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Balance of Payments

The current account:
à Balance of trade in goods
à Balance of trade in services
à Net primary income
à Net secondary income
A Balance of payments deficit on the current account is financed by a surplus on the financial
account
The capital account:
à Sale/transfer of patents, copyrights, franchises, leases and other transferable contracts, e
...

international buying and selling of land by businesses
à Debt forgiveness/cancellation
à Capital transfers of ownership of fixed assets
The financial account:
§ Includes transactions that result in a change of ownership of financial assets and liabilities
between UK residents and non-residents
1
...
Net balance of portfolio investment flows, e
...
inflows/outflows of debt and equity
3
...
g
...
Changes to the value of reserves of gold and foreign currency
Causes of a current account deficit
1
...
Higher inflation than trading partners
b
...
Weaknesses in design, branding, product performance
2
...
High currency value increases prices of exports
b
...
Recession in one or more major trade partner countries - DEMAND
a
...
Might be barriers to switching to other markets, e
...
UK businesses struggles to sell
to emerging markets such as India, Vietnam, Mexico
4
...
Exporters of primary commodities might be hit by a fall in world prices
b
...

Consequences from a current account deficit
§ Loss of aggregate demand if there is a trade deficit, which causes weaker real GDP growth
and reduced living standards
§ Bug current account deficits will cause the currency to depreciate, leading to higher costpush inflation and a deterioration in the terms of trade
§ Can lead to a currency weakness and higher inflation and a country may run short of vital
foreign currency reserves
§ Trade deficit might be a reflection of lack of competitiveness/supply-side weaknesses in the
economy
§ Some countries running a current account deficit may choose to borrow to achieve a
financial account surplus - increase risks

§

Unsustainable current account deficits can ultimately lead to a loss of investor consequence,
leading to capital flight and a currency/balance of payments

Possible advantages to a deficit:
§ Short term boost to consumers living standards
§ Deficit might be due in part to increased demand for imported capital goods and new
technology - which improves LRAS
§ Deficit may be mainly cyclical - reflecting a period of strong demand/GDP growth
§ Provided that capital flows can finance a current account deficit, it shouldn’t be too much of
a problem
§ Current account surpluses are not always the sign of a healthy macro-economy, e
...

Germany and Japan
Problems arising from a persistent payments deficit:
§ Structural weakness
o May be a signal of a wider structural economic problem, e
...
loss of international
competitiveness in overseas markets
§ An unbalanced economy
o A large deficit in trade is typically the consequences of a very high level of consumer
spending contrasted with a weaker industrial sector
§ Potential loss of output and employment
o E
...
arising from falling production in export sectors and rising import penetration
§ Potential problems in financing a current account deficit
o Countries cannot always rely on inflows of financial capital into an economy to
finance a current account deficit
§ Downwards pressure on the exchange rate
o Threatens higher cost-push inflation from more expensive imports
Causes of a current account surplus
1
...
In these countries consumption could be higher and this would help to
rebalance trade
2
...
An export surplus may be the result of very high prices for exports of commodities such as
oil and gas
4
...


Fiscal Policy
Proportional taxes:
This has a fixed tax rate for all tax payers, regardless of income
Progressive taxes:
This has an increase in the average rate of tax as income increases
...
g
...
The collection cost must be low relative to the yield
2
...
The timing and way of paying must be convenient for the taxpayer
4
...

Disadvantages of flat tax rate:
- Regressive - unfair to low income households
- Income tax is a significant source of income to the government - progressive tax could earn
the government more money
- It can disproportionately benefit the rich
The budget position:
Budget surplus - tax receipts exceed expenditure
Budget deficit - expenditure exceeds tax receipts
Balanced budget - expenditure is equal to tax receipts
Budget deficits are financed by borrowing and can be reduced by cutting government expenditure
Problems with decreasing budget deficit:
• Higher taxes - disincentive effect
• Lower expenditure - lower economic growth, lower tax revenue etc
...
Government will increase spending or reduce taxes
...
They are triggered without government
intervention
...
g
...
This discourages spending
and investment among the private sector
...

Crowding in:
This occurs when government spending which is financed by debt and borrowing leads to an
increase in private investment
...
g
...
g
...
If these rise, then SRAS will shift to the left, raising
the price level from P1 to P2
...
g
...
g
...
g
...
g
...
Inflation Vs
...
Economic growth = inflation
b
...
Inflation Vs
...
Jobs are created in periods of high growth
b
...
the Phillips curve shows the trade of between the two
d
...
THIS IS A SHORT RUN CONCEPT - the long run curve is a vertical straight line as there
is no trade-off between the two

Deflation
Causes of deflation:
§ A large fall in aggregate demand
o External economic shocks
§ Global economic slowdown or recession leading to a fall in exports and
investment
§ A rise in the exchange rate - lower exports, cheaper imports
§ Declines in domestic and international asset prices
o Deliberate attempts to reduce AD by macroeconomic policy through tightening of
fiscal and/or monetary policy
§ An increase in long run aggregate supply
o Impact of rapid technological advances
o Higher productivity which drives down the unit cost of production
o Exploitation of economies of scale
o Excess supply due to over-investment in new capital machinery
§ An increase in short run aggregate supply
o Falling commodity prices, oil especially

Consequences of Deflation:
à Consumers may opt to postpone consumption if they expect prices to fall further
à Real value of household, corporate and government debt rises when the price level is falling
à Real interest rates will rise if nominal rates of interest do not fall in line with prices - another
factor driving spending lower
à Company profit margins come under pressure - leading to higher unemployment
à Falling asset prices hit personal sector financial wealth and confidence - leading to further
declines in aggregate demand
à Demand for notes and cons increases mainly for saving rather than transactions
Benign deflation:
If the falling prices are simply the result of improving technology or increased productivity
Malign deflation:
Prices fall due to a lack of demand
Policies to avoid deflation
1
...
Fiscal expansion through higher government spending and borrowing
b
...
Tax cuts may be announced as temporary
d
...
Consequences for national debt
ii
...
Might stoke up some inflationary pressure if too much stimulus is applied
for too long
2
...
Cuts in nominal interest rates and/or quantitative easing to stimulate the demand
for money
b
...
If confidence is low the impact is small
ii
...
The higher real value of debt encourages saving

The Financial Sector
How does the financial sector work?
SAVERS AND LENDERS:
• Households
• Firms
• Government
SUPPLY FUNDS

FINCNCIAL INTERMEDIARIES:
• Banks
• Building Societies
• Pension Funds
• Insurance Companies
• Hedge Funds

INVESTORS/BORROWERS:
• Firms
• Household
• Government
DEMAND FUNDS

FINCNCIAL MARKETS:
• Capital markets stock markets
• Money markets
• Foreign exchange
markets

Roles of Financial Intermediaries:
• Channel savings into investment
• Transform risky investments into safer opportunities for saving (diversifying investments)
• Transform short-term saving facilities into long term loans to households and firms
Further roles of banks:
• Provide an expertise on investment and saving opportunities
• Provide a payments mechanism
UK Financial Sector:
• Benefits from external economies of scale
o In the city - banks share a pool of skilled labour
o Makes the UK banks more competitive
• Have the ability to trade with NA and Asia due to its location regarding tie zones
Principle of the loan:
The original amount lent
ASSET is something you own, LIABILITY is something you owe

Secured loan:
Collateral is offered in case you do not pay, e
...
mortgage

Unsecured loan:
When no collateral is offered - tend to have a higher rate of interest as they are riskier, e
...
creditcard, personal loans

Liabilities - financial claims by customers on a bank (money a bank owes)
Assets - financial claims by a bank on its customers (things a bank owns)
Liquidity - the ability to change assets into cash
Asset
Cash
Balances at central bank
Money at call at short notice - interbank lending
Financial investments
Loans
Mortgages
Fixed assets - property

Liability
Deposits from customers
Short term borrowing
Long term borrowing
Reserves - retained profit
Share capital

Banking trade off:
There is no profit in liquidity
If banks make too many risky loans the value of their assets will fall
Insolvency:
ASSETS < LIABILITIES - the central bank will not act as a lender of last resort
to an insolvent bank
Money

SECURITY - risk of
losing money

PROFITABILITY

LIQUIDITY closeness to
cash

Roles of money:
1
...
Store of value
3
...
Standard of deferred payment
Narrow money - cash
Broad money - bank deposits (retail sight and time deposits, wholesale sight and time deposits),
banks reserves help at the Bank of England
MZM - Current spending
M4 - Broad money (notes, coins, bank deposits, repos, securities held for less than 5 years)
M4ex - M4 minus bank deposits of Intermediate Other Financial Corporations
Money Creation:
New loans increase the money supply because they are matched by new deposits; but repayments
of loans reduce the money supply as repayments is matched by fall in deposits
- Issue more loans
- Banks could sell more shares
- Central bank may buy bonds from households and credit their accounts with deposits
In a recession - expectations of deflation (pay back loans - threat of unemployment, deflation will
increase the size of the debt)
This will decrease AD due to a decrease in the money supply
QE - increases the money supply in order to prevent deflation and boost economic growth
The banks face 2 types of risk here:
• Liquidity o Banks attract short term deposits but lend for longer time periods

This means the bank may not be able to repay all of the deposits
To reduce liquidity risk, banks try to attract longer term deposits and hold some
liquid assets
• Credit risk o The risk to the commercial bank of lending to borrowers who cannot repay their
loan
o Can be controlled by:
§ Proper research into credit-worthiness of borrowers
§ Prudential regulation - the size banks must hold back in case of bad debts
Limits to credit creation:
o
o

-

Monetary policy - the level of interest rates influences the aggregate demand for loans
Market forces - the scale of profitable lending opportunities
Banks becoming more credit risk averse
Behaviour of businesses and consumers - decisions about how much debt to repay, in
recessions especially they will not want to take on new loans
Regulatory policies - capital reserve requirements

Liquidity Preference:
The idea of needing cash as money, as it is most liquid
The demand for money:
- The demand for money is determined by:
o Income:
§ The higher the level of income, the greater the demand for money
§ Due to higher spending
o The rate of interest:
§ The higher the rate of interest, the greater the opportunity cost of holding
money
§ The higher the rate of interest, the lower the demand for money will be
Increase in demand due to an increase in income
At high interest rates:
P of bonds and shares = low, therefore high return
At low interest rates:
P of bonds and shares = high, therefore low return
The liquidity preference is horizontal at low rates of
interest as households as it is not worth keeping
money in savings so they keep it in cash from
Bond Yields:
A bond has a fixed amount of interest, e
...
£50
% rate of interest = (interest ÷ P of bond) x 100
high prices = 50 ÷ 5000 = 1%
low prices = 50 ÷ 2500 = 2%
Determining the rate of interest:
The interest rate is the price of money

There are 3 motives to hold money:
1
...
Precautionary - to finance unexpected events INELASTIC
3
...

However, the central bank could choose to increase the
money supply and allow the rate of interest to remain the
same
(Bank of England can increase the money supply after an
increase in demand if they want to keep interest rates low)
the central bank can alter bank rate or money supply - NOT
BOTH
Loanable funds theory:
- The rate of interest is determined by investment and saving in an
economy
- The equilibrium rate of interest is fixed where the level of savings is
equal to the level of investment
This is good in a simple economy BUT in a modern economy, it is much more
complicated
...
g
...
g
...

3-10%
lowest

Interbank lending
This is a form of short term lending between banks
It exists to manage liquidity and keep output and transactions happening
It assumes that banks are SOLVENT, but they may temporarily run out of liquidity
The interest rate between these banks is known as LIBOR or the overnight rate
LIBOR is usually close to but above the banks rate - during the financial crash, the interbank lending
ceased to happen due to banks being unwilling to lend to each other (LIBOR was >1%)
The Central Bank
It is a public institution that manages the currency of a country or group of countries and controls
the money supply
...

• Operate monetary policy:
o Set base rate and confirm QE
o Maintains the money market

•

o It can either be independent, or reaching a target set by government
Exchange rate policy
o Manage country’s foreign currency reserves etc
...
g
...
Central bank acts in the LONG RUN
+ Public may have more confidence in the central bank - more expertise
...

o Because banks only keep a small percentage of total deposits as cash, a bank run can
quickly drain a bank's liquidity
o In a situation in which a bank's reserves fail to prevent a bank run, a lender of last
resort can inject it with funds in an emergency so that customers seeking
withdrawals can receive their money without creating a bank run that pushes the
institution into insolvency
+ Helps to reduce impact of financial instability
Disadvantages of a central bank acting as the LOLR
- Moral Hazard - ambiguity of terms encouraged banks to take risks and believe they were
‘too big to fail’
- Banks may have insufficient liquidity so instability is more likely
- Unfair? Should financial companies be saved but not non-financial firms?

Inflation targeting:
This is when the government set a target, e
...
2%
Central bank then runs monetary policy to achieve the target
Symmetric targeting:
Where the central bank takes action if inflation is either above or below target, e
...
UK +/- 2%
Asymmetric targeting:
When the central bank only has an upper limit to its target, e
...
ECB close but below 2%
If inflation is expected to be above target, raise interest rates and/or reduce money supply - cut AD
using contractionary monetary policy
If inflation is expected to be below target, cut interest rates and/or increase money supply - raise AD
using expansionary monetary policy
A central bank would decrease the money supply by selling short-term securities
If the central bank has a sufficiently credible commitment to price stability, economic agents will
take their price and wage setting decisions in the expectation that their target will be hit
Advantages of a central bank targeting the inflation target:
+ Certainty/clarity of focus of policy
+ Helps to manage inflation expectations
+ No political meddling
+ General historical success and widely used in developed economies
Disadvantages of a central bank targeting the inflation target:
- Lack of flexibility - if inflation is focus, then monetary policy may not be used for
employment (need to choose their priorities)
- Accountability
- The historical success may just be luck
This all depends on:
§ Credibility of the central bank
§ Success - builds confidence and trust
§ Macro-stability
§ Depends on how the banks mandate is written
The Quantity Theory of Money
This describes how a change in the supply of money affects the price level and so can cause inflation
MV = PY
M = money supply
V = velocity of circulation - usually about 7 and very stable
P = price level
Y = output - usually very stable in the short run
PY = Nominal GDP/SRAS
If V and Y are constant, we get the equation ∆M = ∆P, thus showing that increasing the money
supply will result in inflation

Implications:
§ ∆M = ∆P
§ ∆M - ∆Y = ∆P
§ If demand increases but supply does not, you will get rising prices due to excess demand,
and thus inflation
§ Increases in the money supply go to the economic agents, thus meaning they have more to
spend - INFLATION IS DEMAND-PULL
Policy Implications:
§ The policy - track and control the growth of the money supply relative to output
§ Used in the 80’s but didn’t work - how to define and measure MS?, banks got around
regulation etc
...
In reality, there are many different
measures and types of money
§ The economy must have these characteristics:
o An exogenous money supply
o Full or near full employment
o High capacity utilization
o Relatively closed to trade
o Stable velocity of circulation
However, there has never been a hyperinflation without the MS being significantly increased suggests that QE could lead to hyperinflation

Monetary Policy
There could be a conflict with other macroeconomic objectives, such as economic growth and
employment
...
They do this by
manipulating interest rates and using quantitative easing
...

Interest rates
When interest rates are high, the reward for saving is high, and the cost of borrowing is higher
...
This is
used to stimulate aggregate demand and thus boost economic growth
If there is no other way to increase the supply of liquidity, the Bank of England will step in as it is
known as the lender of last resort
Quantitative Easing:
It is used when inflation is low, but interest rates cannot be lowered any further
• The bank bought assets in the form of government bonds using the money they have
created
...

• The scale of quantitative easing could make it impossible to sell bonds back to the market
and this will damage the UK’s ability to borrow in the future
Limitations of monetary policy:
• Banks might not pass the base rate onto consumers, which means that even if the central
bank changes the interest rate, it might not have the intended effect
• Even if the cost of borrowing is low, consumers might be unable to borrow because banks
are unwilling to lend
• Interest rates will be more effective at stimulating spending and investment when consumer
and firm confidence is high
...


The Liquidity Trap

The diagram shows a liquidity trap
...

This means monetary policy cannot be used to influence
consumption and investment
...

It increases the quantity or quality of the factors of production
Education:
Why?
• lowers costs for firms as they will have to train fewer workers
• improves the quality of labour resulting in a more productive workforce
• increases the potential output of an economy
How?
• government could subsidise training or spend more on education
• improving access to training and education, it becomes more convenient for people to
improve their skills
But…
• time lags
• quality of training
• regional unemployment - may not be jobs available
Tax Reforms:
How?
• provide incentives to help stimulate factor output
• lower income tax will act as an incentive for unemployed workers to join the labour market,
or for existing workers to work harder
• lower corporation tax provides an incentive for entrepreneurs to start and so increase
national output
But…
• impacts on equality
• poverty trap
Labour Market Flexibility:
Why?
• seek to make the British labour market more flexible
• reduces the risk of structural unemployment
How?
• increased spending on education and training
• improved partnerships between trade unions and employers - increase productivity and
improve flexibility that workers have in their jobs
• (BASICALLY = MORE ZERO HOURS CONTRACTS ETC
...

• increased efficiency à increased output
But…
• short term unemployment risks
most privatisations have already happened

Trade

Trade will:
§ Increase the variety of goods available
§ Improve the standard of living as more can be consumed more cheaply
§ Improve efficiency etc
...

This means they have to give up producing less of another good than another country, using the
same resources
As long as there is a difference in the opportunity cost of producing the 2 goods, both countries can
benefit from trade and specialisation
To find the comparative advantage:
1
...
Compare the opportunity costs of each country
OTHER GOES OVER
Cars
Opportunity cost of car
Brazil
30
6/30 = 0
...
75 planes
(P of trade - cars: 0
...
75, planes: 1
...
3 cars

Output before trade:
Brazil (at mid-point): 15 cars, 3 planes = 18
UK (at mid-point): 12 cars, 9 planes = 21
Total = 39
Output after trade:
Brazil: 30 cars
UK: 18 planes
Total = 48
Exchange Rate matters
Trade allows a country to consume beyond its PPF, - the purpose of trade is to import
Criticisms of comparative advantage theory:
§ It may overstate the benefits of specialisation - it ignores costs such as:
o Transport
o Sea/air pollution
§ It assumes markets are perfectly competitive
o Especially: thinking there is perfect mobility of factors without any diminishing
returns
§ Complete specialisation may create unemployment as workers cannot transfer between
sectors

§
§
§
§
§

Relative prices and exchange rates are not taken into account
Comparative advantage may change over time, e
...
non-renewable resources can run out
Many countries strive for food security - even if they specialise in non-food products, they
should keep some food in case of emergency
The theory is derived from a highly simplistic two-good trade model - reality is far more
complex
According to Krugman - economies of scale means that may countries can produce very
cheaply ∴ countries produce a large variety of products

Overall the theory of comparative advantage is still slightly relevant, but becoming less so due to
globalisation
Terms of trade:
This is an index that shows the value of a country’s average export prices relative to their average
import prices
(weighted index of average export prices) ÷ (weighted index of average import prices) x 100
What determines TOT?
§ The strength and demand for exports from and imports to a country:
o This depends on D & S - higher demand for X
The use of terms of trade is to examine how a country’s buying power in the world has changed over
time
If the terms of trade increase in value, there is an IMPROVEMENT:
§ increase S of living as can buy more
§ stops cost-push inflation - indicates falling import prices relative to export prices
§ decrease in competitiveness
§ worsening balance of payments
If the terms of trade decrease in value, there is a DETERIORATION:
§ increase our competitiveness
§ we need to export more to purchase a given quantity of imports
§ it helps our current account
Improvement in TOT:
§ Increase in exports:
o Consumption
o Investment - if profits increase
o Taste
o Demand for imports
o Increase in the price of substitutes
o Complimentary goods
§ Higher export prices, caused by domestic inflation:
o If PED is elastic, it will lead to a larger decrease in demand
o This leads to an increase in the balance of payments
o Most exports become price elastic in the LR
Changes in the TOT:
§ Income: LR
o Higher income (MEDC) = increased demand for imports
§ Increase in productivity/technology: LR

§
§
§

o Lower C of P à Lower P of exports à Lower TOT à increased competitiveness
Demand for exports from and imports to a country: SR
Exchange rate changes:
o Appreciation can reduce cost push inflation - TOT improve
Relative inflation rates:
o If UK inflation > German inflation, P of UK imports rise faster and TOT improve

Heckscher Ohlin
Countries have different factor endowments
...

Countries will tend to specialise in and then export products which intensively use the factors in
which it is best endowed, and import the other good
e
...
US is capital abundant, China is labour abundant
The US will produce capital intensive goods and China will produce labour intensive
Criticisms:
§ Poor predictive power - not always true
§ Identical product function o This assumes all production functions are identical for all countries
o In reality - countries have different technology
§ Capital as endowment:
o Capital is not an endowment - it is a production power accumulated by previous
investment
§ No unemployment
Krugman - New Trade Theory
§
§
§

Explains why large countries trade with large countries
In some industries, two countries have no differences in opportunity cost
But, if one country specialises in a particular industry then it may gain economies of scale
and other network benefits from its specialisation
...

This means that in these global industries with very large economies of scale, there is likely to be
limited competition, with the market dominated by early firms who entered, leading to a form of
monopolistic competition
...
It explains why countries can both
export and import designer clothes
...
Therefore, being the first firm to reach industrial
maturity gives a very strong competitive advantage
...

International Competitiveness
Problems with policies used to increase competitiveness:
§ If import penetration grows it implies a firm will be losing competitiveness anyway
§ Cause and effect - increased competitiveness = increased growth (R&D)
§ Supply side policies should ensure that companies have the incentives to increase
productivity
§ Depreciation can cause companies with high import prices to become uncompetitive
§ Depreciating the ER will help domestic producers IF there are domestic producers
§ An efficient supply side is necessary - this causes unemployed people to try and find jobs



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