The UK Balance of Payments

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BAM020 International Money and Finance                Jinal Patel K0804775

                Iris Colin K1164491


  1. Explain the swings in the current account balance over time. Use theory and existing empirical evidence in your discussion.  

The current account represents an account of the balance of payments of a country (Tribe, 2011). The latter is an account showing a country’s international transactions over a certain period of time and comprises three accounts of international transactions: the current account, the capital account and the official reserve account (Book, 2011). The current account contains exports and imports of goods and services as well as income and transfers and is composed of four categories: merchandise trade, services, factor income and unilateral transfers (Machiraju, 2009). The current account balance is the difference between exports and imports plus unilateral transfers (Book, 2011). As a consequence if a country experienced a current account deficit it implies that it used more output than it produced (book, 2011). The current account balance, and particularly the trade balance, is sensitive to exchanges rates (Book, 2011). According to the elasticity’s approach to the theory of the balance of payments, changes in exchange rate influence the relative prices and change resources/consumption expenditures between the production and consumption of tradables and non tradables (Machiraju, 2009). In fact, if a country’s currency depreciates against the currencies of its major trading partners, the country’s exports would rise whereas imports would fall, ameliorating the trade balance (Machiraju, 2009). This can be explained by the prices of goods and services decreasing in foreign current terms, resulting in a rise in foreign demand; imports become more expensive in domestic currency terms, subsequently diminishing domestic demand, and in turn creating swings in the current account (Book, 2011). Consequently, the current account balance is highly dependent on the movements in exchange rate (Book, 2011). Another factor affecting the current account balance is the economic growth and as a result consumer spending (EconomicsHelp, 2012a). In a period of economic growth, the spending power augments, often resulting in higher spending on imports, except in the case of an export led economic growth, and thus provoking swings in the current account balance (EconomicsHelp, 2012a). On the other hand, in times of recession, consumer spending on imports would fall and leading to swings in the current account balance (EconomicsHelp, 2012a). For instance, in the 1980s, the UK economy was experiencing a boom leading to higher consumer spending and inflation widening the current account deficit (Economics, 2012a).

An additional factor creating swings in the current account balance is competitiveness (Economics, 2012a). If a country is experiencing a lack of competitiveness compared to others depending on relative wages, labour productivity or standard of infrastructure, exports will tend to fall compared to imports and thus creating swings in the current account balance (EconomicsHelp, 2012a). Many western countries such as the UK and France experienced a loss of competitiveness due to low costs countries such as China and higher productivity countries like Germany leading to a fall in exports (EconomicsHelp, 2012a).

Finally, the current account balance is dependent on how many capital flows a country can attract (EconomicsHelp, 2012a). For example, a lot foreign investors were willing to buy dollars while allowing the US to run a high current account deficit and thus preventing the dollar to fall in value and thus reducing the current account deficit it would have faced (EconomicsHelp, 2012). Consequently, the swings in the current account balance over time can be explained by the changes in exchange rates, competitiveness, economic growth and capital flows (EconomicsHelp, 2012a).

  1. In a freely floating exchange-rate system, if the current account is running a deficit, what are the consequences for the nation’s overall balance of payments? What are some possible solutions to current-account deficits and how likely are they to work?

 

As previously stated, the balance of payments comprise of a current account, a capital and financial account and the reserve account (Mueller, no date). A current account deficit occurs when exports exceed imports and requires a positive capital and financial account so that the overall balance of payments still balances in accounting terms (Mueller, no date). A positive capital and financial account results in a rise of domestic assets by foreigners (Mueller, no date). Over a short period, a current account deficit is not necessarily an issue as it can be compensated by borrowing from overseas, overseas inward investments or by selling assets overseas (Tribe, 2011). However, these options reduce the country’s foreign wealth with the accumulation of debt and loss of ownership and, in the long run, they become limited forcing the government to intervene (Tribe, 2011). The possible solutions to current account deficit can take the form of devaluation, deflation and/or protectionism (Book, 2011).

Devaluation is the policy of letting a country’s currency to depreciate under a freely floating exchange rate system (Book, 2011). The expected effect of this policy is the stimulation of exports by making the country’s foreign currency price cheaper and the diminution of imports by augmenting their price in the domestic currency (Book, 2011). The success of this is related to the demand elasticity, i.e. the extent to which exports and imports are responsive to the changes in exchange rates (Machuraji, 2009). For instance, devaluation will only augment total foreign currency earnings from exports if demand is elastic, so that the decrease in the foreign currency price per unit is offset by a greater proportionate increase in demand (Book, 2011).

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The second possible solution to overcome current account deficit is deflation (Machuraji, 2009). Deflation is the policy by which a government diminishes spending power in the economy and can be effectuated through a rise in interest rates or a rise in taxes (Book, 2011). The expected effect of this policy is the reduction of spending power which in turn would reduce imports as imports represent a fundamental proportion of consumer expenditure (Book, 2011). Moreover, deflationary policies would force manufacturers to lessen their costs leading to more competitive exports and thus rising exports (EconomicsHelp, 2012). Nevertheless, this policy might lead ...

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