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Unit 4
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7 and 4
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5-4
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5 Balance of payments
• Current account
>>balance of trade
>>invisible balance
• Capital account

Blog posts "Balance of trade"

Blog posts: "Current account"

4
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8 Terms of trade
• Definition of terms of trade
• Consequences of a change in the terms of trade for a country's bop and its domestic economy
>>The significance of deteriorating terms of trade for developing countries
Higher level extension topics
• Measurement of terms of trade
• Causes of changes in a country's terms of trade in the short-run and long-run
• Elasticity of demand for imports and exports

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Unit 4
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These transactions include merchandise exports and imports, tourist
expenditures, and the sale and purchase of financial and real assets abroad,
including stocks, real estate, government bonds, etc
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welkerswikinomics
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8 Balance of Payments

Balance of Payments
the Current Account

The current account summarizes a country's trade in currently produced goods and
services
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It measures the is the difference between a country's
expenditures on imports and its income from exports of goods and services
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• If a country spends more on imports than it earns from exports, it is said
to have a "current account deficit" or a "trade deficit"
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For example: US expenditures on laptop computers made in Taiwan count towards a deficit
in the US current account
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Taiwan's expenditures on airplanes made in the US count towards a deficit in Taiwan's
current account
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welkerswikinomics
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8 Balance of Payments

Balance of Payments
the Current Account

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What does it tell you about trade between the
US and China
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Source: http://www
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biz/foreign-trade/balance/c5700
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welkerswikinomics
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Balance of Payments
the Current Account

BoP Case Study: Examine the image below
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Source: http://en
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org/wiki/Balance_of_payments

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Americans investors want to save in
Europe, Demand for euros increases and euro appreciates
2) Strong Euro causes Europeans to demand more American goods, Americans demand fewer
European goods, shifting the US towards BoP surplus, the EU towards deficit
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Equilibrium exchange rate of $1
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4) The appreciation of the dollar resulting from new demand for American goods reduces the
incentive for Europeans to buy American, shifting the US towards a BoP deficit and the EU
towards a surplus, restoring balanced trade between the US and Europe
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6

Market for Dollar in the Europe after
increase in D for US goods
∈/$

S$


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welkerswikinomics
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8 Balance of Payments

Balance of Payments
and Floating Exchange Rates

Floating exchange rate system:

• Definition: When a country leaves the value of its currency up to the free market
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Flexible rates should automatically correct any imbalance in the balance of payments
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welkerswikinomics
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Supply of $ increases, demand
decreases, depreciating the US$

As depreciation occurs, prices for goods and
services from the US become more attractive and
the demand for them will rise
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 The current account deficit reached $225 billion in the fourth quarter of 
2005, up from $185
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 For the year 2005 the deficit was $805 billion, equivalent to 6
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The latest figures show that rather than being closed, the payments gap is widening
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“The bottom line is that a current account deficit of this unparalleled magnitude is unsustainable and there is no hope of it 
being painlessly resolved through higher exports alone,” Paul Ashworth, an analyst at Capital Economic told the Financial 
Times
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 “This is clearly not going to happen,” 
Ashworth continued
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”
In other words, the only way the deficit would start to fall is through a major recession in the US
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 And a significant interest rate rise would bring a 
downturn in the economy
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This is because the very structure of the US economy, in which imports of goods and services are some 59 percent higher than 
exports, means that normal economic growth automatically increases the deficit
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welkerswikinomics
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8 Balance of Payments

Balance of Payments
the Capital Account

Capital Account:
• The capital account summarizes the buying and selling of assets between countries,
including anything that can be owned and that has value such as land, real estate,
companies, bank deposits, stocks and shares, treasury bills, government bonds,
foreign currency
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this is a capital account SURPLUS
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this is a capital account DEFICIT
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S
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S
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This will be counted as a positive on the US capital account
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S
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But if a US investor buys an office building in Shanghai or builds a golf course in
Malaysia, this counts as a negative on the capital account
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A government's reserves are built up when its income from exports
exceeds its expenditures on imports
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BoP Deficits and Surpluses:
• A drawing down of official reserves measures a nation’s balance of payments deficit;
a building up of official reserves measures its balance of payments surpluses
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• A balance of payments deficit is not necessarily bad, nor is a balance of payments
surplus necessarily good
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• To correct its balance of payments deficit, a nation might implement a major
depreciation of its currency or other policies to encourage exports
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welkerswikinomics
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8 Balance of Payments

Balance of Payments
the Official Reserves Account

BoP Case Study: Examine the table to the right:
1) What has happened to China's foreign reserves
since 1997?
2) What happened in China in 1977 that led to a
build up of its foreign reserves?
3) Where do China's
foreign reserves come from?

China's Official
Reserves Account
1977 - 2007

4) What do you think China does with its reserves of
foreign currencies?
Blog post: "Excuse us China, could you lend us
another billion?"

CLICK HERE: Balance of Trade data between US
and every other country in the world

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Calculate US's balance of trade with
each of its top 15 trading partners
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censusbureau
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html

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Threatens economic sovereignty, national security
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• Foreign indebtedness: Current account deficits must be offset by capital
account surpluses
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Example: China uses some of its US$ reserves to buy US gov't bonds, financing
US budget deficits
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Since much of US consumption is made up of imports from China,
low taxes mean strong demand for Chinese output
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As Country A acquires more of
Country B's assets, the threat of protectionism by Country B grows
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Floating exchange rate should restore a more
balanced current account
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8 Balance of Payments

Balance of Payments
Consequences of current and capital account imbalances

In 2007 the US current account deficit was about $800 billion
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S
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• This growth of income has boosted U
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purchases of foreign goods
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• Also, a declining savings rate in the U
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has contributed to U
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trade deficits and an
increase in foreign investment in U
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Implications of U
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trade deficits

• A trade deficit means that the U
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is receiving more goods and services as imports from
abroad than it is sending out as exports
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• A trade deficit is considered “unfavorable” because it must be financed by borrowing from
the rest of the world, selling off assets or dipping into foreign currency reserves
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5 billion more assets in U
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than Americans owned in foreign
assets
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S
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• But it could also mean higher economic growth as foreign investment expands our capital
base

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8 Balance of Payments

Balance of Payments
the Marshall-Lerner Condition

What will happen to a country's exports as its currency
depreciates or is devalued?
• Exports should increase
or
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• Imports should decrease
WHY?

How should the depreciation or devaluation of a country's
currency affect its current account balance?
• shift towards trade deficit
or
• shift towards trade surplus
Why?
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Since they give up less of their
currency to buy Swiss, income from exports will decline in Switzerland
WHY?
How will the price elasticity of demand for imports affect the amount domestic
consumers spend on imports as their currency depreciates or is devalued?
ELASTIC PEDm: Franc depreciates, Swiss are highly responsive to higher price of
imports, so expenditures on imports decrease
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How could a depreciation or a devaluation of a nation's currency actually WORSEN a
current account deficit?

1) a country's currency is devalued or depreciates
2) the country's exports become cheaper to foreign consumers, BUT, demand is price inelastic,
SO
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5) as the price of imports goes up, consumers don't respond much to the change in price, and
since it takes more domestic currency to buy imports, expenditures on imports actually
INCREASES!
6) A decrease in income from exports and an increase in expenditures on imports actually
WORSENS the current account deficit!

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PEDexports +PEDimports > 1,
Interpretation: a depreciation in a nation's currency will move
a county's current account towards surplus
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if PEDx +PEDm < 1,

then a depreciation in a nation's currency will move a country
towards a current account deficit
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If PEDm were inelastic and the price of imports rose as a result depreciation, then the % change
in imports would be less than the % increase in their price, meaning more spending on
imports
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The table below shows the SR and LR price elasticities of demand for exports and
imports for several countries
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SR PEDm

...
1

...
0

...
0

...
6

...
3

...
6

...
1

ML met?
______
______
______
______
______
______
______

What would it look like if we were
to plot one of these nation's current
account balances over time to
reflect the effect of a currency
depreciation or devaluation?

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Surplus

SR PEDx

...
1

...
3

...
2

...
9

...
3

...
6
1
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9

...
6

...
3

...
3

total
1
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6

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3
1
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2
1
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8 Balance of Payments

Balance of Payments
the Marshall-Lerner Condition
P

P

D for Swiss exports

P

D for Swiss exports

Swiss Import D

P

P1

P1

P2

P2

P2

P2

P1

Swiss Import D

P1

Dexports

Dimports

Dimports

Dexports

Q1Q2

Q

Q1

Q2

Q

Q2Q1

Q

Q2

Q1

Q

Shade a box in each of the graphs showing the change in export spending or import income
when the deprecation of the Franc causes a change in price from P1 to P2
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2
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4
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the effect of a Franc depreciation on export revenues when the demand for exports is elastic
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the effect of a Franc depreciation on spending on imports when the demand for imports is elastic
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8 Balance of Payments

Balance of Payments

• If PEDx is inelastic in the SR, then a
weaker currency will lead to a fall in
export revenue
• As export revenue falls and spending
on imports rises, the country's current
account deficit deepens
• Over time, consumers at home will
begin to replace their consumption of
imports with more domestic goods,
and consumers abroad will begin
buying more of our country's now
cheaper products
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Time
m
et

• If PEDm is inelastic in the SR, then a
weaker currency will lead to an
increase in expenditures on imports

the J-Curve

M
LC

M
LC

The J-curve: Reflects the effect of changing PED
for exports and imports over time on a nation's
current account after its currency depreciates

Current account Current Account
surplus
deficit

the Marshall-Lerner Condition and the J-Curve

no

tm

et

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tutor2u
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In late 1992 the pound was devalued by nearly 15% following the United Kin gdom's exit
from the European Exchange Rate Mechanism
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Import volumes remained steady - but were more
expensive following the decline in the exchange rate
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But in 1993-94 there was a clear acceleration in export volumes and a slower growth of
imported goods and services as the effects of the exchange rate depreciation started to
take effect
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"
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High scoring answers are likely to progress
beyond this to explain the influence of specific factors on demand and supply, and to relate these to
appreciation; e
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exports, imports, capital flows, official financing
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Students who distinguish between short run reasons (e
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speculation) and long run reasons (e
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underlying competitiveness) should be rewarded
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Explain why the depreciation of a country’s exchange rate might not improve
its balance of payments
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Reasons for not helping the balance of payments might include: MarshallLerner condition not fulfilled; the J curve effect; importance of non-price factors; possibility of
competitive depreciations; rising import costs causing a loss of competitiveness as a result of
inflation
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To reach band 4, candidates must make explicit reference to export revenues and
import expenditure in the context of the Marshall/Lerner condition/J curve effect
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8 Balance of Payments

International Economics
Practice Questions

a) “Whether the exchange rate rises or falls there are always losers
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Candidates can receive full credit for answers based only on domestic perspectives
Definitions that should be included:
•
exchange rate
•
appreciation/depreciation; revaluation/devaluation
For currency appreciation the following issues could be addressed:
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loss of domestic and international markets as the price of exports
increases and the price of imports falls
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the resulting impact on the Balance of Payments
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the Marshall-Lerner condition
•
possible falls in domestic output and employment
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possible effects of policies to deal with Balance of Payments deficits
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hot money/capital flows
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effects of cheaper imports on inflation
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de-industrialisation
For currency deprecation, the following issues could be addressed:
•
effect on domestic and international market shares
•
the Marshall-Lerner condition, the J-curve and the Balance of Payments
•
possible effects on inflation (cost push and demand pull)
•
hot money and capital flight
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terms of trade
•
debt repayments/debt servicing ratios and the effect of these on
public expenditure and investment
•
loss of confidence in the currency
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competitors may devalue to restore competitiveness / possible global instability
•
environmental issues
[25 marks]

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For full marks to be earned it is sufficient to discuss the two aspects of speculation (i
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buying and
selling of a currency) with appropriate diagrams
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Implicit in the
answer should be an awareness of why speculation takes place
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In addition, candidates may also be rewarded for
discussing other relevant points such as: the importance of the type of exchange rate regime; whether
the exchange rate rises or falls depends on the magnitude of the speculation; possible central bank
action; the impact of changes elsewhere in the balance of payments
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Illustrate your answer using supply
and demand analysis
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If no progress is made beyond this point, a maximum of [3 marks] should be
awarded
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The demand for exports will rise, while the demand
for imports will fall
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A maximum of [6 marks] should be awarded if no diagrams are used
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[10 marks]

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