Essay Ken Hutchinson
In 1994 the UK had a Balance of Payments current account deficit. Explain the possible effects that this deficit might have upon the economy
Discuss what, if anything the UK Government could have done to reduce or eliminate this current account deficit.
The balance of payments is a record of one country's trade dealings with the rest of the world. Any transaction involving UK and foreign citizens is calculated in sterling (UK pounds). Dealings, which result in money entering the country, are credit (plus) items while transactions, which lead to money leaving the country, are debit (minus) items.
The balance of payments can be split up into two sections:
1. the current account which deal with international trade in goods and services;
2. transactions in assets and liabilities which deals with overseas flows of money from international investments and loans;
The current account consists of international dealings in goods (visible trade) and services (invisible trade).
Invisible trade includes payments for overseas embassies and military bases: interest, profit and dividends from overseas investment; earnings from tourism and transportation.
The cause of a deficit was that the UK imported more visible goods than it exported and there was a net deficit on transfers, our service earnings plus overseas incomes did not exceed our service payments plus investment income paid abroad sufficiently to prevent the balance on current account being well in deficit.
The state of the trade balance is extremely important since changes in imports and exports have a important bearing on the real economy and in particular on output and employment. In the longer run, a persistent deficit, if it cannot be offset by a surplus on invisibles, will have serious implications. It will handicap the conduct of the macroeconomic policy. Its effect will be to increase instability of exchange rates and/or interest rates as the UK becomes dependent on inflows of hot money to finance the deficit. Higher interest rates are also likely to cause a reduction in real investment and therefore in economic growth. The current account deficit might also be financed by increased sales of assets to overseas firms and residents, which in the long run, will lead to an increased outflow of interest, profits and dividends.
continued borrowing of foreign currency;
increasing interest rates to attract overseas investors;
imposing exchange controls;
Imposing tariffs and import quotas.
In the long run, the government can correct a balance of payments deficit by reducing demand in the economy for all goods including imports. Reducing UK inflation rates or encouraging a sterling depreciation will also help.
The correct measures to remedy a deficit will depend upon its cause and also upon the exchange rate regime. A short-term deficit might be dealt with by running down reserves or by borrowing. Another short-term measure might be to raise interest rates to encourage the inflow money. When there is a more fundamental payments deficit, other methods will have to be taken.
The following show ways in which the government can tackle the problem of a deficit in the Current Accounts.
Deflation is where the demand for imports are restrained by restricting the total level of demand in the country through fiscal and monetary polices
Protection is where the country cuts all trade with the outside world by cutting off all imports and therefore protecting the home market from foreign competition
Devaluation is where a fixed exchange rate drops the external price of its currency, as the UK did in 1967 when the rate changed from £1=$2.80 to £1=£2.40, this is referred to as a devaluation which means exports will now appear cheaper to foreigners while imports will seem more expensive to domestic customers.
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