Economics A2 Booklet 2

Year 13
2024-2025
Unit 11 part 2
11.1 Policies to correct disequilibrium in
the balance of payments
11.2 Exchange rates
Name: ______________________________
ALIS grade: ____________
Target grade: ___________

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 Paper 3 grade thresholds
Percentage Grade
80% A
70% B
64% C
57% D
50% E
Below 50% U
Paper 4 grade thresholds
Percentage Grade
64% A
54% B
49% C
44% D
37% E
Below 37% U
The overall thresholds for Assessments (Combining paper 3 and 4 and AS marks)
Percentage Grade
72% A*
63% A
53% B
45% C
40% D
31% E
Below 31% U

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11.1 Policies to correct disequilibrium in the balance of payments

11.1.1 Components of the balance of payments accounts:

48.1 The components of the balance of payments
§ The balance of payments records all economic transactions between residents
and non-residents during a given time period.
§ The balance of payments account consists of the current account, the capital
account and the financial account.
§ It also includes net errors and omissions (also sometimes known as the balancing
item).
§ Net errors and omissions: a figure included to ensure that the BOP balances
sometimes called the balancing item.
§ For some countries, the financial account is the largest component of the balance
of payments.

Financial account
§ The financial account forms a large part of some countries’ balance of payments. It
records movements of funds into and out of the country.
§ It is made up of four parts:
1. Direct investment covers the building of a factory in another country and the
takeover of an existing firm in another country (debit items), or the setting up of
a new plant or the takeover of a firm in the country by a foreign firm (credit
items).
2. Portfolio investment includes the purchase and sale of government bonds and
shares that do not involve legal control of a firm.
3. Other investments cover shorter-term movements of financial investment
including bank deposits, bank loans and inter- government loans that move
between countries. Direct, portfolio and other investments generate investment
income that appears in the primary income section of the current account.
4. Reserve assets are made up of the government’s holdings of gold, foreign
exchange reserves, Special Drawing Rights (a form of international money
created by the International Monetary Fund (IMF)) and changes in the country’s
reserve position in the IMF. Reserves are kept to settle international debts and to
influence the value of the foreign exchange rate. Additions to the reserves are
shown as debit items, while reductions to the reserves are shown as credit items.
This is because, for instance, if the central bank of a country sells some of its
foreign currency, the country will be gaining its own currency in exchange, so
there will be a flow of currency into the country.

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A financial account deficit
§ A financial account deficit is not necessarily a problem, especially as it will give
rise to an inflow of profits, interest and dividends in future years.
§ The deficit may also be short-term, resulting from hot money flowing out of the
country in search of higher interest rates and in expectation that other currencies
may rise in value.
§ However, if it results from a long-term lack of confidence in the country’s
economic prospects, it will be a concern. Such a concern might result in a capital
flight, when the country’s residents move their money from domestic to foreign
banks and the countries’ firms move some production abroad.
§ The movement of funds and production out of the country reduces tax revenue
and reduces potential employment economic growth.
§ A financial account deficit may also result in a depreciation in the exchange rate.

A financial account surplus

§ A financial account surplus arises when more direct and portfolio investment and
loans enter the country than leave it. This may occur as a result of foreigners
being impressed by the country’s economic prospects.
§ A financial account surplus can have a number of advantages:
Ø It can finance a deficit on the current account of the balance of payments.
Ø It can also create employment in the country and raise the country’s
economic growth.
§ In the long run, however, a financial account surplus will result in more money
flowing out of the country in the form of profit, interest and dividends.
§ This may result in a deficit on the primary income balance of the current account
unless offset by an increase in the country’s direct and portfolio investment and
loans abroad.

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Capital account
§ For most countries, the capital account is a relatively small part of the balance of
payments.
§ It includes non-produced, non-financial assets.
§ Examples of items in the capital account are government debt forgiveness, money
brought into and taken out of the country by migrants, the sales and purchases of
copyrights, patents, trademarks and mineral rights.

Net errors and omissions

§ The balance of payments as a whole must always balance.
§ This is because any credit item has to be matched by a corresponding debit item.
§ For example, if a country sells exports, these exports will be recorded as credit
items.
§ To purchase the exports, foreigners would have to obtain the currency of the
country they are importing from. They may do this by, for instance, borrowing
from the country’s banks – a debit item.
§ A deficit on the current account of the balance of payments should be matched by
a surplus of equal value on the capital and financial accounts.
§ In practice, with so many transactions involved, it is difficult to keep an accurate
record. Some mistakes are likely to be made and some transactions may not be
included.
§ To compensate for this, a net errors and omissions figure is included.
§ For example, if the current account plus the capital and financial accounts, add up
to minus $2000 million, this means that $2000 million more must have come into
the country than was recorded. In this case, a net errors and omission figure of
plus $2000 million would be added. By including the net errors and omissions
figure, it means that the current account, capital account, financial account and
net errors and omissions equal zero.
§ More and better-quality information is likely to become available over time, and so
the size of the net errors and omissions figure usually declines.
§ The value of current account deficits experienced by some countries should be
matched by the value of the current account surpluses experienced by other
countries, but again, due to mistakes and items being left out, this is not the case.

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1.

2.

3.

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48.2 Effect of fiscal, monetary, supply-side, protectionist and exchange rate
policies on the balance of payments:
§ A government and its central bank may use a range of policies to influence the
components of its balance of payments.
The scope for using fiscal and monetary policies to reduce a current account
deficit or surplus:
§ It could use contractionary fiscal and/or contractionary monetary policy to reduce
demand for imports and encourage firms to switch some of their products to the
export market.
The scope for using supply-side policies to improve international
competitiveness:
§ Supply-side policy measures may be introduced to promote greater international
competitiveness.
The scope for using protectionist policies to reduce spending on imports and
increase spending on domestic goods:
§ Protectionist policy may be used to reduce demand for imports largely by seeking
to replace spending on imports by spending on domestically produced products.
The scope for using exchange rate policies to reduce a balance of trade deficit
§ Changes in the exchange rate can be implemented to affect the price of exports
and imports and so the trade balance. Such changes in the exchange rate may
only have a short- term effect on the current account balance.
§ An exception may be a government deciding to stop maintaining an exchange
rate that is set above or below the market value.
§ For example, if a central bank has kept an exchange rate above its equilibrium
level, the high export prices and low import prices may have led to a current
account deficit.
§ In this case, allowing the exchange rate to increase to its market rate may
reduce the country’s deficit.

Evaluation of the policies:

o Depending on the measures adopted, fiscal policy, monetary policy and exchange
rate policy can be used to reduce either a deficit or a surplus on the current account
of the balance of payments.
o In contrast, supply- side policy would only be used to try to reduce a current account
deficit. It is also likely that protectionist policy would be most likely to be used to
reduce a deficit.
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o There can be occasions when a government or central bank, in pursuing another
macroeconomic policy objective, introduces a policy measure which has an
unintended consequence for the balance of payments.
o For example, a government may lower income tax in an attempt to reduce
unemployment, but some of the increase in spending created may go on imports.
This could increase a current account deficit.
o If government wishes to increase its country’s economic development, or to finance
a deficit on the current account it may aim for a surplus on the financial account of
the balance.
o Attracting multinational companies to set up in the country may increase
employment and income growth.
o Selling shares in the country’s firms to foreigners will provide funds for the firms to
expand.
o Borrowing from abroad may help to cover the cost of imported raw materials and
capital goods which may, in the long run, reduce a current account deficit.
o To attract a net inflow of direct investment, portfolio investment and bank loans, a
government will aim for macroeconomic stability.
o The main type of policy it is likely to use is supply-side policy. A rise in the quantity
and quality of the country’s resources that result from improvements in education,
training, infrastructure and technology is likely to prove attractive to foreign
investors.
o Trade union reform may make multinational companies more willing to invest in the
country if the reform results in a fall in industrial action. Privatisation may also
increase the opportunity for foreign direct investment. Of course, as previously
mentioned, some supply-side policy measures can take time to have an effect and
the outcomes are not certain.
o To encourage domestic consumers and firms to switch to buying domestic products,
a government may impose a tariff on imports or increase an existing tariff. Such a
tool works more effectively when domestically produced substitutes of a high quality
are available.

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48.3 Expenditure-switching and expenditure-reducing policies
o There are two broad-based policy approaches that can be used to correct an
imbalance in the balance of payments. These are expenditure switching policy and
expenditure reducing policy.
o Expenditure switching policy: policy tools designed to encourage people to
switch from buying foreign-produced products to buying domestically produced
products.
o Expenditure reducing policy: policy tools designed to reduce imports and
increase exports by reducing demand.

Expenditure-switching policy
§ An expenditure-switching policy is any action taken by a government that is
designed to persuade purchasers of goods and services, both at home and abroad,
to buy more of that country’s goods and services and less of the goods and services
of other countries.
§ This would include any policy tools designed to persuade domestic households and
firms to buy domestically produced goods and services rather than imports.
§ It would also include policy tools designed to persuade foreign households and firms
to buy more exports from the domestic economy.
§ Expenditure-switching policies are not designed to reduce the total amount of
spending in a country but to redirect or ‘switch’ spending to the country’s products
rather than those produced in other countries.
§ The intended impact is a fall in import expenditure and a rise in export earnings.
§ The types of policy which are most commonly used as expenditure- switching
policies are supply-side, protectionist and exchange rate.
§ For example, a government may increase spending on infrastructure to reduce the
cost and price of domestic products, may impose import tariffs to reduce demand
for imports or may instruct its central bank to lower the exchange rate to lower
export prices and raise import prices.

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Expenditure-reducing policy
§ An expenditure-reducing policy is any action taken by a government that is
designed to reduce the total level of spending in an economy.
§ An expenditure-reducing policy has two effects.
§ One is a reduction in spending, which will mean that there will be fewer
purchases of imported goods and services.
§ The second is that domestic producers will find that their domestic market is
reduced.
§ As a result, domestic producers may try to make up for the decrease in domestic
sales with an increase in sales abroad.
§ The overall effect of an expenditure-reducing policy may be a fall in imports and
a rise in exports.
§ Fiscal policy and monetary policy can be used as expenditure-reducing policies.
§ A government could raise taxes and cut its spending.
A central bank could reduce the money and increase the rate of interest to
reduce spending in the economy

Exit ticket:
Answer textbook questions for chapter 48 pg. 532, 533 and 534.
Q. Ans.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Mark ___/10
Percentage

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11.2 Exchange rates

49.1 Measurement of exchange rates

§ There are a number of ways of measuring the price of a currency.
§ It can, for example, be measured in terms of how much it costs in another
currency.
§ It can also be measured in terms of what can it buy in another country or
countries and in terms of a basket of currencies.
§ Exchange rates can be measured in terms of nominal value, real value and
trade-weighted value.

Nominal and real exchange rates

§ Nominal exchange rate: is the price of one currency in terms of another
currency.
§ Real exchange rate: a currency’s value in terms of its real purchasing power. This
is often referred to as purchasing power parity.

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§ Economists also measure real exchange rates. A real exchange rate takes price
changes as well as exchange rate changes into account to assess changes in the
competitiveness of a country’s products in global markets.
§ A fall in a country’s foreign exchange rate would be expected to make its exports
more price competitive. However, if the country is experiencing a relatively high
inflation rate, export prices may actually be increasing.
§ A real exchange rate compares the relative price of two countries’ products:

§ The real exchange rate may rise as a result of:

Ø an appreciation of exchange rate
Ø an increase in the country’s relative inflation rate.
§ The price of products in the country will increase relative to those in another
country or countries.
§ More imports could be purchased for a given quantity of exports. As the country’s
products are more expensive relative to its competitors, the country is likely to
import more and export less.
§ The real exchange rate has more of an impact on the current account balance than
the nominal exchange rate as it reflects international price competitiveness.

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Trade-weighted exchange rate:
§ Trade-weighted exchange rates: the price of one currency against a
basket of currencies.
§ A country trades with a number of other countries and it is possible that its
currency may rise in value against some countries while falling against
others.
§ A trade-weighted exchange rate is a measure, in index form, of the price of
a currency against a basket of currencies.
§ These are weighted according to the relative importance of the countries in
the country’s trade.
§ These are weighted to reflect the relative importance of trade for the
country of the currencies in the basket. If, for example, the UK does
five times more trade with the EU as it does with Japan then the euro will
be given five times the weight of the yen.

49.2 Determination of exchange rates

§ Exchange rates can be determined by a government, by the free market
forces of demand and supply or by a combination of the two.
§ Most governments and their central banks today allow market forces to play
a large role in determining their countries’ exchange rates but may intervene
if there are large fluctuations in their value.

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A fixed exchange rate system
§ It is an exchange rate set by the government and maintained by a central
bank.
§ The central bank will maintain the rate by direct intervention and/or by
trying to influence the market demand for and supply of the currency.
§ Direct intervention will involve the central bank buying or selling the
currency.
§ It may try to influence the market demand and supply by changing the
rate of interest.
§ If, for instance, there is downward pressure on the exchange rate because
the supply of the currency is increasing on the foreign exchange market,
the central bank is likely to buy the currency.
§ The central bank may also increase the rate of interest. Such a measure
may attract hot money flows, with people buying the currency to place into
accounts in the country’s financial institutions.

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 § If the supply of the currency increases to S1, the central bank may buy
enough of the currency to shift the demand curve to D1 and maintain the
value of the currency at $0.25.
§ It is easier for a central bank to maintain a fixed exchange rate if that rate
is set close to the long-run equilibrium value of the currency.
§ This is because it will only have to offset short-run – and possibly relatively
small – fluctuations.
§ If, however, the exchange rate is overvalued, the central bank may be in
danger of running out of reserves trying to keep the exchange rate at a
level that does not reflect its market price.
§ Devaluation: A reduction in the value of a fixed exchange rate to a lower
level.
§ Revaluation occurs when the government raises the exchange rate to a
new, higher fixed rate.

Disadvantages of a fixed exchange rate

§ The need to keep reserves. This involves an opportunity cost, as the
foreign exchange or gold, for instance, could be used for other
purposes.
§ There is also the risk that a government may sacrifice other policy
objectives in order to maintain the fixed exchange rate. For instance, a
central bank may raise the interest rate in a bid to keep the exchange
rate at the price the government wants maintained. However, a higher
interest rate may reduce aggregate demand and increase
unemployment.
§ Market pressures may mean that the rate at which the currency is fixed
may have to be changed over time.
Advantages of fixed exchange rate:
§ A fixed exchange rate does create certainty, which can promote
international trade and investment. For instance, a foreign firm may be
more willing to set up a branch in the country if it knows how much any
revenue it earns will be worth in its own currency.
§ A fixed exchange rate also imposes discipline on a government to keep
inflation low, so that a loss of international price competitiveness does not
put downward pressure on the exchange rate.

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A managed system
§ A managed system, in effect, combines features of a floating exchange
rate system and a fixed exchange rate system.
§ It usually involves a government allowing the exchange rate to be
determined by market forces within a given band, which has upper and
lower limits.
§ Figure 49.5 shows that the government sets a central value of P, an upper
band of Pa, which it does not want the exchange rate to exceed, and a
lower limit of Pb, which it does not want it to fall below.
§ If the exchange rate is within the limits, for example at Pc, no action will
be taken. If, however, demand for the currency were to rise to D1, the
central bank would sell the domestic currency to increase supply to S1 and
so keep the exchange rate within the desired band.

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49.3 Revaluation and devaluation of a fixed exchange rate
a. Revaluation of Fixed exchange rate:
§ A revaluation occurs when a government raises the exchange rate to a new,
higher fixed rate.
§ This higher price will be maintained by the government.
§ If there is downward pressure on the currency, the central bank will buy the
currency, using some of its reserves.
§ It might also raise the interest rate.

b. Devaluation of Fixed exchange rate:

§ A devaluation is a reduction in the price of the currency arising from a
government’s decision to maintain it at a new lower level.
§ If there is upward pressure on the new, lower exchange rate, the central
bank will sell its currency.
§ The increased supply of the currency on the foreign exchange market may
keep the price low.
§ The central bank might also lower the interest rate to reduce demand for
the currency and increase its supply.

Devaluations and revaluations occur for two main reasons.

§ One reason is that the current exchange rate is not sustainable. It results
in surpluses or shortages of the currency in the foreign exchange market.
§ The second reason is the use of devaluations and revaluations as a policy
tool.

Changes in the exchange rate under different exchange rate systems

A floating exchange rate will change:
§ When there are changes in the market forces of demand and supply.
§ The main reasons why demand for the currency may rise are increases in
demand for the country’s goods and services, increases in direct and
portfolio investment in the country and speculation that the currency will
rise in price.
§ The supply of the currency will decrease if the country buys fewer imports,
invests less abroad and it is expected that the currency will rise in price.

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A fixed exchange rate does not often change but a change when it does
occur is the result of a government decision.

§ A government will devalue its currency if:

Þ the government thinks that it cannot maintain its current price.
Þ If market forces are putting downward pressure on the price of the
currency, there is a risk that the central bank will run out of the
reserves that it can use to buy the currency.
Þ A government may also be reluctant for its central bank to raise the
interest rate to encourage hot money flows. This is because the higher
interest rate could reduce economic activity.
Þ A government may also devalue the currency to increase the
international competitiveness of its products so as to reduce a current
account deficit, increase economic growth and reduce unemployment.
§ A government may instruct its central bank to bring about a
revaluation of the currency if:
Þ it thinks there is too much upward pressure on the currency. The
government may not want to sell large quantities of its currency to
keep the exchange rate down to its target rate as this action may add
to the money supply.
Þ A government may also revalue its currency to reduce inflationary
pressure. A higher exchange rate will reduce the price of imports, which
can increase the pressure on domestic industries to become more
internationally competitive.

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49.5 The effects of changing exchange rates on the external economy
§ The effect of a change in the exchange rate on the current account balance
will be influenced by the price elasticities of demand for exports and
imports.
§ Marshall-lerner condition: the requirement that for a fall in the exchange
rate to be successful in reducing a current account deficit, the sum or price
elasticities of demand for exports and imports must be greater than 1.
§ If this condition is met, a fall in the exchange rate would reduce a current
account deficit, while a rise in the exchange rate would reduce a current
account surplus.
§ The table below uses simplified figures to illustrate the Marshall–Lerner
condition in the case of a fall in the exchange rate.
§ The greater the combined PED for exports and imports, the smaller will be
the fall in the exchange rate required to improve the current account
position.
§ If the PED is less than 1, a revaluation of the exchange rate would be the
more appropriate policy strategy.

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J curve
§ The J curve effect is related to the Marshall–Lerner condition.
§ J curve effect: a fall in the exchange rate causing an increase in a current
account deficit before it reduces it due to the time it takes for demand to
respond.
§ In some cases, a fall in the exchange rate will actually worsen the current
account position before it starts to improve it. This is because, in the short
run, demand for imports and exports may be relatively inelastic. It takes
time to recognise that prices have changed and then to search for
alternative products.
§ In the long run, demand becomes more elastic, and the current account
position may move from deficit into surplus as shown in Figure 49.9.

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 § A higher exchange rate may increase a current account deficit or reduce a
current account surplus, but the outcome will depend mainly on the price
elasticities of demand for exports and imports.
§ The Marshall– Lerner condition and the J curve work in reverse. So, a
current account surplus will only be reduced if the sum of the price
elasticities of demand for exports and imports is greater than 1.
§ A rise in the exchange rate may increase a current account surplus in the
short run before reducing it in the longer run as shown in Figure 49.10

Exit ticket:
Answer textbook questions for chapter 49 pg.543 and 544.
Q. Ans.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
Mark ___/10
Percentage

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