NYJC H1 ECON ESSAY QN 4

H1 Essay Question 2 (a) Explain the possible causes of a country’s worsening balance of payments. [10] (b) Comment on the measures available to a government faced with a worsening balance of payments. [15] (a) Explain the possible causes of a country’s worsening balance of payments. [10] Synopsis Students are required to describe structure of the BOP and its components and explain how various factors may cause unfavourable changes to components in the current and capital account leading to a worsening of the overall balance of payments. 1. Introduction – Define and explain basic components of BOP a. Current account i. Balance of trade - visible /invisible ii. Unilateral transfers iii. Income flows b. Capital account i. Short term capital flows – Portfolio Investments ii. Long term capital flows - Foreign Direct Investment 2. Cause of worsening current account a. Global recession - fall in global income woul d negatively affect domestic exports. Given everything else consta nt there would be a fall in net exports causing a worsening of the current account. This may have a positive effect on the BOP. A fall in global income also may lead to decrea se in tourist arrivals leading to a fall in the invisible trade component of the current account. b. Domestic income level Sustained economic growth and rising dom estic income encourages demand for locally produced goods and imports. Given a significantly high YED (YED > 1) of imports especially for higher quality luxury products, a rise in income will increase its demand. Therefore, given a constant rate of export revenue there will be a worsening of the current account and therefore the BOP. c. Country’s stage of development A developing country might have the te ndency to import more than it exports therefore running a trade deficit due to the need to acquire raw materials and capital goods for infrastructure development. A signi ficant worsening of the current account may negatively impact the BOP.

3. Cause of worsening capital account a. Political Instability A poor investment outlook due to political in stability, uncertainty and pessimism with respect to long term policy changes, et c. would suggest a poor environment for attracting foreign businesses. Firms might be inclined to uproot and start operations in a relatively stable economy exhibiting potential for growth. It would also deter companies intending to set up operations in the country. This movement of companies leaving an economy and companies not wanting to enter would constitute a fall in the long term flow of the capital account hence worsening the BOP. A politically unstable economy wo uld also deter individuals in wanting to invest in financial assets in the affected economy. This will cause short term investors to release existing holdings of cu rrency and financial assets held as a store of value resulting in a flight of funds to more stable offshore assets and be recorded as an outflow on the short term capital flow of the capital account. b. Interest rates Falling interest rates due to expansionary m onetary policy may lead to an outflow of short term capital by foreigners in order to exploit better returns in another region. This would negatively affect the short term capital segment of the capital account. c. Expected changes in exchange rate Any expected fall in the exchange rate valu e of a country’s currency (for instance the possibility of the monetary authority de preciating the domestic currency) may cause capital outflows and a capital account deficit in the short term cap ital flow segment. This is because investors may withdraw holdi ngs of funds in the domestic currency in order to seek better options to protect the value of their currency holding. 4. Conclusion Therefore, a worsening of the BOP can be due to the capital or current account being negatively affected. However, ve ry often it is not a single factor but a combination of causes negatively affecting the various compone nts of the BOP that lead to a worsening of the BOP. Hence, policy prescription has to take a multifaceted approach addressing a range of key sources. L1 An answer that exhibits some knowledge of factors worsening the BOP. Only provides 1 or 2 causes with inadequate explanations. 1-4 L2 An answer that provides a limited explanation of factors that negatively affect the current and capital account of the BOP. OR A thorough answer that provides an explanation of factors negatively affecting ONLY the current OR capital account of the BOP 5-7 L3 A clear and thorough answer that provides clear explanations of factors (at least 4) that worsen the current AND capital account thereby worsening the overall balance of payments. 8-10

(b) Comment on the measures available to a government faced with a worsening balance of payments. [15] Synopsis Students are required to provide measures av ailable to a government that are geared towards the current and capital account and how it addresses a worsening balance of payments. Measures suggested should clearly explain what component/s of the balance of payments are affected and how it would improve the overall balance. Measures should also be evaluated to highlight limitations and/or negative side effects. 1. Introduction - Implications of a balance of pa yments deficit. A persistent BOP deficit uses up a nation’s reserves to cover money that is owed and also sends a negative signal to investors. Therefore any possible investment into an economy improving growth and creating employment would be stifled. Given the negative e ffects of a worsening BOP a country may employ a number of measures to reverse the net outflow. There are two such categories of policies: Expenditure Reducing and Expenditure Switching. 2. How a country may deal with a worsening BOP a. Expenditure reducing policies - involves reducing the level of expenditure on imports which can be attained through contractionary monetary and fiscal policies. - Condition of usage: Since expenditure reducing methods invol ve cutting back expenditure that will affect growth it w ould have to be employed only if the economy is functioning close to full capacity. Imposing expenditure reducing measures for an economy that has troub le improving growth would have very serious negative consequences and would not be justified in targeting a specific problem like a worsening BOP against the backdrop of the wider economy. i. Contractionary monetary policy - Explain Policy - How it affects overall BOP (curre nt account and capital account): - Effect on current account Given an increase in interest rates through a contractionary monetary policy; the cost of borrowing for consumers will rise. Also higher interest rates would increase the opportunity cost of sp ending as money in the bank will be generating more interest income therefore discouraging spending. This reduction in spending will translate to a reduction in expenditure on imports. This impr oves the balance of trade in the current account if exports are unchangi ng. Given everything else is constant there will be an improvement in the balance of payments. - Effect on capital account The increase in interest rates will also attract ‘hot money’ into the economy which will positively affect the shor t term capital flow segment of the capital account thus reinforcing the improvement in the BOP.

Possible evaluation: Effect of interest rates on the exchange rate An increase in the inflow of short term i nvest ‘Hot money’ caused by an increase in interest rate will increase the demand of domestic financial assets thereby placing upward pressure on exchange rates. However, due to signed contracts for domestic importers and signed contracts of foreign im porters the PED of im ports and