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 flig