ECON2: The National Economy

2.13 The Balance of Payments on Current Account

Why do countries trade with each other?

2.13 What you need to know

The different components of the current account

The meaning of a deficit or surplus on the current account

How the strengths and weaknesses of the domestic economy may impact upon the balance of payments of the current account

2.13 You should be able to:

Identify and explain the different components of the current account; trade in goods, trade in services, investment income and transfers

Understand and explain the meaning of a deficit or surplus on the current account

Explain and analyse how strengths and weakness in the domestic economy can impact upon the balance of payments on current account

Definition

“A record of a country’s trade/transactions with the rest of the world.”

Measuring the Balance of PaymentsThree sections of the Balance of Payments1. The Current Account

o Trade in Goodso Trade in Serviceso Investment Incomeo Transfers

2. The Financial Accounto Transactions in financial assetso Investment flowso Government transactions

3. The Capital Accounto Transfer of assets by individuals

This is the largest component of the

Balance of Payments. Only knowledge of this

section is required.

These components are smaller and a

detailed knowledge of them is not required.

Surplus or DeficitA surplus is when the sum of exports of goods, services, investment income and transfers is greater than imports.

>A deficit is when the sum of exports of goods, services, investment income and transfers is less than imports.

>

The Trade in GoodsTrade in goods measures the net exports (X - M) of visible

goodsThe UK has traditionally run a large deficit on the Trade in

Goods component of the current accountThere are a number of reasons for this

An increase in the demand for consumer goods, many of which have to be imported

Decline in the UK manufacturing sector as secondary production is outsourced to low wage economies

Lower production of primary materials such as gas and oil The UK now imports significant quantities of primary materials from

other countries A strong currency makes imports of goods more affordable and

exports less attractive to foreign buyers

The Trade in ServicesTrade in services measures the net exports (X - M) of

invisible items e.g. banking, insurance and tourismThe UK has traditionally run a large surplus on the Trade

in Services component of the current accountThere are a number of reasons for this

The UK has seen a shift away from primary and secondary sectors towards tertiary sector employment, thus specialising in the provision of services

This specialisation has meant that the UK is more competitive in the provision of these services, and can offer better services at lower cost

London has developed as one of the world’s prime financial centres and become a major source of income and wealth generation in the UK

Investment Income

Investment income is generated by UK owned overseas assets e.g. a UK firm might own a company abroad, or generate income from overseas investments

The profits & dividends that are received are sent back to the UK, and count as a credit item of Investment Income on the current account

However, debit items also occur as foreign investments into the UK may yield profits which are sent back to the country of investment origin

Transfers

Transfers are payments made (or received), usually by the government, to or from other countries.

The main transfers includePayments for membership of the European UnionForeign Aid

Given its status in the European and global economy, the UK typically runs a deficit on the transfers section of the current account.

Balance of Payments in the UK

Look at the chart above showing net balance of trade in the UK. Summarise the main trends and list the main causes of the persistent deficit that the UK is

experiencing.

Source: tradingeconomics.com

1) As consumer spending increases, so does our demand for goods. In the UK we have a high propensity to consume imported goods, thus improvements in economic growth and consumer spending feeds through to an increased and persistent deficit.

Why is there a persistent deficit on the current account?

IMPORTS

EXPORTS

2) In terms of manufacturing, UK firms have become less competitive in the manufacture of goods. UK firms are unable to compete with low wage economies, and as globalisation has increased and widened, so has the UK’s reliance on imported goods.

3) It is also argued that our exchange rate is too strong, which makes our exports less competitive and makes imports relatively more affordable.

4) The deficit is also a sign of an unbalanced economy. Both primary and secondary business activity is shrinking over time, compared with significant growth in the tertiary sector.

1) Controlling consumer spending will reduce the demand for imports. Whilst this may improve the balance of payments, consideration should be given to other aspects of the economy if this occurred.

Redressing the balance

IMPORTSEXPORTS

2) Investing in the supply-side of the economy should improve productivity of UK firms in terms of quality and price competitiveness. Enhanced productivity measures may give rise to higher exports through greater output.

3) Depreciation of the exchange rate may make our exports more price competitive. However, it will increase the relative price of imports, which may be problematic if we cannot produce alternatives domestically.

4) Improve overall macroeconomic conditions in the UK. This will encourage investment and domestic growth as well as reducing our reliance on imports.

Read the article and re-cap the previous slides to construct a table of key points to develop a balanced argument as to whether or not a persistent deficit on

the current account of the balance of payments matters or not.

Yes, it matters No, it doesn’t matter

Multiple Choice 1

All other things being equal, which of the following is most likely to reduce a balance of payments deficit on current account? An increase ina) the price levelb) consumptionc) productivityd) the money supply

Can you explain your answer?

Multiple Choice 2All other things being equal, which of the following is

most likely to lead to an increase in imports? A fall ina) the exchange rateb)national incomec) government expenditured) the savings ratio

Can you explain your answer?

Multiple Choice 3

The table shows the components of the balance of payments on current account for an economy. It follows that the balance of payments on current account is

a) +£2150 bnb) +£200 bnc) -£200 bnd) -£50 bn

Can you explain your answer?

£bnExport of Goods 500

Export of Services 400Import of Goods 800

Import of Services 300Net Investment

Income+50

Net Transfers +100

Multiple Choice 4

All other things being equal, which of the following combinations is most likely to lead to a deterioration in UK balance of payments on current account?

Can you explain your answer?

UK Inflation Rate Exchange Rate of £

UK Unemployment

A Increase Decrease DecreaseB Decrease Increase IncreaseC Increase Increase DecreaseD Decrease Decrease Increase

2.13 You should be able to:

Identify and explain the different components of the current account; trade in goods, trade in services, investment income and transfers

Understand and explain the meaning of a deficit or surplus on the current account

Explain and analyse how strengths and weakness in the domestic economy can impact upon the balance of payments on current account