You will have to review your AS notes, 2.8 The Balance of Payments on the Current Account before starting this unit. You will also be tested on this knowledge in the Unit 4 exam.
Many of the topics covered there are essential knowledge at A2.
The current account has been dealt with in detail at AS, in this chapter you will learn about the capital and financial accounts.
The capital account of the UK’s balance of payments shows the flows of funds into and out of the country. Money entering the country is described as a credit and money leaving the country is called a debit. It includes money involved with the buying and selling of fixed assets, money held by people entering or leaving the UK and grants paid to and by the government.
The UK’s financial account includes most of the money that flows into and out of the UK. It can be broken down into the following:
- Foreign direct investment (FDI) – investment made into the UK by foreign firms is an example of a credit on the financial account, whilst a UK firm investing money into a foreign factory would be classed as a debit.
Provide some examples of FDI that would be classed as a credit.
Provide some examples of FDI that would be classed as a debit.
- Portfolio investment – this includes the purchase of paper financial assets, such as shares.
- Other capital flows – include the movement of money that is invested in banks and other financial institutions often for speculative purposes, it is often described as hot money.
Short-Term and Long-Term Capital Flows
Foreign direct investment and portfolio investment are classed as long term capital flows as investments are usually made with a view to making a profit over a period of time that is greater than one year.
Short term money flows are greater than the long term flows and are usually made by speculators hoping to make a quick profit or to take advantage of a higher interest rate. The speculation may be based upon changes in the stock market or the exchange rate. Hot money will also flow into an economy to take advantage of comparatively higher interest rates. It is possible that these flows of money can have a destabilising effect on an economy.
The City of London and Financial Services
London occupies a unique position in the UK economy accounting for 19% of total UK GDP, 15% of its jobs but only 12% of its population. It has seen a large increase in the numbers employed in the financial and business services market; employment has more than doubled, growing from fewer than 750,000 jobs in 1971 to over 1.5 million jobs in 2006. This compares to just 240,000 people employed in manufacturing, compared to over 1 million in 1971. The reliance upon the financial and business services sector can be highlighted by the fact that it provides one in three jobs in London, compared with 18% of jobs in the rest of the UK.
It is estimated that London contributed to 40% of the UK’s service exports, nearly £50 billion out of £125 billion.
London is home to the headquarters of 22 of the world’s largest 500 companies. It is described as being a World City – whilst there is no hard and fast definition for this, it stands alongside New York, Paris and Tokyo as being the highest ranked cities in the world.
Does a Deficit Matter?
Many economists and those in government are not too worried about a deficit on the current account. It isn’t a macro economic objective of the present UK government, the reasons for this are:
- The deficit is a symptom of strong consumer demand, when the economy slows the level of imports will decline.
- The imports are helping to build up the supply side of the economy and increase its long term productive capabilities.
- A country with a strong credit rating can finance a deficit. The UK has had a deficit on the current account every year since 1998 without any significant negative side effects.
It is possible to counter these arguments by highlighting the problems that can be associated with a deficit:
- The deficit is a leakage from the circular flow of income and it is reducing the potential national income of a country.
- The deficit may be a symptom of a weak economy that is not competitive and losing its comparative advantage in the present era of globalisation.
What will the impact upon jobs be in the long term if the UK is unable to compete with other nations?
- It can lead to the nation’s currency weakening as there is little demand for it in order to buy goods and services.
Methods of Correcting a Deficit
There are a number of policy options available to reduce a balance of payments deficit.
Devaluing the EXCHANGE RATE
A government may decide to devalue its currency in order to try and reduce the deficit on the current account.
How would devaluing a currency affect the price of imports and exports?
What would you expect to happen to the demand for imports by the UK?
What would you expect to happen to the demand for UK exports?
What impact would this have on the deficit on the current account?
The effectiveness of this policy will depend upon the price elasticity of demand for imports and exports, the length of time contracts have been signed for and how long it takes for information for changes in prices to become known to economic agents.
If demand is price elastic in the UK and abroad we would expect to see a percentage fall in prices leading to a larger percentage increase in demand for exports which will increase the revenue from exports. A percentage rise in the price of imports would lead to a larger percentage fall in the quantity demanded which would lead to fall in the value of imports. Combining the fall in imports with a rise in exports there would be a reduction in the deficit or the current account would possibly move into surplus.
However after a depreciation it may not be able to switch away from imports and UK exports may not increase if economic agents are tied into contracts, goods can’t be sourced from elsewhere or they are not aware of the changes in the relative prices. This will lead to the demand for exports and imports being price inelastic.
This situation would mean that in response to a percentage increase in the price of imports demand would fall by a smaller percentage leading to an increase in the money spent on imports. This would have the impact of making the deficit worse.
Similarly, a percentage fall in the price of exports that leads to a smaller percentage increase in the demand for exports would reduce receipts from other countries. This would also make the deficit worse.
In the short run, if price elasticity for demand for imports plus exports is inelastic the current account deficit will worsen in response to a devaluation of the currency. This is known as the J curve effect and it is shown on the diagram below.
It is only at point A that the deficit begins to reduce – this will only happen if the price elasticities of demand for imports plus exports equal more than one; this is known as the Marshall-Lerner condition.
If the UK current account is running at a deficit the pound will depreciate due to a lack of demand for UK goods and services, which in turn means there is little demand for sterling. This depreciation will have the same impact as a managed depreciation.
Reducing the level of aggregate demand in the economy will lead to a decline in imports. This is a particularly effective policy in the UK due to it high marginal propensity to import. This could be achieved through monetary or fiscal policies.
Evaluate the monetary and fiscal policies that could be used to reduce aggregate demand.
SUPPLY SIDE POLICIES
By improving the supply side of the UK’s economy the government would hope to see an increase in demand for its exports and a fall in reliance upon foreign produced goods.
Analyse the supply side policies that could be used to achieve this.
The government could introduce tariffs or quotas to reduce the quantity of imports. The problems of pursuing such a policy is that other countries may retaliate and it nothing to solve the underlying problem of the deficit.