F585 Extract Two

Anlayse two reasons why the effective exchange rate index of the US dollar has seen a downward trend (as per Fig 2.2 6

1. The effective exchange rate is a weighted average value of a country's currency (in this case the US dollar) relative to all major currencies, with weights determined by the importance of trade conducted in each currency. 2. May be caused by a decrease in interest rates in the US relative to other countries. This would lead to a decrease in hot money inflows as people no longer want to save money in US banks. This would result in a decrease in demand for the US$ and thus the price of the US$ will decrease resulting in the downward trend in the effective exchange rate of the US. In addition hot money outflows would increase as investors take money out of the country to take advantage of higher returns in other countries. This would increase supply of US$ and so the price of US$ would fall. 3. Secondly if the demand for US exports from foreign countries decreased (due to exports becoming less price or non-price competitive), then demand for US$ would decrease leading to a decrease in price for the US$ and thus there would be a downward trend in the US effective exchange rate as the currency depreciates. In addition if competitiveness of US industry fell then this may result in US consumers purchasing more competitive imports. This would increase supply of US$ which would lead to a decrease in price for the US$ and thus there would be a downward trend in the US effective exchange rate.

Analyse two reasons why international financial flows may move from poor to rich countries (An unlikely Q as this is what the latter part of the Extract explains...) 6

1. many developing countries have "excess savings" and the financial institutions (e.g. banks) in developing countries want to invest this money somewhere which is both safe and offers a good return. 2. Another reason why international financial flows may move from poor to rich countries is because of the 'lack of development of financial markets' in developing economies. A lack of developed financial markets means that saving is more difficult and less likely to occur through the banking system. 3. Another reason financial flows may move from poor to rich countries is because developing countries often run a current account surplus (i.e. more money flows into the economy than out through the current account). These inflows need to be balanced by outflows on the capital account, as the two must balance.

Comment on the extent to which running a current account deficit will always be harmful to an economy 10

1. A current account deficit is when inflows of money exceed outflows relating to trade in goods and services, net investment income and overseas transfers going out of a country is more than the amount coming in. 2. Harmful: May result in net exports decreasing as BoT may be in deficit. AD, diagram, GDP, fall in production, unemployment, fall in incomes, fall in standards of living, maybe increase in welfare spending. Must be financed by the capital account. If cannot been done naturally, govt must borrow, worsen govt budget, lower spending or increase taxes. 3. Not Harmful: If cause is import of capital goods, this benefits econ in the LR. Increase QQE of capital goods and tech. Increase in factor endowment, increase in productive capacity, LRAS shift right, non-inflationary growth, boost incomes and employment. Not a problem if it's "self-correcting" in medium to long-term. As deficit naturally causes the currency to depreciate, fewer exports sold means less D for currency, a depreciation improves the int. comp., causes increase in demand for exports and fall for imports, improving the BoT and current account position. 4.IDO: Size Duration

Describe what is meant by 'balance of payment imbalances' 4

1. Balance of payments definition and what it is. 2. Imbalance definition: Refers to the structural/persistent deficits or surpluses on the current or capital account for a country. 3. For example, Extract 2 shows that China runs a persistent current account surplus and US = an even larger current account deficit. As must balance, means that China has net outflows of financial capital on its current account to offset the current account surplus and vice versa for the US.

Analyse how globalisation has increased balance of payments imbalances 6

1. Balance of payments imbalances refers to structural or persistent deficits and surpluses on both the capital and current accounts for an economy. These could be caused through the process of globalisation through a number of reasons: Globalisation has allowed economies to exploit their comparative advantage and specialise accordingly, due to the reduction in trade barriers and trade costs. As countries specialise accordingly, there is an increased need to trade with one another to increase the variety of goods and services available domestically. This, combined with increased trading opportunities abroad due to reduced trade barriers and increased ease of trade has led to an increase in global exports. This has resulted in the current accounts of countries around the world growing, and has causes the 'imbalances' which are being discussed in Extract 2. Globalisation has also lead to an increase in labour mobility, due to reductions on the restrictions of movement of labour (such as the Schengen agreement in Europe). This has allowed workers to move abroad seeking employment opportunities, and has resulted in increased migration. These workers send portions of their wages back to their home country in the form of remittances to support family back home. Increased remittance flows act as a transfer payment on the current account and this has resulted in the current accounts of countries around the world growing, and has caused the 'imbalances'. Globalisation has led to an increase in both FDI and portfolio investment flows. This is because globalisation has resulted in reduced capital restrictions between economies which has allowed firms to seek investment opportunities abroad. Combining these opportunities with the increased demand for goods globally and an increased ability to trade globally has encouraged firms to become multi-national to increase their profit levels. The investment that flows between countries is represented in a country's capital account balance, and an increase in investment would result in increased imbalances.

Analyse why a depreciation in the USA's effective exchange rate index should lead to a fall in their current account deficit 6

1. Define an effective exchange rate index and a current account deficit. 2. Eco. theory would suggest that a depreciation of this exchange rate would improve the current account position. Fall in export prices = increase in demand and value of exports. Rise in import prices = fall in demand and therefore value of imports. Improves the balance of trade of goods and services. The above analysis assumes that the combined PEDs of imports and exports are greater than 1 (i.e. the marshall-lerner condition holds true).

Analyse why a depreciation in the USA's effective exchange rate index might not necessarily lead to a fall in their current account deficit 6

1. Define an effective exchange rate index and a current account deficit. 2. Should cause a fall in the current account deficit. But: Marshall-Lerner condition may not hold true. The marshall-lerner condition is states that for a depreciation to improve the current account position, the combined elasticities of demand for exports and imports must be greater than 1. So if the combined elasticities where less than 1 then there would not be an improvement in the current account. In addition, the J-curve explains how these elasticities values may change over time. << INSERT J-CURVE DIAGRAM>>. A depreciation occurs at point A when there the country is already running a current account deficit. In the short-term the combined PED of X and M are inelastic and so the deficit will get worse (A to B). After point B, in the medium to longer term consumers will start to change their spending habits and firms will be able to negotiate or change contracts with suppliers and so the elasticities of demand start to become more elastic. This means that in the short-term there will not be an improvement and it is only after point B in the longer-term that the Marshall lerner condition starts to hold true and so there is an improvement in the current account position. In addition, it depends on whether a depreciation will worsen int. comp. and therefore the trade balance in the long-term as it may lead to cost-push inflation. This is because imports prices rise so if domestic firms import their raw materials and inputs, they will face an increase in costs of production. They may react by passing this increase in cost onto the consumer in the form of higher prices and so this will worsen export price competitiveness. This will worsen the balance of trade and current account position in the long-term.

Comment on the extent to which a depreciation in the USA's effective exchange rate index should lead to a fall in their current account deficit 10

1. Define an effective exchange rate index and a current account deficit. 2. Analysis for why this will happen 3. Marshell lerner J-curve 3. Depends on the effects on int. comp. Depends on ceteris paribus on the current account 4. On balance, a depreciation of a country's effective exchange rate is very likely going to reduce a country's current account deficit. However, the extent to which it is reduced will depend on how large the depreciation is (the larger it is, the larger the impact is likely to be) and how large trade is as a component of the current account.

"Comment on the extent to which current account imbalances should be corrected by changes in the exchange rate 10

1. Define current account imbalances. 2. How a depreciation of the exchange rate should help solve a current account deficit. 3. Marshell lerner J-curve 4. It depends on whether a depreciation will worsen int. comp. and therefore the trade balance in the long-term as it may lead to cost-push inflation. This is because imports prices rise so if domestic firms import their raw materials and inputs, they will face an increase in costs of production. They may react by passing this increase in cost onto the consumer in the form of higher prices and so this will worsen export price competitiveness. This will worsen the balance of trade and current account position in the long-term.

Analyse two causes of a current account surplus in countries such as China 6

1. Define Current Account Surplus: A current accout surplus is the amount by which money relating to trade in goods and services, net investment income and overseas transfers coming into a country is more than the amount going out. 2. The country may have strong international price competitiveness. For example in China there are low labour costs (and other resource costs) and high investment levels in capital (resulting in improved efficiency or productivity). Decreases average costs of production for domestic firms and increase their price competitiveness (relative to other economies). This will lead to an increase demand for exports and decrease demand for imports and so the trade balance and thus the current account position will improve. 3. Secondly, China may have had an undervalued exchange rate and this will Increase int comp of domestic firms. A low or depreciating bilateral or effective exchange rate will decrease price of x and increase price of M. Thus D for X increase, D for M decrease and so the balance trade of g and s (value of exports minus the value of imports) will improve. As the balance of trade is a section of current account, the overall current account should improve. 4. Improved non-price competitiveness. High levels of investment in china means increased R & D spending, improved innovation and increase use of technology. Increase in QQE. = Improve non-price competitiveness (which China was seen as being weak at) and so will lead to an increase in demand for Xs and decrease in demand for Ms. Balance trade of g and s (value of exports minus the value ofimports) will improve and as the balance of trade is a section of current account, the overall current account should improve

Analyse two causes of a current account deficit in countries such as the United States 6

1. Define Current Account deficit: A current account deficit is the amount by which money relating to trade in goods and services, investment income and transfers going out of a country is more than the amount coming in. 2. Result of a lack of int. comp. of domestic firms. There may be structural weaknesses in the economy (eg high unit labour costs, low productivity levels and poor infrastructure) meaning that domestic firms have a higher average cost base than international competitors. Less price competitive and therefore D for Ms increase and D for Xs decrease. Therefore the BoT worsens and as this is a section of the current account, so will the current account. 3. A deficit could be due to an economy experiencing a boom phase in its economic cycle with high GDP levels resulting in in high employment and therefore incomes. This increase purchasing power of consumers and will cause an increase demand for imports. Imports tend to be luxury goods (YED elastic) therefore a larger than proportionate increase in demand for imports. Therefore value of Ms > value of Xs and the balance of trade and current account worsens.

Distinguish between the current account and the capital account of the balance of payments 4

1.On balance of payments. Along with net errors and emissions. 2. What Current Account is, and what makes it up. BoT in goods (value of exports minus the value of imports of goods), Bot in services (value of exports minus the value of imports of goods), net investment income (income flows from investments made in the capital account) and net overseas transfers (small section for example covering government subscription to international organisations and foreign aid spending/receipts). 3. What capital account is, and what makes it up. all international flows of financial capital and money. Examples of these capital flows are Foreign direct investment (FDI) (MNCS investing in physical assets in overseas countries), portfolio investment (investing in stocks, shares and bonds) and hot money flows (money movements based on changes in rates of interest) 4. The two must balance. As it says in extract 2; China and US examples.

Analyse two policies which would help the USA solve its current account deficit 6

A current account deficit is when inflows of money exceed outflows relating to trade in goods and services, net investment income and overseas transfers going out of a country is more than the amount coming in. The government could use various policies to solve this deficit. 1. Exchange rate manipulation. The govt could use its stores of currency reserves to intervene in the foreign exchange market and so improve the int. comp. of domestic firms. The govt could sell its own currency to increase supply on FOREX markets and so cause a depreciation in the x-rate. This would make domestic firms more price competitive and so increase demand for exports and therefore value of exports. Import prices would also rise so demand for them would fall along with the value of imports. Therefore the value of exports - value of imports would increase so improving the balance of trade and therefore current account. 2. Supply side improvements (quality and price). The govt could undertake supply-side policies to try to improve the int. comp. of domestic firms. For example, the govt could offer tax breaks or subsidies for firms to encourage investment into new technology or training schemes which would boost productivty levels and so reduce unit costs. This would improve the price competitiveness of domestic firms and so so increase demand for exports and therefore value of exports. Import prices would also rise so demand for them would fall along with the value of imports. Therefore the value of exports - value of imports would increase so improving the balance of trade and therefore current account. Other possible policies:- Control inflation (through'deflationary' fiscal and monetary policy). Govt increase interest rates or increase income tax to decrease C and I. this would decrease AD, reduce the price level and make domestic firms more price competitive. - Protectionism. Eg The govt could increase tariffs, ncrease price of imports, increase int. comp. of domestic firms, domestic consumers switch expenditure from imports to domestic products, improve balance of trade.

Analyse how the USA has been able to finance its current account deficit 6

A current account deficit occurs when inflows of money exceed outflows relating to trade in goods and services, investment income and transfers going out of a country is more than the amount coming in. The US has to have a large capital account surplus to fund this current account deficit and ensure that the balance of payments does balance. The US has had large natural market inflows of financial capital in recent times resulting in a capital account surplus that allows it to fund its current account deficit. The main reason for this is that many developing countries run a current account surplus which means they have to operate a capital account deficit - large international financial outflows of money occur on their capital account (eg FDI, portfolio investment and short term banking flows) and into countries such as the US. This is seen by many developing countries having "excess savings" and the financial institutions (eg banks) in developing countries want to invest this money somewhere overseas which is safe, low risk and offers a good return (eg US govt bonds and US housing market). If, however, the US did not receive this financial inflow then the government would be responsible for ensuring that there was a capital account surplues to balance the current account deficit. The govt would have to borrow money from overseas to create the financial inflows and this would worsen the govt budget position. The govt may have to raise taxes (possibly reducing spending, investment and AD) or may have to cut back on spending, for example in areas such as welfare payments, health or education which would affect the L-T growth and st of living in the economy

Comment on the extent to which running a current account surplus will always be beneficial to an economy 10

Define: A current account surplus Beneficial: May mean the balance of trade is improving Running a current account surplus means an economy can run a capital account deficit and this allows them to export investment to other countries (via FDI inflows and financial flows into capital investment projects of countries such as the US). For countires such as China, this boosts overseas assets holdings which can provide large revenue flows and returns back into the economy in LT. Will cause currency to appreciate can lead to rising protectionist sentiment within trade deficit countries which in the long run threatens the export growth of the domestic economy. May damage LT export growth that China relies upon to boost its AD and maintain high eco growth rates, high employment and incomes. IDO: Size Negative output gap

Explain what is meant by the term 'excess saving' 4

Define: Excess savings occur when savings (income not spent) in an economy are greater than what is needed to fund domestic investment. 2. Many developing countries have "excess savings" and the financial institutions (e.g. banks) in developing countries want to invest this money somewhere which is safe and offers a good return. 3. US govt bonds and US housing market are seen as low risk and offering a good return so this is why savings from poor countries have flooded into the USA.

Comment on the extent to which international financial flows imbalances are beneficial to the 'poor' (developing) countries 10

Many developing countries run a current account surplus which means they have to operate a capital account deficit - large international financial outflows of money occur on their capital account (eg FDI, portfolio investment and short term banking flows). This is seen by many developing countries having "excess savings" and the financial institutions (eg banks) in developing countries want to invest this money somewhere overseas which is safe and offers a good return (eg US govt bonds and US housing market. For "poor" countries, running a current account surplus means an economy can run a capital account deficit and this allows them to export investment to other countries (via FDI inflows and financial flows into capital investment projects of countries such as the US). For countires such as China, this boosts overseas assets holdings which can provide large revenue flows and returns back into the economy in the longer term. The net investment income flows in the future provide income for the owners of these assets, and will act as steady inflows into the economy. This could reduce poverty domestically and provide an opportunity for development if these funds are directed to those most in need. A current account surplus may mean the balance of trade is improving (i.e. the value of exports is greater than the value of imports) so increasing net exports (X-M). This will result in an increase in AD as net exports a component, causing AD to shift to the right. This would result in short run economic growth as real GDP has increased (Y1 to Y2), as firms increase production in face of rising demand. The result of this is that firms recruit more workers and this results in a fall in unemployment. The benefits of reduced unemployment include increased living standards for those who gain employment, and an improved budgetary position for the government as they no longer have to fund high levels of benefit spending and tax revenue will increase due to the increased spending domestically. However, the extent to which these 'imbalances' would be beneficial for "poor" countries depends on a number of factors:First, it will depend on the size of these imbalances. If the financial flows in question are relatively small, then the impact of running a current account surplus on aggregate demand and thus unemployment will be relatively small - yielding less benefits for the domestic economy. If the imbalances are larger, this might mean larger inflows on the current account, resulting in a significant decrease in unemployment and thus gains in terms of development. It might also depend on who is receiving the inflows on the current account and how well the government redistributes these gains. If those most in need are receiving the benefits of these financial flows, then they will have a significant impact on reducing poverty and helping to boost unemployment. If they are not going to the poorest in society, and if the government doesn't have an efficient means of making this occur, then it will be less likely to have a positive impact on society. In addition, the returns and revenues that this overseas investment generates for these economies depends on how wisely this money has been invested. If it has not been invested well, then the net investment income gains in the future will be smaller, thus resulting in less benefit for the recipient economy. If these funds have been well invested, then the returns in the future are likely to be greater, resulting in increased inflows in the longer-term which is more likely to have a positive impact on growth, development and thus standards of living. On balance, developing economies are likely to benefit from these financial outflows in the longer term, but it does reduce the amount of funds available domestically for investment, so won't be that beneficial in the shorter-term.