Essential guidance on economics exam technique:
A2 Macroeconomics / International Economy
Balance of Payments - National Income
National income and the balance of payments
What are the links between the rate of growth in an economy and movements in the balance of payments? Normally, as domestic incomes rise we expect to see an increased demand for imports. This can come from both consumers and firms. The extent to which imports rise when incomes grow is shown by the income elasticity of demand for imports. In the diagram below, spending on imports is assumed to be directly linked to the level of national income. The higher the marginal propensity to consume the steeper will be the gradient of the import function. Exports are assumed to be exogenous of the level of domestic national income.
If the marginal propensity to import is high then imports will rise quickly when the economy experiences economic growth. Unless there is a corresponding rise in the volume of exports sold overseas, the balance of trade will worsen.
The balance of payments and living standards
A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In the short term if a country is importing a high volume of goods and services this acts as a short-term boost to living standards since it allows consumers to buy a higher level of household durables and other items. A widening trade deficit might also be the result of an increase in imports of capital equipment and technology which will provide a boost to a country’s potential national output. If imports of investment goods improve our competitiveness, this raises the prospect of an increase in employment and real incomes arising from a better supply-side economic performance.
However in the long term, if the trade deficit is a symptom of a weakening domestic economy and a lack of international competitiveness then living standards may decline.
Policies to control / reduce a balance of payments deficit
Which policies are likely to be most effective in improving the current account deficit of the balance of payments? We need to make a distinction between demand and supply-side causes of the problem. If the root cause of a high trade deficit is an excessive level of aggregate demand, the deficit may improve automatically in the event of an economic downturn or recession, when real incomes and spending slow down. However if the deficit is largely the consequence of supply-side economic weakness, then policies need to be effective in improving our cost and non-price competitiveness and in expanding the economy's productive potential is essential - particularly the tradable sector, to allow it to grow without its external position continuing to deteriorate.
Central to improving the UK’s trade performance is the health of the manufacturing sector: although services are a growing part of the economy, manufacturing still accounts for about 75% of exports. The government's growth strategy is focused on improving the supply side of the economy such policies may be effective but they will take time to work.
Expenditure Reducing Policies
These are policies that aim to reduce the real spending power of consumers
Expenditure Switching Policies
These are policies that attempt encourage consumers to switch their spending away from imports towards the output of domestic firms. ‘Expenditure-switching’ occurs if the relative price of imports can be raised, or if the relative price of UK exports can be lowered. Measures might include:
The key to controlling the BoP deficit in the long term is for the economy to achieve relatively low inflation with sufficient productive capacity to meet the domestic demand from consumers. Often, price is not the deciding factor in winning the demand from buyers in highly competitive international markets. Competitiveness in global markets is driven by many factors, one of which is the level of research and development spending, an area where the UK continues to lag behind.
The UK continues to lag behind in research and development
** Foreign-owned. * Not in 2000 Scoreboard.
Limits to the impact of a depreciation of the currency
The risks of inflation
A lower exchange rate can lead to an increase in the costs of imported goods and services risking higher ‘cost-push’ inflation.
It is important to remember that a depreciation or devaluation of the exchange rate will not normally be enough on its own to correct a balance of payments deficit for an economy. This is particularly the case if the causes of the deficit are long term and structural. Other policies are required that improve the supply-side performance of the economy and make domestically produced goods and services more competitive in international markets
The ‘J-Curve’ effect
In the short term a depreciation of the exchange rate may not improve the current account deficit of the balance of payments. This is due to the low price elasticity of demand for imports and exports in the immediate aftermath of an exchange rate change. Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed. However, depreciation raises the sterling price of imports causing total spending on imports to rise. Export demand will also be inelastic in response to the exchange rate change in the short term. Therefore the earnings from exports may be insufficient to compensate for higher spending on imports. The balance of trade may worsen in the immediate aftermath of a fall in the external value of the currency. This is widely known as the ‘J-Curve’ effect.
Providing that the elasticity of demand for imports and exports are greater than one, then the trade balance will improve over time. This is known as the Marshall-Lerner condition.
|Author: Geoff Riley, Eton College, September 2006|
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