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Balance of Payments

Asked by Otto | Feb 11, 2008 | A Level > Economics > Homework
Otto asks:

Edexcel June 2006

a) Both the USA the UK's balance of payments accounts are recording large deficits on their trade in goods balances. Do such deficits matter? Justify your answer. (40 marks)

b) Compare the effectiveness of supply side and fiscal policies to correct deficits on a country's current account of the balance of payments. (60 marks)

Thank you for any help, or extrra notes given. It is much appreciated.

etutor answers:

For both the UK and the US the persistent trade/current account deficit has a number of causes, both short and long term; much of the emphasis here is on the UK:

There is a high propensity to buy imported goods and services – a tendency for consumers to prefer foreign produced output and in a consumer boom we often see an acceleration in the volume of imports coming into the country.
A lack of productive capacity of firms - if home producers have insufficient capacity to meet demand from consumers then imports will come in to satisfy the excess demand.
Poor price and non-price competitiveness of firms - cost levels and thus prices relative to international competitors are a measure of competitiveness, while non-price factors are also important. These include quality, design, reliability and after-sales service.
Declining comparative advantage in many areas - the advantages that countries have in producing certain goods and services change over time as technology alters and other countries exploit their economic resources and develop competing industries. UK and US manufacturing industry has suffered over the years from low cost production in newly Industrialising countries and from parts of the European Union.
An over valued exchange rate - Some economists suggest that trade problems stem from the exchange rate being set at too high a level - this is more relevant to the UK than to the US. The strength of the pound over recent years has made life difficult for UK exporters in overseas markets. This is because a rise in the value of sterling leads to a rise in the foreign price of UK exported goods and services. When UK prices are higher, foreign consumers are less likely to buy our products. The high exchange rate also makes imported goods cheaper inside the UK. This leads to a rise in the volume of imports and a fall in the share of the UK market taken up by goods and services imported from overseas. This particularly affects the manufacturing sector, both in domestic and export markets
A higher growth rate in the UK in recent years than that in our major trading partners (USA, EU, Japan) which, given the UK’s high income elasticity of demand for imported goods, means that the growth of imports has exceeded the growth of exports (held back by low growth or recession elsewhere).

The rising UK current account deficit suggests that the UK is continually ‘living beyond its means’. It is, however, seldom regarded as a problem, and this is why it receives remarkably little coverage, either in the press or in parliament. The Balance of Payments automatically ‘balances’ in that credit and debit entries must add up to zero; so any current account deficit will be matched automatically by an equivalent surplus on the financial account. The latter is dominated by direct and portfolio investment and by short term financial flows, and the UK has experienced no difficulty in recent years in attracting capital inflows. In this sense, the current account deficit is not a problem. There are essentially three types of inward investment. Direct investment, including mergers and acquisitions, is in deficit. Portfolio investment (in bonds and equities) is broadly in balance. Hence the key financial mechanism has been 'other investment', which is made up largely of liquid and short term flows, including cash on deposit. This has flooded into the UK on account of higher interest rates and booming property and financial markets. This could be seen as gains for UK banks and investment institutions at the expense of UK exporters.

Hence the current account deficit is only a problem if the financing of it puts a strain on the economy. The UK deficit as a % of GDP has risen, but remains quite small (still less than 4%); the US deficit is nearer 5% of GDP. In the UK at least it has been relatively easy to finance the deficit through inflows of foreign direct, portfolio (hot money) and other investment. The enormous trade surpluses and rising savings levels from the fast-growing Far Eastern countries and OPEC nations also have to find a home in the global economy and the UK seems to have attracted a disproportionate share of this cash, as overseas investment floods into London property, UK government bonds and bank accounts which offer a relatively high interest rate. The UK’s ability to attract hot money depends largely on the interest rate differential that keeps UK rates at a higher level than those set in the USA, Japan and the eurozone.This, however, means that interest rates are perhaps higher than they need be (reducing potential domestic growth), while the inflows of FDI are highly volatile. There is already some evidence that the UK is steadily becoming less of a haven for direct investment by foreign companies, as other EU member states and South East Asian countries become increasingly attractive alternative options. Moreover, capital inflows on the scale required are not guaranteed to last indefinitely, especially given the turbulence seen on world financial markets since 2007. The COMPOSITION of the deficit raises greater concern, because it highlights the relative weakness of the UK manufacturing sector. Uncompetitive manufacturing exports lead to job losses and the rundown of productive capacity, and thus exacerbates regional disparities. In the long run, if imports are increasingly taking over from domestic producers, this threatens economic growth, employment and living standards. The staggering size of the trade deficit in goods is symptomatic of a deeper lack of competitiveness of UK industrial sectors as they face up to the challenges and pressures of globalisation. The UK has undoubtedly built an impressive comparative advantage in many service industries, not least in business and financial services and also in cultural products But manufacturing industry exports the majority of the output it generates and many service jobs depend on maintaining a healthy and successful manufacturing base. And, economic events, some beyond the UK’s control, could eventually challenge the conventional view that deficits, on whatever scale, are readily financed.

Effective strategies to control/reduce a current account deficit should focus on the underlying causes of the excess of imports over exports. A critical distinction should be made between cyclical causes and structural causes of a trade deficit. If the trade gap is largely the result of the strength of aggregate demand, then a slowdown in the economy, induced by deflationary fiscal (or monetary) policy will provide an automatic correction. If the main problem is seen as an over-valued exchange rate¸ then a policy of gradual exchange rate adjustment (perhaps through intervention in the currency markets by the Bank of England) might be appropriate. However if the trade deficit is the result of structural supply-side reasons such as long term loss of competitiveness, or a relatively low level of productivity, then the most effective policies are those that seek to achieve a genuine improvement in the supply-side of the economy.

There are two main groups of fiscal (or monetary) policies designed to reduce the scale of a current account deficit:

Expenditure Reducing Policies
These policies might be used when the root cause of the trade deficit is too much aggregate demand for goods and services leading to acceleration in the growth of imports. These are policy changes that aim to reduce the real spending power of consumers and to bring aggregate demand into equilibrium with aggregate supply (i.e. close a positive output gap). For example, Fiscal Policy can be used (e.g. a rise in income tax that reduces real disposable income) and monetary policy can also be effective. Higher interest rates would have the effect of dampening consumer spending (and borrowing). The disadvantage of deflationary policies is that they shift the AD curve to the left and thus reduce economic growth. This in turn will have a downward multiplier effect. While spending on imports will be reduced, the economy's capacity to produce exports will also be reduced, and so there may not be must improvement in the current account position.

Expenditure Switching Policies
These are policies that attempt to cause consumers to switch demand away from imports towards the output of domestic businesses. This occurs if the relative price of imports can be raised, or if the relative price of UK exports can be lowered. This should then cause a change in the spending patterns of consumers away from foreign goods and towards output produced within the domestic economy. Expenditure-switching measures include a devaluation / depreciation of the exchange rate which increases the price of imports and reduces the foreign price of exported goods and services. A lower exchange rate increases the profitability of exporting products overseas. The effects of an exchange rate change depend crucially on the price elasticity of demand for exports and imports and also the price elasticity of supply of domestic producers. Policies that reduce the rate of inflation in the economy below that of other international competitors, leading to a gradual improvement in price competitiveness, should also improve the current account, as will measures to reduce the unit costs of domestic firms, such as export subsidies and policies to encourage higher investment and labour productivity.

A depreciation or devaluation of the exchange rate will, however, not normally be enough on its own to correct a balance of payments deficit, particularly if the causes of the deficit are long term and structural, reflecting a loss of comparative advantage in leading export industries, and rising import penetration. Hence different policies are required that improve the supply-side performance of the economy and make domestically produced goods and services more competitive in international markets. In theoretical terms, such policies shift the aggregate supply curve to the right, resulting in higher real GDP and lower prices. Hence the current account improves as domestic producers sell more exports and satisfy more home demand for goods and services.

These policies might include:

Reforms of the tax and benefit system to improve labour productivity - cuts in personal and corporate tax rates, the promotion of small firms, a decrease in the real value of social security benefits.
Fiscal policy incentives to encourage capital investment, research and development and entrepreneurship in industries with export potential, including attraction of direct overseas investment
The reduction of trade union power and greater labour market flexibility (lowers production costs).
The creation of the conditions (such as low taxation, low start-up costs, easy access to finance, advance factories) favourable to increased investment in industries with large growth potential in international markets.
The development of an ‘enterprise culture’ aiming at increasing the productive capacity, efficiency and flexibility of the economy.
An emphasis upon education and training - a recognition of the importance of human capital as a vehicle for increasing productivity and trend growth. This is seen in the introduction of (and annual increases in) the national minimum wage, the adoption of the employment protection provisions of the EU Social Chapter, and the use of an elaborate system of tax credits to make work a more attractive option for the low paid.
Investment in infrastructure - particularly transport systems.

It should be noted that the UK's trade performance in services is much better than in goods – for example there is a huge surplus in financial and business services (although travel, tourism, shipping and aviation are all in deficit). In the coming years, world trade in knowledge-based services will continue to expand at a rapid rate. The British economy needs to retain and develop its comparative advantage over other nations in high-valued services traded across countries. There are, however, limits to the impact that economic policy can have in reducing a balance of payments deficit because the overall flow of trade in goods and services is the result of millions of individual spending and saving decisions by consumers and businesses, both at home and overseas, all of which are subject to a wide variety of factors. Most supply side policy also takes a great deal of time to deliver its effects. The main role that economic policy can probably make is to create the macroeconomic conditions (low inflation, low business taxes, economic stability) favourable for high investment and productivity – two key factors that drive comparative advantage in the long run.

I hope this is helpful.

1 student responses

"I hope this is helpful."

That was first class; helpful is an understatement. Thank you very much for the time you went to in providing me with such an extensive answer. It is much appreciated.

Economics is the subject for which I am told I have potential, but I lack confidence for some reason. My politics and history papers always come back with As, but Economics is more in the region of C-B. This is why your answer is so beneficial to me; it's something I can aspire to. Thank you again.
responded Feb 15, 2008 8:50:41 PM GMT
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