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

• Fiscal policy can be used (e.g. a rise income tax that reduces disposable income)
• Higher interest rates would dampen consumer spending and reduce economic growth

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:

• A depreciation of the exchange rate which has the effect of increasing the UK cost of imports and reduces the foreign price of UK exported goods and services. A lower exchange rate also increases the profitability of exporting products overseas, and this profit signal should, over time, act an as incentive for UK businesses to reallocate factor resources towards potential export markets
• Tariffs or other import controls can occasionally be used – but the UK is bound by its commitments to the World Trade Organisation. Protectionist policies are not a viable option for an economy wishing to control its total trade deficit
• Policies that reduce the rate of inflation in the economy below that other international competitors leading to a gradual improvement in price competitiveness

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.

Top 15 UK companies by size of R&D investment
Company		Position in 2000	R&D	Growth of R&D (1 year)	Sector
1.	GlaxoSmithKline	2	£2839m	+2%	Pharmaceuticals
2.	AstraZeneca	1	£1981m	+10%	Pharmaceuticals
3.	BAe Systems	4	£1110m	+1%	Aerospace
4.	Ford **	8	£763m	-12%	Automotive
5.	Unilever	5	£736m	-2%	Food Producers
6.	Pfizer**	10	£598m	+8%	Pharmaceuticals
7.	Airbus**	-*	£345m	-1%	Aerospace
8.	Shell	11	£288m	-5%	Oil & Gas
9.	Rolls-Royce	12	£282m	0	Aerospace
10.	BT	9	£257m	-23%	Telecoms
11.	BP	14	£229m	+26%	Oil & Gas
12.	Land Rover**	-*	£227m	-7%	Automotive
13.	Vodafone	37	£219m	+28%	Telecoms
14.	Marconi	6	£186m	-6%	IT Hardware
15.	Amersham†	16	£182m	-1%	Health

** 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.

Export and Import Volumes - the importance of Elasticity of Demand
Original exchange rate	£1 = $1.80
Exports of Pocket PCs from the UK			Imports of US DVD players
UK price (£)	£350		USA price ($)	450
US price ($)	630		UK price (£)	250
Demand	40,000		Demand	60000
Export revenue (£)	14,000,000		Import spending (£)	15,000,000
New exchange rate	£1 = $1.60
Ped for UK exports = 1.4			Ped for US imports = 0.5
UK price (£)	£350		USA price ($)	450
US price ($)	560		UK price (£)	281.25
Demand	46,220		Demand	56670
Export revenue (£)	16,177,000		Import spending (£)	15,938,438
% change in ex rate	11.1		% change in ex rate	11.1
% change in demand	15.55		% change in demand	5.55
Net trade balance
Original exchange rate	£1 = $1.80		-1,000,000	Deficit
New exchange rate	£1 = $1.60		+238,562.5	Surplus
Combined elasticity of demand for X and M + 1.4 + 0.5 = 1.9