You are to produce a report on the subject the balance of payments and exchange rates. In it you need to define what the various terms mean and examine critically their importance to the UK economy. You should concentrate on their role in how the economy

In BOP it consists of 2 accounts the current and capital account. In the current account it records the transaction in goods and services and the income flow, it take account of the balance of trade in goods which is mostly related to consumer product, balance of trade in services which is tourism and insurance, net income flows which is wages and local investment in the country. Financial account records transaction in the “financial investment, it takes account of total investment from aboard but for example if a UK firm brought a factory overseas it would be a withdrawal from the economy” (Sloman), the net financial flows which is the monetary flow the short term money that enter and leaves the country for example people exchanging currency, the capital account which is the “transfer of funds relates to fixed assets such as lands.” () The government always try to make the balance of payment equal where the supply and demand of the currency will be equal, but in most cases there is usually either the current account will be on deficit and there will be a surplus on the financial account, vice versa.

 Changes in exchange rate can be a big effect on BOP with a time lag. If the UK pounds is strong “it will be hard to export good and cheaper to import goods and services” () with the same amount of sterling you could purchase more; this will then lead to a deficit in the economy. Having the strong sterling will also have disadvantage to UK too as “exports fall, this causes a reduction in aggregate demand and reduce the economic growth” (Exchange Rates and International Finance). A strong exchange rate may threaten output employment and living standards more in some regions, especially in those that are more dependent upon markets for exports.

        There are many polices that will get affected by the BOP and exchange rates which includes the 3 main polices in the economy fiscal, monetary and supply side policies. Fiscal policy is mainly concerning the taxes and government spending helping aggregate demand and supply, monetary policies is mainly concerning the exchange rates, interest rates and the money supply helping aggregate demand, lastly the supply side policies uses a range of design measures to increase aggregate supply and hence the potential output of the economy though improvements that comes from the private sector. During a BOP deficit the government will use the fiscal policy to increase direct taxes aiming to reduce aggregate demand shown on (Appendix 1), but in the same time there might be a risk of a “sharp fall in consumer spending might lead to a steep economic slowdown” () might even cause the country into a recession if the country is on a negative output gap. Using the monetary polices the bank of England will increase the interest rates therefore less people will borrow money therefore slowing down the consumer’s spending and demand for imports. Depreciation in exchange rate will boost overseas demand for UK goods therefore allow more export and less import, but this will also depend on the firm is they are willing to cut prices as a decrease in sterling might also mean an increase in production and raw material if they are from overseas, “it will also depend on the price elasticity of demand for UK goods in overseas.” () Using the supply side polices is the key method to reduce BOP deficit in the long term trying to shift the long run aggregate supply(LRAS) outwards, government will persuade businesses to put investment in “research and development, more effective marketing strategies can have powerful long term effects in winning and maintaining market share in highly competitive global markets.” () Having more UK firms in export markets, increase investment in services industry for example tourism industry can earn a large amount of foreign currency in the same time expanding the local expenses, investing in new product development then exporting it aboard, all this will cause the LRAS to shift outwards increasing real national output but having the same price level shown in (appendix 2).

        The BOP works as the indicator of how the total amount of money that has enters or leaves the country in each year and the exchange rate can be seen as an instrument use to control the balance of payment by either increasing or decreasing import or export. In the UK BOP has been on deficit for almost 20 years now, and policies has always been affected by the BOP because in real life situation the BOP is never equilibrium therefore many polices is uses to act against the deficit. The monetary, fiscal and supply side policies are use mainly trying to adjust the aggregate supply and demand to achieve BOP equilibrium.

Reference

Sloman, John (2004). Economics. Penguin. pp. 516, 517, 555–559.

Laurence Copeland. Exchange Rates and International Finance (4th ed.). Prentice Hall. pp. 10–35.

Appendix

1

2