The value of global exports is now more than 30 times what it was in 1950. World trade has grown more than proportionately with GDP – in some countr...

2.5 The Balance of Payments 1 YEAR 12 MACROECONOMICS 2023-24 There has been a huge increase in the amount of international trade, especially since WW2. The value of global exports is now more than 30 times what it was in 1950. World trade has grown more than proportionately with GDP – in some countries, the value of exports to GDP ratio is significantly higher than the world average. Balance of Payments (2.5) Why countries trade (4.1) Exchange Rates (4.2) International Globalisation (4.3) TRADE Protectionism or Integration (4.1, 4.4) Definitions and Measurements Definition The balance of payments (BoP) records all economic transactions between residents of an economy and the rest of the world. The Balance of Payments is a system of accounts in which many ‘balances’ can be derived, such as the balance of trade in goods and services, the current account balance, and the capital and financial account balance. The BoP should balance overall, with the current account balance being offset by the financial and capital account balance. There is also a ‘balancing item’ called ‘net errors and omissions’ which ensures that the BoP is indeed balanced. Components of the Balance of Payments Current Account: covers trade in goods and services, as well as net primary (stream of income from existing foreign assets, such as rent, interest, dividends) and net secondary income (transfers, which are one-way flows). Financial Account: covers transactions that result in a change in ownership of financial assets and liabilities between UK residents and foreign residents. This includes net FDI, net portfolio investment (debt and equity), banking flows (‘hot money’), and changes in gold and foreign currency reserves. Capital Account (we will not study this): covers sale/purchase of non-produced, nonfinancial assets such as patents, copyrights, leases, franchises. https://www.tutor2u.net/economics/reference/balance-of-payments-the-financialaccount Current Account or Financial Account for the UK? ØTesco buys green beans from Zambia ØI go on holiday to Chicago ØJack gets monthly rent from a property he owns in Chicago ØI earn interest from my savings account in India ØHearing that the Reserve Bank of India will lower interest rates, I decide to move my money back to the UK ØToyota opens a new factory in the UK ØAlex sends money from the UK to South Africa to help her sister go to university Components of the Current Account The BoP Current Account records all income flows from international trade in goods and services, primary income (investment income) and secondary income (transfers). 1. Trade balance: a measure of net international trade in goods and services. The trade balance records the total value of exports minus the total value of imports. Exports: credit item on the current account (money flowing in) Imports: debit item on the current account (money flowing out) If value of exports > value of imports, there is a trade surplus. If value of exports < value of imports, there is a trade deficit. Components of the Current Account 2. Primary Income (investment income) balance: this is the difference between total earnings received by domestic residents from assets located outside the domestic economy and the total income paid out to foreign owners of assets located in the domestic economy. Examples: rent on foreign property, interest payments from foreign bank accounts, dividend payments from foreign financial assets. 3. Secondary Income (transfers) balance: net balance on one-way transfers into and out of the domestic economy. Examples: foreign aid, membership dues to international organisations, remittances sent by individuals to relatives overseas, social security payments abroad. The Current Account balance Money earned by domestic residents and flowing into the country counts as a credit item, while money flowing out to foreigners counts as a debit item. There is a current account (CA) surplus if: Trade Balance + Net primary and secondary income balance > 0 This means that more money is flowing into the country from trade in goods and services, as well as primary income and secondary income, than is flowing out. Similarly, there is a current account (CA) deficit if: Trade Balance + Net primary and secondary income balance < 0 Note that it is not enough to simply look at exports and imports in order to determine the CA balance. Source: ONS Note that the UK current account is normally in deficit. Between 1999 Q1 and 2019 Q4, there was only one quarter where the current account was in surplus. UK Current Account Balance of payments, UK Office for National Statistics (ons.gov.uk) UK Trade Balance (part of the Current Account) UK Primary Income (part of the Current Account) The Financial Account The financial account looks at the domestic ownership of foreign assets (e.g. UK residents holding foreign bank accounts or shares in foreign companies), as well as foreign ownership of domestic assets (e.g. foreigners owning UK government bonds or holding UK bank accounts). A current account deficit places the UK as a net borrower with the rest of the world, indicating that overall expenditure in the UK exceeds national income. The UK is consuming more than is producing. The UK must attract net financial inflows to finance its current account deficit. This can be achieved through either selling some of UK’s foreign assets or accruing liabilities with (borrowing from) the rest of the world. UK Financial Account Can’t balance your balance of payments? Chalk it up to net errors and omissions! Factors influencing the current account 1. Economic activity in the domestic economy Increasing economic activity in the domestic economy is likely to increase the demand for imports, reducing net exports (X-M). This is because higher income for domestic households, firms and government, is likely to increase aggregate demand, some of which will be satisfied through the purchase of imports. This will worsen the trade balance and is also expected to lead to an increase in a current account (CA) deficit (or a fall in a CA surplus, or turn a CA surplus to CA deficit). Similarly, Falling economic activity in the domestic economy is likely to ______________. This is because ___________________________________________________. This will improve the trade balance and _______________________________. Current account deficits – Chains of Reasoning | tutor2u 2. Economic activity in other countries Increasing economic activity in other countries is likely to increase the demand for exports, increasing net exports (X-M). This is because a higher income for foreign households, firms and government, is likely to increase external demand, increasing the total value of exports. This will improve the trade balance and is expected to lead to a fall in the CA deficit (or increase a CA surplus; or turn a CA deficit to CA surplus). Similarly, Falling economic activity in other countries is likely to ____________________. This is because ____________________________________________________. This will worsen the trade balance and _________________________________. 3. Inflation rate in the domestic economy ØA relatively low domestic rate of inflation is likely to increase the relative pricecompetitiveness of domestically-produced goods and services. ØIf prices of domestically-produced goods and services rise slower than prices of goods and services produced in other economies, there should be an increase in demand for exports and a fall in demand for imports. ØThe total value of exports should increase, and the total value of imports should fall; thus, the balance of trade should improve. ØA low rate of domestic inflation should lead to a fall in a current account deficit (or increase a CA surplus; or turn a CA deficit to CA surplus). Can you write a similar chain of reasoning for how a relatively high domestic rate of inflation affects the CA balance? 4. Productivity growth in the domestic economy ØHigher productivity growth in the domestic economy is likely to increase the relative price-competitiveness of domestically produced goods over time. ØAs average costs of domestic production fall relative to foreign production, domestic goods should become more price-competitive. ØThere should be an increase in demand for exports and a fall in demand for imports. The total value of exports should increase and the total value of imports should fall. Thus, the balance of trade should improve. ØTherefore, rising productivity growth in the domestic economy should lead to a fall in a current account deficit (or increase a CA surplus, or turn a CA deficit to CA surplus). How does low productivity growth in the domestic economy affect the CA? Current account deficits – Chains of Reasoning | tutor2u 5. The exchange rate The exchange rate is the price of one currency in terms of another currency (or currencies). In this case, we can think of it as the price of domestic currency in terms of foreign currency; for example, what is the price of £1 in US dollars or euros? We will talk about this in Section 4.2. A fall (depreciation) in the exchange rate is likely to increase the relative pricecompetitiveness of domestically produced goods for foreign buyers, as less foreign currency is required to buy goods priced in domestic currency. This should lead to an increase in demand for exports and fall in demand for imports (as prices of imports also rise for domestic buyers). There should be an increase in net exports (X-M)1, leading to a fall in a current account deficit or increase a CA surplus (or turn a CA deficit to CA surplus). 1Whether or not this happens depends on the price elasticity of demand for exports and imports and whether or not the Marshall-Lerner condition holds (Section 4.2) Current account deficits – Chains of Reasoning | tutor2u