In-depth summary covering the knowledge required under the OCR A level economics specification. Includes a number of analysis and evaluative points to assist students with essay-based questions.
The Balance of Payments
Balance of payments: a set of accounts showing the transactions conducted between the residents of
a country and the rest of the world.
Credit: money flowing into the country as the result of a transaction
Debit: money flowing out of a country as a result of a transaction
Policy of a sustainable balance of payments position: The overall balance of payments
(combining the credit and debit items from all three accounts) must always be zero however each
other the three accounts may not individually be in balance.
Why is it important to achieve a sustainable balance of payments position?
● An equilibrium on the current account means that the country can sustainably finance the
current account which is important for long-term growth. If it becomes difficult to attract
sufficient financial inflows, the pound could depreciate which may lead to inflationary
pressures on the UK. Heavily financing the current account with the financial account is
dependent on the level of confidence that investors have in the economy.
● An imbalance in the balance of payments suggests that the Uk is reliant on the performance
of other countries, if export markets such as the EU become weak, this will affect the Uk
economic performance.
How can deficits in one account be balanced? If one country is in a CA deficit, its BOP may be
balanced if the FA is in surplus. This can be seen in the case of the USA and China. The USA has a
CA deficit but it finances it by running a FA surplus. China on the other hand has an excess of funds
due to its CA surplus. These large reserves of cash are invested in countries with a CA deficit - China
buys many bonds and shares from the USA which creates financial inflows for the USA financial
account. US buys goods such as manufactured clothes and toys from China and China uses this
foreign currency to buy US bonds
The Current Account: an account identifying transactions in goods and services between the
residents of a country and the rest of the world, together with income payments and international
transfers.The current account is the most substantial part of the BOP and measures the value of
goods and services not the volume.
What is included in the current account:
● Trade in goods and services (balance of trade)
● Primary Income: earnings accrued to domestic citizens on past investment abroad - this
includes incomes from interest, profits, dividends generated from foreign investment and
migrant remittances (payments from people living and working overseas who send money
back to the UK)
● Secondary income: spending and transfers on foreign overseas aid and payment to
multinational bodies - includes transfers with EU institutions (transfers that are provided
without the expectation of payment - nothing of economic value received in return)
, The Financial Account: an account identifying the transactions in financial assets between the
residents of a country and the rest of the world.
What is included in the financial account:
● Foreign direct investment: UK investors undertake investment overseas and overseas
investors purchase assets in the UK. Although net flows of FDI are part of the financial
account, the income received in future years appears in the current account.
● Portfolio investment (buying and selling of corporate bonds, government bonds, shares,
derivatives) - equities and securities + transactions in other financial assets
● Reserve assets (currency or gold held by the Bank of England)
The Capital Account: an account identifying transactions in physical capital between the residents of
a country and the rest of the world. Smallest influence on the BOP.
What is included in the capital account:
● Flow of capital associated with migration - if someone migrates to he UK, the person’s status
changed to being a resident - their property then becomes part of the UK’s assets - transfers
of financial assets by migrants
● Debt forgiveness
● Measures changes in national ownership of assets
● Capital transfers (ownership of fixed assets, transfers of funds)
● Acquisition of non-financial assets (transfers of ownership of fixed assets, copyrights,
patents, franchises and transferable contracts)
Imbalances in the Current Account:
Causes of a CA deficit:
● Low competitiveness of domestic production relative to other countries: if productivity at home
is weak, or domestic firms are producing poor quality products, the demand for exports will be
relatively low. E.g. in the Uk there has been a decline in the exporting manufacturing sector
because it has struggled to compete with developing countries in the far east which has led to
a persistent deficit in the balance of trade. Low competitiveness could be caused by:
○ low labour productivity which increases unit labour costs
○ High minimum wages relative to competitor countries which also increases unit labour
costs leading to higher prices
○ Poor investment which implies that capital machinery is outdated / depreciating -
increased costs of production lead to higher prices than competitor countries who
have more productive capital - also may impact non-price competitiveness and affect
the quality of a country’s goods or services
● If inflation is high relative to elsewhere: exports are more expensive so the demand for
exports falls
● Strong domestic growth and higher incomes at home: if real disposable incomes are high at
home then the marginal propensity to import will increase and imports will be “sucked in”
● Recession abroad: if real disposable incomes fall abroad then demand for exports will
decrease. This will particularly be the case if there was a recession in the UK’s main trading
partners.
● Strong / overvalued exchange rate: makes exports more expensive and imports cheaper -
demand for imports will rise while demand for exports will fall - depends on the Marshall
Lerner condition.
● Government restrictions on free trade: if foreign governments increase or impose new trade
barriers on domestic exports such as tariffs or quotas then it will be harder to access
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