These are the slides from my revision presentation on Extract 2 for the OCR F585 A2 Global Economy paper for June 2016.

1. Extract 2
Globalisation and balance of payments imbalances
Globalisation and Balance of Payments Imbalances
OCR F585
Extract 2

2. Extract 2: Text and Commentary
• While globalisation has
brought about an
increase in the volume of
world trade, it has also
increased balance of
payments imbalances.
• Much of the discussion
about these global
imbalances has focused
on China’s current
account surplus and the
USA’s current account
deficit
• Imbalances refer to
persistent current
account surpluses for
some countries
contrasted with large
current account deficits in
other nations.
• The main way of
measuring the scale as
trade / current account
imbalances is as a % of
GDP.

3. Extract 2: Text and Commentary
• The period between 2007
and 2013 saw
fluctuations in the
current account deficit of
the USA and in its
effective exchange rate
index.
• Changes in its effective
exchange rate (see Fig.
2.2) did not always have
the expected impact on
the USA’s current account
deficit.
• The USA runs a permanent
(structural) current account
deficit on their balance of
payments
• Countries running external
deficits normally see their
currency depreciate
• The size of the US external
deficit halved from 2007 to
2009 – in large part due to the
economic recession.
• It has since been stable at
around $400bn per year
• But real GDP growth in the US
economy post crisis has
brought about a fall in the
external deficit as a % of US
GDP

4. Fig. 2.1 Current Account Balances of China and USA
China’s current account surplus has more than
halved since peaking > $400bn in 2008. It has
also declined as a % of China’s GDP
The US current account deficit has narrowed
from over $700bn in 2007 to under $400bn in
2009 and has remained fairly stable at this level
since – it must be declining as a share of GDP
Surplus
Deficit
This chart shows surpluses and deficits in trade
US recession in
2009 – causing
falling import
demand and a
thus smaller
trade deficit

5. Current Account Balances of China and USA (% of GDP)
China’s current
account surplus
measured as a
share of GDP has
diminished since
peaking at 10% of
GDP in 2007.
The Chinese surplus
averaged 2% of GDP
in the years 2012-
2014
Note: This data
shows trade with all
other countries and
not just the United
States!
Surplus
Deficit
Using % of GDP is a better measure of
the scale of a trade deficit or a surplus

6. Fig. 2.2 Effective Exchange Rate Index of US Dollar ($)
This is a depreciation between
2009 and 2011 of 8.65% but the
US deficit got worse between
2009-2011! See Fig 2.1
This is an appreciation between
2011 and 2013 of 4.2%
Base Year for
the Index
100
95
98
99
104
99
103
Overall, the US dollar has been depreciating against a trade-
weighted basket of other currencies. But the percentage changes
in the external value of the United States $ have been small.
This is a trade-weighted exchange rate index – i.e. based on share of USA trade with each country

7. Fig. 2.2 Effective Exchange Rate Index of US dollar ($)
Since the stimulus material was prepared –
the US dollar has continued to appreciate
strongly on a trade-weighted basis.
In part this is because of the decision by
the US Federal Reserve to start raising
interest rates + the summer 2015
devaluation of the Chinese Yuan

8. Chart: The US Dollar – Chinese Yuan Exchange Rate
China ends their fully-
fixed exchange rate
against the US dollar
Yuan per $1
Yuan appreciating v $
Effective return of a fixed
exchange rate during the
global financial crisis
China devalues the Yuan
in summer of 2015

9. How changes in exchange rates affects the trade balance
Depreciation in the
external value of
the US $
$ has fallen in value
e.g. v Chinese Yuan
and Japanese Yen
US goods and
services now
cheaper in foreign
currency terms
Imports into the
USA are more
expensive priced in
US $s
Overseas demand
for US exports
should rise
Demand for
imports coming
into USA should fall
Ceteris paribus, the
value of US exports
will rise
Ceteris paribus, the
value of US imports
will fall
So the US trade
deficit should
reduce in size

10. Evaluating the Effects of a Currency Depreciation
In theory a depreciation of the exchange rate causes an expansion
of aggregate demand and economic growth ....but this depends on:
1. The length of time lags as consumers and businesses respond
2. The scale of any change in the exchange rate i.e. 5%, 10%, 20%
3. Whether the change in the currency is short-term or long-term –
i.e. is a change in the exchange rate temporary or likely to persist
4. How businesses and consumers respond – the coefficient of
price elasticity of demand is important i.e. will there be a big
change in demand for exports & imports?
5. The size of any second-round multiplier and accelerator effects
6. When the currency movement takes place – i.e. which stage of
an economic cycle & the cycles of trade partners

11. Will an Exchange Rate Depreciation improve the BoP?
Time period after
depreciation
Trade
surplus
Trade
deficit
Currency
depreciation
here
Trade deficit may
increase in the
initial period after
depreciation
Net improvement in
trade provided certain
conditions are met –
known as the Marshall
Lerner condition
The diagram below shows the “J Curve effect” – it shows the time
lags between a falling currency and an improved trade balance

12. Understanding the Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation /
devaluation of the exchange rate will eventually lead to a net
improvement in the trade balance provided that the sum of the
price elasticity of demand for exports and imports > 1

13. Understanding the Marshall Lerner Condition
The Marshall Lerner condition states that a depreciation /
devaluation of the exchange rate will eventually lead to a net
improvement in the trade balance provided that the sum of the
price elasticity of demand for exports and imports > 1
Ped for exports Ped for imports
Sum of price
elasticity =
Will a fall in the
currency
improve the
trade balance?
Country A 0.4 0.3 0.7 No
Country B 1.2 0.7 1.9 Yes
Country C 0.8 0.2 1.0
Will leave the
trade balance
unchanged

14. Fig. 2.1 Current Account Balances of China and USA
Surplus
Deficit
This chart shows surpluses and deficits in trade
Extract 2: “Changes in its effective exchange rate did not always have the
expected impact on the USA’s current account deficit”

15. Why has the US current account deficit stayed large?
Extract 2: “Changes in its effective exchange rate did not always have the
expected impact on the USA’s current account deficit”
1. The scale of the exchange rate depreciation has been small (in % terms) – the US
dollar is the world’s reserve currency – it is seen as a safe haven
2. Impact of a fall in the exchange rate on US export and import demand depends on
coefficient of price elasticity of demand – a low Ped gives rise to the J curve effect
3. A fall in the value of the US dollar increases the price of imported components and
raw materials, pushing up costs of production for US firms e.g. car exporters – many
US exporters rely on imports of components in a world of complex supply chains
4. Inflow of portfolio investment / hot money into the USA e.g. from China has led to an
increased outflow of investment income which then worsens current account!
5. The role that the exchange rate plays on trade balances depends on the degree of
openness – the USA is a relatively closed economy with a trade-to-GDP ratio of less
than 30% - so the currency is less significant
6. Depreciation of the US $ may have happened when world trade was slowing down
7. Supply-side factors are more important in the long run in determining the scale of the
US current account deficit including capital investment, productivity and innovation

16. Extract 2: The Balance of Payments Accounts
• “These
international
financial flows are
recorded on the
financial account
of the balance of
payments of
individual
economies.”
• “Countries with a
current account
deficit experience
inflows on the
financial account
of the balance of
payments, and
countries with a
current account
surplus
experience
outflows.”
• Current Account
• (1) Balance of trade in goods
• (2) Balance of trade in services
• (3) Net primary income (e.g. interest, profits, dividends and migrant
remittances)
• (4) Net secondary income (including national contributions to the EU,
military aid, overseas development aid)
• Capital account
• Sale/transfer of patents, copyrights, franchises, leases and other
transferable contracts, and goodwill
• Transfers of ownership of fixed assets
• Financial Account – includes transactions that result in a change of ownership of
financial assets and liabilities between UK residents and non-residents
• Net balance of foreign direct investment flows (FDI)
• Net balance of portfolio flows (e.g. inflows and outflows of debt and
equity)
• Balance of banking flows (e.g. hot money flowing in/out of the banking
system)
• Balancing item (estimated errors & omissions)
• Changes to the value of reserves of gold and foreign currency
• Overall balance of payments = zero

17. Extract 2: The Balance of Payments Accounts
• Current Account
• (1) Balance of trade in goods
• (2) Balance of trade in services
• (3) Net primary income (e.g. interest, profits, dividends and migrant remittances)
• (4) Net secondary income (including EU payments, military aid, development aid)
• Capital account
• Sale/transfer of patents, copyrights, franchises, leases and other transferable
contracts, and goodwill
• Transfers of ownership of fixed assets
• Financial Account – includes transactions that result in a change of ownership of financial
assets and liabilities between UK residents and non-residents
• Net balance of foreign direct investment flows (FDI)
• Net balance of portfolio flows (e.g. inflows and outflows of debt and equity)
• Balance of banking flows (e.g. hot money flowing in/out of the banking system)
• Balancing item (estimated errors & omissions)
• Changes to the value of reserves of gold and foreign currency
• Overall balance of payments = zero

18. China’s Foreign Exchange Reserves
1,066.3
1,528.2
1,946
2,399.2
2,847.3
3,181.1
3,311.6
3,821.3 3,843
0
500
1000
1500
2000
2500
3000
3500
4000
4500
2006 2007 2008 2009 2010 2011 2012 2013 2014
ForeignexchangereservesinbillionU.S.dollars
China’s persistent current account
surpluses built around their export-
led economy has been a key factor
allowing the country to build up huge
reserves of gold and foreign
currency – this is shown in the chart

19. Extract 2: Savings From Developing Countries into USA
• “The other part of the
picture of global
imbalances is reflected
in international
financial flows from
developing to
developed economies.”
• “Savings from poor
countries have flooded
into the USA seeking
returns in US
government bonds and
in the US housing
market.”
If domestic savings
exceed the level needed
for capital investment
Surplus savings are
looking for highest risk –
adjusted rate of return
The US dollar is seen as
a safe haven currency
US quantitative easing
has increased demand
for bonds = higher bond
prices
A fresh surge in house
prices has also attracted
capital inflows
Net inflow of capital
into the US economy –
this helps to “cover” or
finance their current
account deficit
Countries with current account surpluses are
able to run capital account deficits (i.e. outflows)

20. Largest Current Account Surplus Countries (% of GDP)
Country 2013 2014 2015
Singapore 17.9 19.1 20.8
Taiwan Province of China 10.8 12.4 12.4
Netherlands 10.8 10.2 9.6
Kuwait 41.2 31.0 9.3
Germany 6.4 7.4 8.5
Switzerland 11.1 7.3 7.2
Korea 6.2 6.3 7.1
Denmark 7.2 6.3 7.0
Norway 10.0 9.4 7.0
Sweden 6.7 6.2 6.7
Slovenia 5.6 7.0 6.7
Thailand -0.9 3.3 6.2
Qatar 30.9 26.1 5.0
Ireland 3.1 3.6 3.2
China 1.6 2.1 3.1
Azerbaijan 16.4 14.1 3.0
Japan 0.8 0.5 3.0

21. Causes of Current Account Surpluses
Structural
Surplus of savings over
investment
Significant long run
competitive advantage
Long run rise in global
prices of main exports
Structural increase in
net investment income
Trend rise in factor
productivity
Cyclical
Depreciation of the
exchange rate
Strong consumer demand
in key export markets
Cyclical improvement in
the terms of trade
Fall in prices of imported
energy / components
Rise in net inflows of
remittances / profits

22. Significance of Current Account Surpluses
Contributor to GDP i.e. net external demand is positive
Might cause demand-pull inflationary pressure
Accumulation of foreign exchange reserves
Pressure on the currency to appreciate
Allows a country to be a net exporter of capital
Huge surpluses could trigger protectionist responses

23. Evaluation: Are Current Account Surpluses Damaging?
Current Account Surplus Countries
Country Surplus $bn % of GDP
Germany 274 7.5
China 183 1.9
The German surplus is
result of excess savings
This depresses demand
and growth for fellow EU
trade partners
Therefore unemployment
in EU is higher and
deflation risks increase
Surplus countries can run a
capital account deficit
This allows them to export
investment to other countries
Increases productive capital in
countries receiving FDI
including emerging economies
Criticisms of
the German
current
account
surplus
Benefits
from the
capital
account
deficits of
current
account
surplus
countries

24. Evaluation: Are Current Account Surpluses Damaging?
Current Account Surplus Countries
Country Surplus $bn % of GDP
Germany 274 7.5
China 183 1.9
The German surplus is
result of excess savings
This depresses demand
and growth for fellow EU
trade partners
Therefore unemployment
in EU is higher and
deflation risks increase
Surplus countries can run a
capital account deficit
This allows them to export
investment to other countries
Increases productive capital in
countries receiving FDI
including emerging economies
Criticisms of
the German
current
account
surplus
Benefits
from the
capital
account
deficits of
current
account
surplus
countries

25. Causes of Current Account Deficits
Structural
Under-investment
Relatively low
productivity
Persistently high
relative inflation
Inadequate R&D,
innovation
Emergence of lower
cost competition
Cyclical
Over-valued exchange
rate
Boom in domestic
demand
Recession in key
export markets
Slump in global prices
of exports
Increased demand for
imported technology

26. Significance of Current Account Deficits
Net outflow of AD from circular flow – this is a drag on real GDP growth
Loss of jobs in export sectors & industries affected by rising imports –
negative multiplier effects e.g. consider steel, coal etc.
Fall in foreign exchange reserves - can be problematic for smaller
developing nations who struggle to attract financial capital
Can lead to exchange rate weakness - reducing real living standards
and increasing investor risk – higher yields on government debt
Can a deficit be financed by hot money and portfolio investments?

27. Extract 2
Globalisation and balance of payments imbalances
Globalisation and Balance of Payments Imbalances
OCR F585
Extract 2

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