All exam boards require candidates to have an understanding of the Balance of Payments and Exchange Rates. In this session we will focus on the causes of the UK’s Balance of Trade (aka Current Account) deficit, what we can do about it, and how an exchange rate depreciation should affect an economy, and has affected the UK post financial crisis.

3. The Balance of Payments (BOP)
• A record of all financial transactions between the UK and rest
of the world
The Current Account + Financial
Account + FX Reserves
The current account
Financial account
FX reserves
Trade in goods
(visibles)
Trade in
services
(invisibles) Trade balance (X-M)
Net factor income
from abroad
Net unilateral
transfers
Portfolio capital flows (e.g.
buying/selling of govt debt)
Direct capital flows (FDI)

4. The Basics
• An export refers to a UK PRODUCED good or service being sold
overseas. This results in an INFLOW of money TO the UK
economy and is a CREDIT on the UK Current Account which
ADDS to UK GDP.
• An import refers to an OVERSEAS PRODUCED good or service
being purchased by UK consumers or firms. This results in an
OUTFLOW of money FROM the UK economy and is a DEBIT on
the UK Current Account which REDUCES UK GDP.
• A Balance of Trade SURPLUS occurs when the VALUE of
EXPORTS exceeds the VALUE of IMPORTS

5. The Basics
• An export refers to a UK PRODUCED good or service being sold
overseas. This results in an INFLOW of money TO the UK
economy and is a CREDIT on the UK Current Account which
ADDS to UK GDP.
• An import refers to an OVERSEAS PRODUCED good or service
being purchased by UK consumers or firms. This results in an
OUTFOW of money FROM the UK economy and is a DEBIT on
the UK Current Account which REDUCES UK GDP.
• A Balance of Trade SURPLUS occurs when the VALUE of
EXPORTS exceeds the VALUE of IMPORTS

6. Precise terminology is key:
– “The Balance of Payments is exports minus
imports and is a deficit”……WRONG, VAGUE
VALUE not QUANTITY…
– “The Trade Balance is a component of the Current
Account of the Balance of Payments. It is
calculated by the value of exports minus the value
of imports. The UK's Current Account balance is
approximately -£60bn, of which -£32bn is
accounted for by the Trade
Balance.”…CORRECT, CLEAR!

7. What fits where in the UK Balance of Payments
Current Account?
David Cameron buys a Mercedes Import, Debit, Trade in Goods
UK government provides aid to Syria
US citizen flies to the UK on British Airways
Wealthy UK landlord income on property he rents
out in Spain
Austrian hotel buys a Dyson vacuum cleaner
Import, Debit, Transfers
Export, Credit, Trade in
Services
Export, Credit, Net
Investment/Factor Income
Export, Credit, Trade in
Goods
Import: Money flows OUT;
Export: Money flows IN
Import: Debit; Export: Credit

8. Explain 4 reasons why the UK runs a current account
deficit
Exam Tips:
• This is an ‘explain’ question which is common across exam
boards.
• Marks are awarded for definitions, analysis and sometimes
application (if there is data) and knowledge…if it is relevant -
check your syllabus!!
• THIS DOES NOT REQUIRE EVALUATION OR A CONCLUSION
• The answers should use a logical chain of progression

9. Explain 4 reasons why the UK runs a BOP deficit
on current account
1. Supply-side deficiencies impacting on price and non-price
competitiveness of UK products
Productivity gap… low
Investment… Feeds through to low R&D… and
low innovation…
Lacking new areas of comparative
advantage / dynamic inefficiency
Vs Germany/US

10. Explain 4 reasons why the UK runs a BOP deficit
on current account

11. Poor productivity and lack of innovation………..
Price
level
Real GDP and
employment
AD
YIDEAL
P
P1
LRAS1LRAS
Y
LRAS2
Over a 10 year
period, the UK
has failed to
deliver the
productivity and
innovation
improvements
that would aid
growth and allow
us to compete
and hence sell
more exports……P2
YUK

12. Other causes of the UK Current Account deficit
High levels of disposable
income ‘sucks in’ imports
High labour costs and EU
regulation inc H&S
Strong Exchange Rate
Marginal Propensity to Import
NMW; Bureaucracy; Red-tape
Historically strong on a trade-
weighted basis

13. Evaluate effectiveness of policies to reduce a deficit on the
Current Account

14. Evaluate the effectiveness of policies to
reduce the UK Balance of Trade deficit
Deflate the economy….really?
Imports depend on the level of
income…
EXPENDITURE REDUCING
POLICIES…
CONRACTIONARY MP/FP
Reduce disposable income…
Reduces MPM
E.g. foreign cars/holidays… BUT… has consequences…

15. Effects of deflating the economy
Price
level
Real GDP and
employment
AD
Y
P
P1
AD1
AS
Y1
UNINTENDED CONSEQUENCES
CONFLICT OF MACROECONOMIC OBJECTIVES
PRIORITISATION

16. Overt Protectionism…
Evaluate the effectiveness of policies to reduce
the UK Balance of Trade deficit
Tariffs are taxes on imports…
Raise the price of imports…
Some expenditure-SWITCHING…
Value of M should fall
(X-M) rises, current account
rises…Back it up with a DIAGRAM

17. Tariff
Price
Quantity
Domestic
demand
P
Q
No trade
Domestic
supply

18. Price
Quantity
Domestic
demand
P
Q
Domestic
supply
World P
QdQs
IMPORTS
Too many imports: QD>QS
Tariff

19. Tariff
Price
Quantity
Domestic
demand
P
Domestic
supply
World P
Qs
World P+Tariff
Qs1 QdQd1
Govt tax
revenue…
Inflationary
pressure…
Domestic industry
benefits…
Allocative efficiency
lost…

20. Retaliation… EU
Customs union…
WTO…

21. PM rises in domestic currency terms
Currency depreciates
PX falls in foreign currency terms
XD rises
Value of X rises
Trade balance increases
MD falls
Value of M falls
Depreciation of the exchange rate….

22. MARSHALL-LERNER CONDITION
PM rises in domestic currency terms
Currency depreciates
PX falls in foreign currency terms
XD rises
Value of X rises
Trade balance increases
MD falls
Value of M falls
If Price X falls; and
Demand for X rises; for
VALUE of X to RISE; need
demand for X to be
ELASTIC
If Price M rises; and
Demand for M falls; for
VALUE of M to FALL;
need demand for M to
be ELASTIC
In SHORT RUN however,
Demand for X and M is
likely to be INELASTIC
Marshall-Lerner condition: if PED of exports + the PED for imports > 1, a depreciation will help
resolve a trade deficit

23. Reasons for a possible
Low price elasticity of demand for exports
Low price elasticity of demand for imports
Supply constraints for exporters
Long-term contracts
Wait-and-see approach

24. Cheaper pound – a boost to
competitiveness of UK economy
Non-price
factors
Global supply
chains
Financial
sector
Import
intensity
Overseas

25. Currency Wars
Brazil
Peru
Colombia
Korea
South Africa
Russia
Switzerland
Japan
U.S
Chile

26. Discuss the view that a depreciation is always
beneficial to an economy
• Exam tips:
– Strategy: ‘build up a case with theory (analysis) and then
knock it down (analysis and evaluation)!!
– Use examples
– Remember to address: ‘to whom’ is depreciation beneficial
and the word ‘always’
Try to spot key words in the
question that can help your
evaluation…

27. Positive effects of a depreciation
•Exports Increase
•Growth and job creation

28. The Theory………Export led growth
Price
level
Real GDP and
employment
AD
Y1
P2
P1
AS
AD 1
Y2
Stimulates exports, injection
into CFoY, higher AD
Derived demand
Positive multipliers

29. Negative effects of a depreciation
INFLATIONARY PRESSURES
Demand-pull inflation…
Cost-push inflation…

30. The reality……….Imported Inflation
Price
level
Real GDP and
employment
AD
Y1
P2
P1
AS
AS 1
Y2
Value judgement:
Likelihood? Undesirability?

31. Currency depreciation
can harm inflation
objectives…