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
Inflation
If 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 Rates
If 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 Competitiveness
If 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.
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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.