Balance of Payments Summary

Balance of Payments Summary

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Shams Kabir The Balance of Payments
1) What is the difference between the current account and the capital account (now
called the financial account)?
Current account ­ measures trade in goods and services and net investment incomes and transfers.
Capital account ­ tracks capital flows in and out of the UK, e.g. share transactions, foreign
investment and the buying and selling of government debt.
2) Does a current account deficit matter?
Partial autocorrection: If some of the deficit is due to strong consumer demand, the deficit will
partiallyself correct when the economic cycle turns and there is a slowdown in spending.
Investment and the supplyside: Some of the deficit may be due to increased imports of new
capital and technology which will have a beneficial effect on productivity and competitiveness of
producers in home and overseas markets.
Capital inflows balance the books: Providing a country has a stable economy and credible
economic policies, it should be possible for the current account deficit to be financed by inflows of
capital without the need for a sharp jump in interest rates.
Structural weaknesses: The trade/current account deficit may be a symptom of a wider
structural economic problem i.e. a loss of competitiveness in overseas markets, insufficient
investment in new capital or a shift in comparative advantage towards other countries.
An unbalanced economy ­ too much consumption: A large deficit in trade is a sign of an
`unbalanced economy' typically the consequences of a high level of consumer demand contrasted
with a weaker industrial sector.
Potential loss of output and employment: A widening trade deficit may result in lost output and
employment because it represents a net leakage from the circular flow of income and spending.
Workers who lose their jobs in export industries, or whose jobs are lost because of a rise in import
penetration, may find it difficult to find new employment.
Potential problems in financing a current account deficit: Countries cannot always rely on
inflows of financial capital into an economy to finance a current account deficit. Foreign investors
may eventually take fright, lose confidence and take their money out. Or, they may require higher
interest rates to persuade them to keep investing in an economy. Higher interest rates then have the
effect of depressing domestic consumption and investment.
Downward pressure on the exchange rate: A large deficit in trade in goods and services
represents an excess supply of the currency in the foreign exchange market and can lead to a sharp
fall in the exchange rate. This would then threaten an increase in imported inflation and might also
cause a rise in interest rates from the central bank. A declining currency would help stimulate exports

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Shams Kabir The Balance of Payments
but the rise in inflation and interest rates would have a negative effect on demand, output and
3) Evaluate the policies that can be used to correct a current account current account
Expenditure reducing policies
Contractionary fiscal policy ­ an increase in income tax.
Contractionary monetary policy ­ higher interest rates.
Expenditure switching policies
These are policies that attempt to encourage consumers to switch their spending away from imports
towards the output of domestic firms.…read more


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