A2 Macro: Balance of Payments and Exchange Rates

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All exam boards require candidates to have an understanding of the Balance of Payments and Exchange Rates. In this session we will focus on the causes of the UK’s Balance of Trade (aka Current Account) deficit, what we can do about it, and how an exchange rate depreciation
should affect an economy, and has affected the UK post financial crisis.

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A2 Macro: Balance of Payments and Exchange Rates

  1. 1. The Balance of Payments (BOP) • A record of all financial transactions between the UK and rest of the world The Current Account + Financial Account + FX Reserves The current account Financial account FX reserves Trade in goods (visibles) Trade in services (invisibles) Trade balance (X-M) Net factor income from abroad Net unilateral transfers Portfolio capital flows (e.g. buying/selling of govt debt) Direct capital flows (FDI)
  2. 2. The Basics • An export refers to a UK PRODUCED good or service being sold overseas. This results in an INFLOW of money TO the UK economy and is a CREDIT on the UK Current Account which ADDS to UK GDP. • An import refers to an OVERSEAS PRODUCED good or service being purchased by UK consumers or firms. This results in an OUTFLOW of money FROM the UK economy and is a DEBIT on the UK Current Account which REDUCES UK GDP. • A Balance of Trade SURPLUS occurs when the VALUE of EXPORTS exceeds the VALUE of IMPORTS
  3. 3. The Basics • An export refers to a UK PRODUCED good or service being sold overseas. This results in an INFLOW of money TO the UK economy and is a CREDIT on the UK Current Account which ADDS to UK GDP. • An import refers to an OVERSEAS PRODUCED good or service being purchased by UK consumers or firms. This results in an OUTFOW of money FROM the UK economy and is a DEBIT on the UK Current Account which REDUCES UK GDP. • A Balance of Trade SURPLUS occurs when the VALUE of EXPORTS exceeds the VALUE of IMPORTS
  4. 4. Precise terminology is key: – “The Balance of Payments is exports minus imports and is a deficit”……WRONG, VAGUE VALUE not QUANTITY… – “The Trade Balance is a component of the Current Account of the Balance of Payments. It is calculated by the value of exports minus the value of imports. The UK's Current Account balance is approximately -£60bn, of which -£32bn is accounted for by the Trade Balance.”…CORRECT, CLEAR!
  5. 5. What fits where in the UK Balance of Payments Current Account? David Cameron buys a Mercedes Import, Debit, Trade in Goods UK government provides aid to Syria US citizen flies to the UK on British Airways Wealthy UK landlord income on property he rents out in Spain Austrian hotel buys a Dyson vacuum cleaner Import, Debit, Transfers Export, Credit, Trade in Services Export, Credit, Net Investment/Factor Income Export, Credit, Trade in Goods Import: Money flows OUT; Export: Money flows IN Import: Debit; Export: Credit
  6. 6. Explain 4 reasons why the UK runs a current account deficit Exam Tips: • This is an ‘explain’ question which is common across exam boards. • Marks are awarded for definitions, analysis and sometimes application (if there is data) and knowledge…if it is relevant - check your syllabus!! • THIS DOES NOT REQUIRE EVALUATION OR A CONCLUSION • The answers should use a logical chain of progression
  7. 7. Explain 4 reasons why the UK runs a BOP deficit on current account 1. Supply-side deficiencies impacting on price and non-price competitiveness of UK products Productivity gap… low Investment… Feeds through to low R&D… and low innovation… Lacking new areas of comparative advantage / dynamic inefficiency Vs Germany/US
  8. 8. Explain 4 reasons why the UK runs a BOP deficit on current account
  9. 9. Poor productivity and lack of innovation……….. Price level Real GDP and employment AD YIDEAL P P1 LRAS1LRAS Y LRAS2 Over a 10 year period, the UK has failed to deliver the productivity and innovation improvements that would aid growth and allow us to compete and hence sell more exports……P2 YUK
  10. 10. Other causes of the UK Current Account deficit High levels of disposable income ‘sucks in’ imports High labour costs and EU regulation inc H&S Strong Exchange Rate Marginal Propensity to Import NMW; Bureaucracy; Red-tape Historically strong on a trade- weighted basis
  11. 11. Evaluate effectiveness of policies to reduce a deficit on the Current Account
  12. 12. Evaluate the effectiveness of policies to reduce the UK Balance of Trade deficit Deflate the economy….really? Imports depend on the level of income… EXPENDITURE REDUCING POLICIES… CONRACTIONARY MP/FP Reduce disposable income… Reduces MPM E.g. foreign cars/holidays… BUT… has consequences…
  13. 13. Effects of deflating the economy Price level Real GDP and employment AD Y P P1 AD1 AS Y1 UNINTENDED CONSEQUENCES CONFLICT OF MACROECONOMIC OBJECTIVES PRIORITISATION
  14. 14. Overt Protectionism… Evaluate the effectiveness of policies to reduce the UK Balance of Trade deficit Tariffs are taxes on imports… Raise the price of imports… Some expenditure-SWITCHING… Value of M should fall (X-M) rises, current account rises…Back it up with a DIAGRAM
  15. 15. Tariff Price Quantity Domestic demand P Q No trade Domestic supply
  16. 16. Price Quantity Domestic demand P Q Domestic supply World P QdQs IMPORTS Too many imports: QD>QS Tariff
  17. 17. Tariff Price Quantity Domestic demand P Domestic supply World P Qs World P+Tariff Qs1 QdQd1 Govt tax revenue… Inflationary pressure… Domestic industry benefits… Allocative efficiency lost…
  18. 18. Retaliation… EU Customs union… WTO…
  19. 19. PM rises in domestic currency terms Currency depreciates PX falls in foreign currency terms XD rises Value of X rises Trade balance increases MD falls Value of M falls Depreciation of the exchange rate….
  20. 20. MARSHALL-LERNER CONDITION PM rises in domestic currency terms Currency depreciates PX falls in foreign currency terms XD rises Value of X rises Trade balance increases MD falls Value of M falls If Price X falls; and Demand for X rises; for VALUE of X to RISE; need demand for X to be ELASTIC If Price M rises; and Demand for M falls; for VALUE of M to FALL; need demand for M to be ELASTIC In SHORT RUN however, Demand for X and M is likely to be INELASTIC Marshall-Lerner condition: if PED of exports + the PED for imports > 1, a depreciation will help resolve a trade deficit
  21. 21. Reasons for a possible Low price elasticity of demand for exports Low price elasticity of demand for imports Supply constraints for exporters Long-term contracts Wait-and-see approach
  22. 22. Cheaper pound – a boost to competitiveness of UK economy Non-price factors Global supply chains Financial sector Import intensity Overseas
  23. 23. Currency Wars Brazil Peru Colombia Korea South Africa Russia Switzerland Japan U.S Chile
  24. 24. Discuss the view that a depreciation is always beneficial to an economy • Exam tips: – Strategy: ‘build up a case with theory (analysis) and then knock it down (analysis and evaluation)!! – Use examples – Remember to address: ‘to whom’ is depreciation beneficial and the word ‘always’ Try to spot key words in the question that can help your evaluation…
  25. 25. Positive effects of a depreciation •Exports Increase •Growth and job creation
  26. 26. The Theory………Export led growth Price level Real GDP and employment AD Y1 P2 P1 AS AD 1 Y2 Stimulates exports, injection into CFoY, higher AD Derived demand Positive multipliers
  27. 27. Negative effects of a depreciation INFLATIONARY PRESSURES Demand-pull inflation… Cost-push inflation…
  28. 28. The reality……….Imported Inflation Price level Real GDP and employment AD Y1 P2 P1 AS AS 1 Y2 Value judgement: Likelihood? Undesirability?
  29. 29. Currency depreciation can harm inflation objectives…

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