Balance of Payments: When Economies Get Out of Balance (HL)

Balance of Payments: When Economies Get Out of Balance (HL)

We've reached the final level of our Balance of Payments trilogy – the HL content! Don't panic though, we'll break down these complex concepts with the same friendly approach. Grab your favourite study snack and let's dive into what happens when economies get seriously out of whack!

When Exchange Rates and Current Accounts Dance Together

Imagine you and your bestie are on a see-saw. When one goes up, the other goes down. That's basically how exchange rates and current accounts work together!

The Current Account → Exchange Rate Connection

When Europe buys more American iPhones (US exports), here's what happens:

1. Europeans need US dollars to buy these products

2. They swap their euros for dollars

3. More demand for dollars = dollar goes up in value

4. Meanwhile, the euro gets sold off = euro goes down in value

Real-world example: After Brexit, the UK pound plummeted against other currencies partly because investors were worried about Britain's future trade relationships. This made UK exports cheaper (good for British exporters like Burberry), but trips to Disney Paris suddenly became way more expensive for British families!

The Financial Account → Exchange Rate Connection

The financial account works similarly with exchange rates:

• When foreign investors pour money into London's property market, they need pounds

• More demand for pounds = pound value increases

• If foreign investors later sell those properties and take their money home, they sell pounds

• More pounds being sold = pound value decreases

Real-world example: When Japan announced negative interest rates in 2016, investors pulled money out of Japanese investments and put it in countries with higher returns like the US. This caused the yen to weaken against the dollar - making Japanese exports like Toyota cars cheaper for Americans!

When Current Account Deficits Become a Problem

Running a small current account deficit is like having a small overdraft - not ideal, but manageable. However, when deficits persist for years (like in the US and UK), there can be serious consequences:

1. Exchange Rate Pressure

A persistent deficit means you're constantly selling your currency to buy foreign currencies, putting downward pressure on your exchange rate.

Real-world example: The UK has run a current account deficit for decades, contributing to the pound's long-term decline from around $2.80 in the 1960s to about $1.25 today. That's why your grandparents always talk about how cheap everything was when they visited America "back in the day"!

2. Higher Interest Rates

To attract foreign capital and support your currency, you might need to raise interest rates.

Real-world example: When the UK's current account deficit widened dramatically in late 2022, the Bank of England had to raise interest rates more aggressively than planned - bad news for anyone with a mortgage!

3. Foreign Ownership of Your Stuff

To finance a current account deficit, you need capital inflows - often meaning selling domestic assets to foreigners.

Real-world example: Many iconic "British" brands aren't actually British-owned anymore! Cadbury was bought by American company Kraft (now Mondelez), Jaguar Land Rover is owned by India's Tata Motors, and even the energy company powering many UK homes (EDF Energy) is French-owned.

4. Debt, Debt, and More Debt

When you can't attract enough foreign investment, you might resort to borrowing.

Real-world example: Greece's persistent current account deficits in the 2000s contributed to its debt crisis in 2009-2010. When lenders finally lost confidence, Greece needed massive bailouts from the EU and IMF, leading to painful austerity measures.

5. Credit Rating Downgrades

Persistent deficits might cause rating agencies to downgrade your country's credit rating.

Real-world example: In 2013, the UK lost its prestigious AAA credit rating partly due to concerns about its persistent current account deficit. This was like going from having a perfect credit score to one that makes lenders slightly nervous.

6. Growth Problems

Addressing deficits often requires slowing down the economy - not fun!

Real-world example: When the UK faced a serious balance of payments crisis in 1976, it had to request an IMF loan with strict conditions including public spending cuts - leading to years of economic pain.

How to Fix a Current Account Deficit

So, your country's spending more than it's earning - how do you fix it? There are three main approaches:

1. Expenditure-Switching Policies: "Buy Local, Sell Global"

These policies aim to make your exports more attractive and imports less attractive:

a) Export Promotion

Helping domestic companies sell more abroad through subsidies, marketing, and trade missions.

Real-world example: The UK's "GREAT Britain" campaign promotes British goods and services globally, from Scotch whisky to financial services.

b) Trade Protection

Making imports more expensive through tariffs (taxes on imports) or quotas (limits on import quantities).

Real-world example: In 2018, the US imposed 25% tariffs on steel imports to protect its domestic steel industry and reduce its trade deficit. Spoiler alert: it didn't really work, and other countries retaliated with their own tariffs!

c) Currency Devaluation

Deliberately lowering your currency's value to make exports cheaper and imports more expensive.

Real-world example: China has been accused of keeping its currency artificially low for years to boost its exports. This strategy helped create China's massive trade surpluses and foreign exchange reserves.

2. Expenditure-Reducing Policies: "Tighten Your Belt"

These policies aim to reduce overall spending in the economy, including on imports:

a) Contractionary Monetary Policy

Raising interest rates to discourage borrowing and spending.

Real-world example: When the UK faced balance of payments problems in the early 1990s, interest rates were raised to as high as 15%! Imagine your parents' mortgage payments doubling overnight – ouch!

b) Contractionary Fiscal Policy

Increasing taxes or cutting government spending to reduce overall demand.

Real-world example: After the 2008 financial crisis, many European countries implemented austerity measures (government spending cuts) partly to address external imbalances. This helped reduce current account deficits but at the cost of higher unemployment.

3. Supply-Side Policies: "Get Better at Making Stuff"

These long-term strategies aim to make your economy more competitive:

a) Education and Healthcare Investments

Improving your workforce's skills and health.

Real-world example: Singapore invested heavily in education and training, transforming from a poor country in the 1960s to one with persistent current account surpluses today.

b) Infrastructure Improvements

Building better roads, ports, and digital networks to help exporters.

Real-world example: South Korea's world-class internet infrastructure helped companies like Samsung and LG become global export powerhouses.

c) Export Industry Support

Targeted policies to boost export-oriented industries.

Real-world example: Germany's "Mittelstand" (mid-sized manufacturing companies) receive specialised support and training, helping Germany maintain strong export performance and current account surpluses.

The Marshall-Lerner Condition: When Currency Devaluation Actually Works

Here's a cool economics concept that might come up in your exams: the Marshall-Lerner condition.

Basically, devaluing your currency only improves your current account if: PED of exports + PED of imports > 1

In normal human language: currency devaluation only works if consumers are sensitive enough to price changes!

If people will buy your exports regardless of price changes (like, say, Apple products or luxury goods), or if you simply must import certain things no matter the cost (like oil or essential medicines), then devaluation might not help much.

The J-Curve Effect: Things Get Worse Before They Get Better

When a country devalues its currency, something funny happens - the current account often gets worse before it gets better, creating a J-shaped curve when graphed:

1. Short Term (Getting Worse): Right after devaluation, imports become more expensive, but export volumes haven't increased yet.

2. Medium Term (Getting Better): Eventually, cheaper exports start selling more, and expensive imports get substituted with domestic alternatives.

Real-world example: After Brexit caused the pound to drop significantly in 2016, the UK's current account deficit actually widened initially before starting to improve – a classic J-curve!

When Surpluses Become a Problem

Surpluses sound great, right? More money coming in than going out! But persistent surpluses can cause their own problems:

1. Reduced Domestic Consumption

If you're producing more than you're consuming, your citizens might be missing out.

Real-world example: Germany has run massive current account surpluses for years, but German household consumption has been relatively weak. Critics argue that ordinary Germans could enjoy higher living standards if more of that surplus went into domestic spending!

2. Currency Appreciation Problems

A strong currency makes your exports more expensive.

Real-world example: Switzerland's persistent surpluses led to such a strong Swiss franc that the central bank had to intervene to prevent it from appreciating too much, which would have hurt Swiss exporters like watchmakers.

3. Inflation Worries

A big surplus means more money flowing into the economy, potentially causing inflation.

Real-world example: China's massive trade surpluses in the 2000s contributed to asset price bubbles in its property markets as all that extra money had to go somewhere!

4. International Tensions

One country's surplus is another country's deficit - leading to accusations of unfair trade practices.

Real-world example: The US has frequently accused China and Germany of deliberately maintaining undervalued currencies to boost their exports at America's expense.

The Big Picture: It's All Connected!

The most important HL concept to understand is that everything in the Balance of Payments is interconnected:

• Current account deficits must be financed by financial account surpluses

• Exchange rates adjust to balance these flows (in floating rate systems)

• Government policies affect all these relationships

• What happens in one country affects everyone else

Real-world example: China's massive current account surpluses in the 2000s were matched by equally massive financial account outflows - mostly into US government bonds. This helped keep US interest rates low, fueling the housing boom that eventually led to the 2008 financial crisis!

Exam Tips for Balance of Payments HL Questions

When tackling those tricky 15-mark HL evaluation questions about the Balance of Payments:

1. Always consider elasticities - The effectiveness of many policies depends on how sensitive imports and exports are to price changes

2. Think about time frames - Many policies work differently in the short vs. long term (J-curve effect!)

3. Consider different stakeholders - Exporters, importers, consumers, and the government all have different interests

4. Include real-world examples - Examiners love when you can apply theory to actual countries

5. Acknowledge trade-offs - There's rarely a perfect solution to balance of payments problems

In Conclusion: Balance is Everything!

The Balance of Payments isn't just some abstract economic concept - it reflects the real economic relationships between countries. Whether it's affecting the value of the pound in your pocket, the price of your next holiday, or even your future job prospects, these international flows matter!

The next time you hear about the UK's "worrying current account deficit" or "Germany's massive trade surplus" on the news, you'll understand what's really going on behind the scenes. And most importantly, you'll be ready to smash those HL exam questions!

Remember - in economics, when something seems too good to be true (like running deficits forever), it probably is!

Key HL Formulas to Remember:

• Marshall-Lerner condition: PED of exports + PED of imports > 1

• When the Marshall-Lerner condition is met, currency depreciation will eventually improve the current account balance

• Remember the J-curve: things often get worse before they get better!

Exam Tip: For those top HL marks, be sure to evaluate the effectiveness of policies using elasticities, time frames, and international considerations. Real-world examples are essential!

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