Notes Of Macro Economics

Balance of Payments
The Balance of Payments is a record of a country’s transactions with the rest of
the world. It shows the receipts from trade. It consists of the current and financial
account.

UK current account 1955-2015

1. Current account
This is a record of all payments for trade in goods and services plus income flow
it is divided into four parts.

 Balance of trade in goods (visibles)

 Balance of trade in services (invisibles) e.g. tourism, insurance.
 Net income flows. Primary income flows (wages and investment income)
  Net current transfers. Secondary income flows (e.g. government transfers
to UN, EU)
2. Financial account
This is a record of all transactions for financial investment. It includes:

 Direct investment. This is net investment from abroad. For example, if a

UK firm built a factory in Japan it would be a debit item on UK financial
account)
 Portfolio investment. These are financial flows, such as the purchase of
bonds, gilts or saving in banks. They include
 short-term monetary flows known as “hot money flows” to take advantage
of exchange rate changes, e.g. foreign investor saving money in a UK
bank to take advantage of better interest rates – will be a credit item on
financial account
3. Capital Account
This refers to the transfer of funds associated with buying fixed assets such as
land

4. Balancing Item

In practice when the statistics are compiled there are likely to be errors,
therefore, the balancing item allows for these statistical discrepancies.

 (note the Financial Account used to be called the Capital Account, which is
potentially quite confusing. Even now some people refer to financial
account as the capital account)
Balance of payments equilibrium

 In a floating exchange rate the supply of currency will always equal the
demand for currency, and the balance of payments is zero.
 Therefore if there is a deficit on the current account there will be a surplus
on the financial/capital account.
 If there was an increase in interest rates this would cause hot money flows
to enter the UK, therefore there would be a surplus on the financial
account
The appreciation in the exchange rate would make exports less competitive and
imports more competitive therefore with fewer exports and more imports there
would be a deficit on the current account.

Factors affecting the balance of payments

A current account deficit could be caused by factors such as.

 1. The rate of consumer spending on imports. For example, during an
economic boom, there will be increased spending and this will cause a
deficit on the current account.
2. International competitiveness. If a country experiences higher inflation
than its competitors, exports will be less competitive leading to lower
demand.
3. Exchange rate. If the exchange rate is overvalued, it makes exports
relatively more expensive leading to a deterioration in the current account.
4. Structure of economy – deindustrialisation can harm the export sector.
 Factors affecting current account deficit
Should we be concerned about a current account deficit?

In the UK, a current account deficit often increases after a period of economic
growth. Higher economic growth leads to higher consumer spending and
therefore more spending on imports.

In an economic downturn, spending on imports usually declines leading to a

smaller current account deficit.
Policies to reduce a current account
deficit
28 July 2019 by Tejvan Pettinger

A current account deficit occurs when the value of imports (of goods/services/inv.
incomes) is greater than the value of exports. Policies to reduce a current
account deficit involve:

1. Devaluation of exchange rate (make exports cheaper – imports more

expensive)
2. Reduce domestic consumption and spending on imports (e.g. tight fiscal
policy/higher taxes)
3. Supply side policies to improve the competitiveness of domestic industry
and exports.
The UK has had a persistent current account deficit since the mid-1980s.

Policies to reduce a current account deficit

1. Devaluation
This involves reducing the value of the currency against others. (e.g. selling
pounds would cause the value of the Pound to fall)

 If there is a devaluation of the currency, the price of imported goods

increases and therefore the quantity demanded of imports falls.
 Exports will become cheaper, and there will be an increase in the quantity
of exports.
 Therefore, assuming demand is relatively price elastic, we would expect a
devaluation to lead to an improvement in (X-M) and therefore the current
account on the balance of payments.
 However, it does depend upon the elasticity of demand for exports and
imports.
The Marshall Learner Condition
This states that a devaluation will improve the balance on the current account, on
the condition that the combined elasticity’s of demand for imports and exports is
greater than one.

 If (PED x + PED m > 1) then a devaluation will improve the current

account.
 If (PED x + PED m > 1) then an appreciation will worsen the current
account.
This is because the effect on the current account depends on the total value and
not just the quantity of exports.

The J Curve effect

 In the short term, demand for imports and exports tends to be inelastic.
Therefore, after a devaluation, the current account tends to get worse
before it gets better. However, over time, demand becomes more price
elastic and the current account improves.
 Another problem with devaluation is that it can lead to imported inflation.
Basically, imports will be more expensive. Higher inflation can reduce the
countries competitiveness. Therefore the improvement in the current
account might only be temporary.
 More on the J-Curve effect
See more on effects of devaluation
Deflationary policies

These are policies aiming at reducing the growth of aggregate demand and
reducing inflation. They can include a tightening of fiscal policy or monetary
policy; this will reduce aggregate demand.

2. Monetary policy

Tight monetary policy involves increasing interest rates.

 Higher interest rates will increase the cost of debt and mortgage
repayments and leave people with less money to spend. Therefore, this
will reduce their consumption of imports, improving the current account.
 Also, higher interest rates will cause a fall in AD and therefore reduce
economic growth. This will reduce inflation and help to make UK exports
more competitive.
 Deflationary policies will also put pressure on manufacturers to reduce
costs, and this will lead to more competitive exports, and so exports may
increase in the long run because of this effect.
Evaluation of monetary policy for reducing current account
 The main issue with using monetary policy to reduce a current account
deficit is that an increase in interest rates will tend to cause hot money
flows and therefore an appreciation in the exchange rate. This appreciation
makes exports less competitive, and imports more attractive. Assuming
demand is relatively elastic, this appreciation will worsen the current
account.
Therefore, monetary policy has two conflicting effects.

1. Higher interest rates reduce spending on imports – improving the current

account.
2. But, on the other hand, higher interest rates cause an appreciation in the
exchange rate – worsening the current account.
 The overall effect is uncertain – it depends on which effect is bigger.
 However, since the UK has a high marginal propensity to import, higher
interest rates will tend to cause a reduction in AD and improve the current
account significantly.
 It depends on many other factors, for example, if the economy is growing
strongly, a rise in interest rates may not actually reduce consumer
spending – because income growth is high and confidence high.
Deflationary fiscal policy

 An alternative to using monetary policy is to use fiscal policy. For example,

the government could increase income tax. This would reduce consumer
discretionary income and reduce spending on imports.
 The advantage of fiscal policy is that it would not have an adverse effect
on the exchange rate. Higher income tax would also improve government
finances.
 However this policy will conflict with other macroeconomic objectives –
with lower aggregate demand (AD), growth is likely to fall causing higher
unemployment. A government is unlikely to want to risk higher
unemployment just to reduce a current account deficit.
3. Supply side policies

 Supply side policies can improve the competitiveness of the economy and
help make exports more attractive. This can improve the current account
position, but it may take considerable time to have an effect.
 For example, if the government pursued a policy of privatisation and
deregulation it may help to increase the efficiency of the economy because
of the profit motive in the private sector. This increased efficiency would
translate into lower costs of production and more exports
See: supply side policies
4. Lower wages

A policy used by many Eurozone economies facing a large current account

deficit (but unable to devalue within single currency) is to reduce wages. Lower
wages will reduce costs of production and improve competitiveness.

 However, lower wages will also lead to lower aggregate demand and could
lead to deflation and low growth.
 If the government cut public sector wages, it may have limited impact on
improving the competitiveness of exports.
 Reducing wages is also known as internal devaluation.
5. Protectionism

The government could increased tariffs on imports or even impose quotas. Both
these measures would have the impact of reducing imports and therefore
improve the current account.

However:
 Protectionism may lead to retaliation – with other countries placing tariffs
on our exports – so exports could decrease.
  Protected by tariffs – domestic industries may become uncompetitive
because there is less incentive to cut costs.

Policies to reduce a current account could also be classified into two types:

1. Expenditure switching policies

 This involves changing the goods that people buy. For example
 Devaluation makes domestic goods relatively cheaper,  and imports
more expensive. Therefore consumers will switch from buying imports
to domestic goods
 Supply side policies make British goods relatively more attractive

2. Expenditure reducing policies

 Policies to reduce overall spending on imports.
 This can involve tight fiscal or tight monetary policy.

Economic Growth
Economic growth means an increase in real GDP – which means an increase in
the value of national output/national expenditure.

Economic growth is an important macro-economic objective because it enables

increased living standards, improved tax revenues and helps to create new jobs.

Aspects of economic growth

 Causes of economic growth
 Costs/benefits of economic growth
 Policies to improve economic growth
 Different types of economic growth
 Recessions (negative economic growth)
 UK
real GDP since 1955. Showing sustained a rise in national output (despite brief periods of negative
economic growth).

Source: ONS
Causes of economic growth

Economic growth is caused by rising demand and an increase in productive

capacity.
1. An increase in aggregate demand AD=(C+I+G+X-M) – a rise in
consumption, investment, government spending, exports – imports.
2. Increase in aggregate supply (increase in capital, investment, higher
labour productivity)
 See more on the causes of economic growth
Diagram showing long-run economic growth
In this diagram, we have an increase in aggregate demand (AD) and an increase
in long-run aggregate supply (LRAS). This enables a rise in real GDP – without
causing inflation.

Example of economic growth

 If the Central Bank cut interest rates, this would provide an incentive for
firms to invest (borrowing would now be cheaper).
 This investment is a component of AD and AD will rise. With higher
investment, more people will be employed, and there is a purchase of raw
materials.
 Also, the cut in interest rates will encourage consumer spending due to
lower borrowing costs and lower mortgage repayments. This will cause an
additional rise in AD.
 The investment will also lead to an increase in productive capacity (LRAS)
with firms gaining more capacity to meet demand.
Productivity

 A key factor in enabling economic growth in the long-term

is productivity. Productivity is output per worker.
 If there is the development of new technology (computers, machines), it
means workers will be able to do produce more.
 This growth in output per worker is a key factor behind economic growth.
Policies to increase economic growth
1. Supply-Side Policies
Supply-side policies are government attempts to increase productivity and
increase efficiency in the economy. The aim is to shift Long Run Aggregate
Supply (LRAS) to the right. Examples could include:

 Income tax cuts (to increase incentives to work);

 Privatisation (Make government-owned firms private to increase the profit-
incentive and efficiency.)
 Reduce red-tape and bureaucracy which raises costs for firms.
 Spending on education and training to improve labour productivity
  More on Supply-Side Policies
2. Monetary policy

Reducing interest rates to stimulate economic activity and increase AD. Lower
interest rates reduce the cost of borrowing. This encourages households to
spend. Also, it is cheaper for firms to finance investment so investment should
rise. If successful, lower interest rates should increase aggregate demand, and in
the long-term, increase long-run aggregate supply.

However, lower interest rates may not always cause higher growth. If confidence
is very low, firms may still be reluctant to invest.

Also, there is a limit to how much monetary policy can increase growth. If the
economy is close to full capacity, then rising AD will cause inflation and the
growth will be unsustainable.

See more at Monetary policy

3. Fiscal policy
Expansionary fiscal policy involves higher government spending and/or cutting
taxes to boost aggregate demand.  This fiscal policy will lead to higher
government borrowing, which can be a constraint on the policy.
  Keynes was an advocate of fiscal policy in a recession. Keynes argued in
a recession, the private sector increased their saving ratios and the
government needed to intervene.
 However, monetarists and classical economists are more sceptical arguing
expansionary fiscal policy will cause crowding out.
Benefits of economic growth

1. Higher incomes for workers and firms.

2. Increased tax revenue for the government which can be spent on public
services, e.g. education, pensions and healthcare.
3. Reduced government debt. Higher economic growth usually reduces the
government’s budget deficit because of the improved tax revenues.
4. Economic growth creates employment and helps to reduce unemployment.
5. Economic growth creates a positive feedback loop. Higher growth
encourages firms to invest. The increased investment enables higher
growth in the future.
6. Economic growth enables a reduction in absolute poverty. In the past 100
years, growth has helped to significantly reduce absolute poverty in
Western Europe, the US and recently in Asia.
See: Benefits of economic growth
 Potential costs of economic growth
1. Inflation. If growth is too fast, we could experience inflation.
2. Current account deficit. If growth is unbalanced, we could see a growing
current account deficit as people buy more imports.
3. Environmental costs. Economic growth leads to higher resource
consumption and pollution.
4. A decline in living standards. Economic growth does not always increase
living standards. Higher growth could cause new problems such as
congestion, increased crime, increased dissatisfaction and more pollution.
5. See more at: Costs of Economic Growth
Types of economic growth

There are different types of economic growth

 Boom and bust economic cycles. If growth is very fast and inflationary,
then the growth will prove to be unsustainable and there will be the costs
of the recession and an economic downturn.
 Export-led growth. Economies such as Japan and China have
experienced export-led growth. This enables economic growth and a
current account surplus. China has increased its ownership of foreign
assets.
 Consumer-led growth. Since 1979, UK economic growth has been more
dependent on consumer spending. The UK has run a persistent current
account deficit with fears the economic growth is unbalanced.
 Commodity exports. Some countries very rich in resources have
economic growth based on production and export of raw materials. For
example, Saudi Arabia (oil), Venezuela (oil), Cuba (sugar) Congo (oil and
natural resources). Whilst export of raw materials can increase wealth, it
can also cause problems. The resource curse states countries which have
growth based on raw materials may struggle in long-term, as raw material
industries crowd out other manufacturing industries and make the
economic growth more volatile – depending on fluctuating prices.
Long-run trend rate of economic growth

The long-run trend rate is the average sustainable rate of growth over a period of
time. The long-run trend rate depends on the growth of productivity and is related
to levels of technology and investment.

Other Definitions
 Balanced growth – growth that is sustainable (avoiding booms and busts)
 Trade cycle – how economic growth can be cyclical – booms, busts,
recovery
 Sustainable growth – growth that is balanced and environmentally
sustainable.
Recessions
A recession is a period of negative economic growth, where output falls for two
consecutive quarters. This graph shows the deep recession in the US economic
2008-09. (known as the Great Recession)
 See: Causes of Recessions
Does economic growth increase welfare?