Macro "Paper 2"

explain the factors that can cause a current account deficit/surplus [8]

1. Competitiveness makes a country's goods more attractive to foreign consumers. High productivity and quality gives a country a comparative advantage in the production of particular G+S so increases demand for exports. 2. A strong currency makes imports relatively cheaper and exports expensive for foreign consumers. This increases demand for imports by domestic consumers and reduces demand for exports by foreign ones, worsening the current account. 3. High inflation erodes the price competitiveness of exports and domestically produced G+S when competing against imports. This worsens the current account deficit if no corresponding fall in exchange rates is seen. 4. Economic growth can attract and deter FDI (depending on other factors) resulting in changes to the current account.

state + describe some components of the capital and financial account [4]

1. FDI 2. portfolio investment - purchase of UK shares + bonds by foreigners minus purchase of foreign shares + bonds by UK citizens 3. SR (hot) money flows 4. changes in foreign currency reserves

state + describe the components of the current account [4]

1. trade in goods 2. trade in services 3. investment income (primary balance) - income earned from assets owned overseas minus income paid to foreigners for assets owned in the UK 4. current transfers (secondary balance) - payments received from foreign institutions minus payments paid from abroad

The British pound fell by over 10% to a 30-year low against the US dollar after the UK voted to leave the European Union. To what extent will this depreciation impact the economic growth of the UK economy. [15]

A depreciation of the pound from £1=$1.46 to £1=$1.23 between Jun and Oct 2016 means more pounds are needed to import the same G+S as before, reducing demand for relatively more expensive UK imports. This is likely to improve the UK's £-15,700m current account deficit (Q4 2020) and shifting aggregate demand right (AD-AD1) because AD=C+I+G+(x-m), stimulating economic growth (Y-Y1). However, J-curve theory states that in the short-run, a depreciation is likely to deteriorate the current account position before it improves in the long-run. Import contracts cause the volume of imports to remain fairly constant in the short-run as it takes time for consumers and firms to change their habits to buy domestic rather than imported goods and services. This is particularly true because the UK has a high MPM so the rising price of imports is unlikely to significantly reduce short-run demand for imports. Depreciation of the pound makes UK exports comparatively cheaper when priced in $US because less $US are needed to buy the same amount of UK goods and services. This would increase demand for the more price-competitive UK exports, representing an injection into the circular flow of income model. This would see a rise in national output and economic growth ceteris paribus. While depreciation might have caused economic growth in countries like China, it might not be the case for the UK. The Marshall-Lerner condition states that depreciation would improve the trade position if the sum of import and export PEDs is elastic, where demand is responsive to changes in price. Because the UK exports relatively price inelastic financial services and manufactured components, quality is likely to be a more significant factor in determining demand and therefore stimulating growth. Furthermore, unresolved Brexit negotiations and non-price barriers have made it difficult for UK firms to export to the EU and US. Therefore, depreciation is unlikely to cause a rise in UK exports if EU consumers find it easier to import from neighbouring countries in the trading bloc. Some may argue that British exports may rise in the long-run as the UK joins other trade agreements e.g. CPTPP.

Explain the likely effect of a fall in the exchange rate of the British pound on aggregate demand. Refer to Extract A in your answer. [5]

A depreciation of the pound means more pounds are needed to import the same goods and services as before, reducing demand for the UK's relatively more expensive imports. Depreciation would also make UK exports more price-competitive, increasing demand. This is likely to improve the UK's balance of payments deficit of £-15,700m, shifting aggregate demand right (AD-AD1) and resulting in economic growth (Y-Y1).

With reference to Extract A and Figure 1, examine the likely impact of the change in the sterling exchange rate on the UK economy. [8]

A depreciation of the pound to £1 = US$1.23 by the end of 2016 means that more pounds are needed to import the same G+S as before, reducing demand for UK imports. This is likely to improve the UK's -£15,700m BoP CA deficit (Q4 2020), shifting aggregate demand right (AD-AD1) since AD=C+I+G+(x-m), resulting in economic growth (Y-Y1). However, J-curve theory states that in the SR a depreciation is likely to deteriorate the current account position before it improves in the LR, so depreciation is unlikely to cause immediate economic growth. Depreciation of the pound makes UK exports comparatively cheaper when priced in US$ because less US$ are needed to buy the same amount of UK G+S. This would increase demand for the more price-competitive UK exports, representing an injection into the circular flow of income model. This would see a rise in national output and economic growth ceteris paribus. However, unresolved Brexit negotiations and non-tariff barriers have made it more difficult for British firms to export to the EU, so export-led growth might not be achieved.

Explain how a devaluation of the euro in 2014 might have helped improve the French current account position on the balance of payments. [4]

A devaluation of the euro is artificial depreciation so would make French imports relatively more expensive and increase the competitiveness of French exports. Becuase less foreign currency is required to buy the same amount of French G+S, this would have reduced the French current account deficit from -1.5% to -0.5% in 2014.

evaluate whether it is more desirable for a country to have a current account deficit or surplus [15]

A persistent current account deficit may be undesirable because it could indicate that the country's G+S are uncompetitive, due to being either more expensive or poorer quality than other countries'. This may increase the rate of unemployment since fewer workers are demanded to meet the lower demand for exports, resulting in lower average incomes and misallocation of resources in the economy. However, if the deficit results from importing capital goods then the country would see an outward shift in the PPF. This enables firms to produce and export more G+S in the future, likely reducing the current account deficit in the LR. Furthermore, a country with a floating exchange rate system may see its currency depreciate following a current account deficit. This is because there is less demand for the currency, resulting in a lower price per unit. A persistent current account surplus may be undesirable because it shifts AD right since AD=C+I+G+(x-m), leading to inflation (P-P1). This erodes the value of money since one unit of currency buys fewer G+S than before. This may reduce standards of living for citizens who rely on savings, such as pensioners.

Since mid-2015 the euro has appreciated. Assess the likely impact of an appreciation of the euro on the current account of the balance of payments for Eurozone countries. [10]

An appreciation of the euro from E1=£0.75 in 2008 to E1=£0.95 in 2009 means less euros are needed to buy the same foreign goods and services then before. This would increase demand for imports by Eurozone countries, worsening the trade position and shifting aggregate demand left (AD-AD1). However, J-curve theory explains that appreciation improves the balance of payment position in the short-term. Import contracts means that the same volume of imports can be bought for less euros, as it takes time for consumers and firms to change habits from buying from other Eurozone countries to importing from countries outside the tracing bloc e.g. UK. Appreciation would also reduce the price-competitiveness of Eurozone exports because more pounds are needed to buy the same goods and services as before. This would reduce demand for exports, worsening the trade position for export-dependent Eurozone countries like Greece, Spain and Italy whose economies rely on tourism. However, the Marshall-Lerner condition explains that an appreciation is unlikely to significantly impact the balance of payments position for countries with net inelastic imports and exports. In the case of Germany, quality is likely to be a more significant factor in determining demand for relatively price inelastic manufactured components, while appreciation would make more elastic imports relatively cheaper, improving Germany's trade position. Therefore, appreciation of the euro may benefit some countries.

With reference to the information provided and your own knowledge, assess the likely causes of the UK's trade deficit. [10]

An appreciation of the pound from £1=E1.07 to £1=E1.44 between Dec 2008 and Jul 2015 means less pounds were needed to buy the same foerign goods and services than before. This would increase demand for relatively cheaper UK imports, and decrease demand for less-competitive UK exports. This would worsen the current account deficit, reaching a high of 6% of GDP in Q3 2014. However, J-curve theory states that appreciation improved the balance of payments position in the short-term. Import contracts means that the same volume of goods and services can be bought for less pounds, as it takes time for consumers and firms to change habits from buying domestically to importing. Productivity following the 2008/09 financial crisis is increasing at a lower rate of 0.2% annually compared with 2.5% before. This would have reduced the price-competitiveness of UK exports because output per unit input is lower, increasing average labour costs. This would reduce demand for the UK's relatively more expensive exports, worsening the trade deficit. However, the Marshall-Lerner condition states that

Evaluate measures to reduce a country's imbalance of the current account

Expenditure-switching policies are designed to alter the pattern of a country's expenditure between domestic and imported G+S. For example, currency devaluation (through QE or lower IRs) would make imports relatively more expensive for domestic consumers and exports relatively cheaper for foreign consumers. J-curve theory explains that a country's current account position is likely to improve in the long-term as domestic firms and consumers change habits from importing to buying domestically. However, the Marshall-Lerner condition states that devaluation is more successful if the combined PEDs of imports and exports is elastic so that a change in prices results in a relatively larger change in quantity demanded. Therefore, devaluation is likely to have a greater impact on the current account of China (which exports low value-added, price competitive goods) than on Germany (whose exports are high quality and more price inelastic). Another example of an expenditure-switching policy would be increasing tariffs or quotas on imports. This would reduce demand for imports since they are relatively more expensive to UK consumers than domestic G+S, improving the current account position. However, supply-side policies such as reducing red-tape and cutting corporation tax might be more successful at improving the current account because it would encourage FDI into the UK since it is easier for foreign firms to retain more of their profits. This would shift AD right in the short-run since G+S produced by firms would now be counted as an export on the UK's current account, increasing (x-m). In the long-run, this would shift out LRAS by increasing the productive potential of the economy, reducing prices (P-P1) and improving price competitiveness of exports. Expenditure-reducing policies are designed to reduce AD. For example, deflationary monetary policy (increasing IRs and reducing QE) reduces AD since the opportunity cost of spending money has increased, delaying consumption and investment of big-ticket items. This reduces price levels so makes UK exports more price competitive to countries with higher inflation rates, increasing demand for UK exports and improving the current account.

define "global trade imbalances" [1]

occur when some countries have current account deficits while other have current account surpluses

define "current account surplus" [1]

occurs when teh total value of a country's exports is greater than the total value of a country's imports

define "current account deficit" [1]

occurs when the total value of a country's imports is greater than the total value of a country's exports

define "balance of payments" [1]

record of all financial transactions between one country and the rest of the world

define "capital and financial accounts" of BoP [1]

shows LR investments + SR capital flows

define "current account" of BoP [1]

shows country's day-to-day transactions w/ other countries