International Trade

Balance of Payments

• The Balance of Payments is a record of a country’s transactions with the rest of the world.

• The B of P consists of the following :

• Current Account

• Financial Account and Capital Account

Current Account

• This is a record of all payments for trade in goods and services plus income flow it is divided into four parts.

• Balance of trade in goods (visibles)

• Balance of trade in services (invisibles) e.g. tourism, insurance

• Net income flows (wages and investment income)

• Net current transfers (e.g. govt aid)

Financial Account • This is a record of all transactions for financial

investment.• It includes:

• Net investment from abroad (e.g. A UK firm buying a factory in Japan would be a debit item)• Net financial flows - These are mainly short term

monetary flows such as “hot money flows” to take advantage of exchange rate changes• Reserves• (note the Financial Account used to be called the

Capital Account)

Capital Account • This refers to the transfer of funds associated with buying

fixed assets such as land

Factors Affecting the B of P • A current account deficit could be caused by factors such as.• High rate of consumer spending on imports (during economic

boom)• Decline in international competitiveness making countries

exports less competitive• Overvalued exchange rates which makes exports relatively

more expensive

Deficit and Surplus • Exports mean credits or positive

• Imports mean debits or negative

Correcting a Persistent Current Account Deficit• Exchange Rate manipulation:

• Supply more of their own currency to buy another currency. This would mean selling GBP and buying USD.

• Lower interest rates to make foreign investment less attractive.

• Both these policies would depreciate the GBP.

• Protectionism:

• Increase Tariffs and Quotas making imports more expensive and making domestic products more attractive.

Contractionary Fiscal and Monetary Policies• Fiscal : increase tax would reduce disposable income and

reduce AD including demand for imports. This would lead to lower inflation and lead to cheaper exports leading to a reduction in current account deficit.

• Monetary: Increase interest rates to reduce spending on imports (financed by borrowing) . This reduces inflation and makes exports more attractive.

• The use of monetary could also have the opposite effect ( see ER manipulation)

Expansionary Supply Side • Contractionary Fiscal and Monetary policy are risky policies

because they effect demand and will affect domestic employment and economic growth.

• A better choice of policy is Supply Side as this will increase the competitiveness of domestic producers and import exports.

• Investment in Education and healthcare.

• Public funding for scientific research and development.

• Investment in modern transportation and communications.

Exchange Rates • Exchange rates are determined by supply and demand. For

example, if there was greater demand for American goods then there would tend to be an appreciation (increase in value) of the dollar. If markets were worried about the future of the US economy, they would tend to sell dollars, leading to a fall in the value of the dollar.

• Appreciation = increase in value of exchange rate

• Depreciation / devaluation = decrease in value of exchange rate

• Please use a demand and supply diagram to illustrate a rise or appreciation and fall or depreciation of the GBP to the USD

Main non price factors affecting the ER InflationIf inflation in the UK is relatively lower than elsewhere, then UK exports will become more competitive and there will be an increase in demand for Pound Sterling to buy UK goods. Also foreign goods will be less competitive and so UK citizens will buy less imports.Therefore countries with lower inflation rates tend to see an appreciation in the value of their currency.

Speculation • FOREX trading

Central Bank Intervention • A central government might buy or sell currency to help it

achieve its economic goals.

Demand for financial investments • The demand for financial investments in Thailand will increase

the demand for Thai baht and appreciate the Thai baht

Demand for Good and Services • An increase in the demand for US goods and services will

increase the demand for the dollar and cause an appreciation of the dollar.

Demand for FDI• If a Japanese firm wishes to build a new factory in the UK

there will be a demand for GBP. FDI will appreciate a currency and the lose of FDI will depreciate a currency.

Interest RatesIf UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK. You will get a better rate of return from saving in UK banks, Therefore demand for Sterling will rise. This is known as “hot money flows” and is an important short run factor in determining the value of a currency. Higher interest rates cause an appreciation.

Change in CompetitivenessIf British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is important for determining the long run value of the Pound. This is similar factor to low inflation.

Effects of an Appreciation An appreciation means an increase in the value of a currency. It means a currency is worth more in terms of foreign currency. e.g. If £1 = €1 An appreciation of Pound could mean £1 = €1.2

An appreciation could occur due to higher interest rates, lower inflation or improved competitiveness.

Appreciation – Advantages • Less expensive imports : a country can enjoy cheaper foreign

goods and services.

• Business that import raw materials and capital goods will see their cost of production reduced.

• An appreciation can put downward pressure on inflation

• A developing country would like encourage FDI. FDI will cause a demand for a currency and cause an appreciation which would be good for a developing country who wishes to import capital goods.

• An exporter is at a disadvantage with an appreciation and therefore this will drive the exporter to become more efficient and find methods of cost cutting.

Appreciation – Disadvantages • Export levels are reduced and this might lead to

unemployment.

• Unemployment in domestic industries if they cannot match price and quality of imported goods.

Depreciation – Advantages • Increase employment at home from exporting businesses.

• Imported inflation from a depreciation because a business needs to import raw materials from abroad.

• With lower export demand and more spending on imports, there will be a fall in domestic Aggregate Demand, causing lower economic growth and lower inflation.

• There will be lower inflation because:

• import prices are cheaper

• Lower AD leads to lower demand pull inflation.

• With export prices more expensive, manufacturers have more incentives to cut costs.

Appreciation contributes to falling AD, leading to lower inflation and lower economic growth.

Evaluation of an Appreciation • The impact of an appreciation depends upon the price

elasticity of demand for exports and imports. For example, if demand for UK exports is price inelastic (because of few alternatives) then there will only be a small fall in demand.

• The impact of an appreciation depends on the situation of the economy. If the economy is in a recession, then an appreciation will cause a significant fall in aggregate demand, and will probably contribute to higher unemployment. However, if the economy is in a boom, then an appreciation will help reduce inflationary pressures and limit the growth rate.

Evaluation • It also depends why the exchange rate is increasing in value. If

there is an appreciation because the economy is becoming more competitive, then the appreciation will not be causing a loss of competitiveness. But, if there is an appreciation because of speculation or weakness in other countries, then the appreciation could cause a loss of competitiveness.

Effects of a Depreciation • A depreciation of the exchange rate will make exports more

competitive and appear cheaper to foreigners. This will increase demand for exports.

• A depreciation means imports will become more expensive. This will reduce demand for imports.

• Higher economic growth. Part of AD is X-M Therefore higher exports and lower imports will increase AD. Higher AD is likely to cause higher Real GDP and inflation.

• Inflation is likely to occur because:• Imports are more expensive causing cost push inflation.• AD is increasing causing demand pull inflation• With exports becoming cheaper manufacturers may have less

incentive to cut costs and become more efficient. Therefore over time costs may increase.

Evaluation • 1. Elasticity of demand for exports and imports. If demand is

price inelastic, the a fall in the price of exports will lead to only a small rise in quantity. Therefore, the value of exports may actually fall. An improvement in the current account on the Balance of Payments depends upon the Marshall Lerner condition and the elasticity of demand for exports and imports

• If PEDx + PEDm > 1 then a depreciation will improve the current account

• The impact of a depreciation may take time to have effect. In the short term, demand may be inelastic, but over time demand may become more price elastic and have a bigger effect.

Evaluation • State of the global economy. If the global economy is in

recession, then a devaluation may be insufficient to boost export demand. If growth is strong, then there will be a greater increase in demand.