BOP – Records economic transactions between residents of one country with all other countries. Current account – related to income and payment flows. a) Trade in goods (X-M) X – credit M – debit. b) Trade in services (X-M). c) Income from investment. d)Current transfer (no exchange of goods and services). Current account surplus (abcd>0):

Inflow of money from exports revenue from trade in goods and services; income from investment and incoming transfer is larger than outflow of money from import expenditure on trade in goods and services; income sent abroad, outgoing transfer. Current account deficit (abcd<0): inflow < outflow. Capital account – related to transaction of capital assets e) Capital transfer (transactions involving transfers of ownership of fixed assets f) Transactions of non-produced and non-financial assets (Transactions of Branding value/ patent). Financial account – related to transaction of financial assets g) FDI (long term investment made by MNC / foreign investors in overseas countries) h) Portfolio investment (short term investment (stocks, savings) i) Reserve assets. Assume no change in capital account. Current account deficit implies financial account surplus. Current account surplus implies financial account deficit.

Consequences of current account deficit: 1) Downward pressure on domestic currency, Demand for country’s X decreases, Demand for DC decreases, Depreciation pressure, Price of import (in DC) increases, Cost of imported raw material increases, COP increases, Inflationary pressure 2) Upward pressure on interest rate, Government may need to maintain a high interest rate to reduce inflation, Higher interest rate, Reduce AD, Reduce EG 3) Increased in foreign ownership of domestic assets, Current account deficit is financed with a financial account surplus, Implies increased incoming FDI, Increased foreigners’ purchase of domestic assets, Many income generating assets are owned by foreigners, Income generated may be sent overseas instead of investing domestically 4) Indebtedness, Current account deficit is financed with a financial account surplus, If there is not enough Incoming FDI/ portfolio investment, Government may need to finance the current account deficit by depleting the reserve assets, May need to borrow from other countries / IMF, Indebtedness. 5) Reduce in international credit rating, Indebtedness reflects the lower ability for government to repay their debt, International credit rating would lower the rating of the government bond, Reduce the ability for the government to generate funds through selling bonds. Evaluation: 1)Current account deficit may be automatically corrected, Price of X (in FC) decreases, Demand for X increases, X revenue increases, M decreases, (Given that Marshall Lerner condition is satisfied), (X-M) increases correct current account deficit 2) Higher interest rate may prevent the domestic currency from dropping to a damaging level 3) Incoming FDI can be a fuel for economic growth, FDI is a types of Investment, AD increases, Create job opportunities, May not bring as much harm as expected 4) Whether current account deficit is problematic depends on how the country finance it, Some countries are able to attract enough incoming FDI/ portfolio, Causing a financial account surplus without depletion of reserve assets. Monetary policy – The use of adjusting interest rate and money supply by the Central bank to affect AD to achieve macroeconomic objectives. Since the demand for commodity is inelastic, decrease in commodity prices causes a proportionately smaller increase in quantity demanded. The reduction in revenue due to lower pirce is larger than the gain in total revenue due to higher Qd. The export revenue would decreases from P1 x Q1 to P2 x Q2. Direct/portfolio investment – involving purchase of foreign assets in another country e.g. property, stock, which is components of financial account. Income from investment – involving income generated from the investment in another country E.g. rent gained by property, dividend gained by stock, which is a components of current account. Contractionary monetary policy is implemented by rising interest rate or reducing money supply. Higher interest rate increases the cost of borrowing, households and firms would borrow less to consume and investment, reducing the consumption expenditure and investment expenditure. Since C & I are components of AD, it causes AD to decrease from AD1 to AD2. APL decreases from P1 to P2, slowed down inflation. Real GDP decreases from Y1 to Y2, slowed down econ growth.

Methods to correct current account deficit: Increases exports revenue, Decreases import expenditure

1) Expenditure switching policies. Aim: switch the expenditure from imported goods to domestic goods, Way: Protectionist measures (Diagram of tariff). Tariff – increases import price, demand for import reduces, reduces import expenditure. Cons: Risk of retaliation – trading partners may impose similar measures on the country’s export, reducing export revenue questionable whether protectionist measures can actually reduce current deficit deficit. Cost of imported raw materials would increases, some exporters rely on cheap imported raw materials, imposing the tariff may increase the cost of production, reducing the export competitiveness, harming export revenue 2)Expenditure reducing policies. Aim: reducing expenditure on import, Way: Reducing spending by reducing AD, Contractionary demand side policy. Fiscal policy – increase income tax / corporation tax, reduce C & I, reduce G reduce AD. Monetary policy – increase interest rate / reducing money supply, higher cost of borrowing reduce C & I, reduce AD. Lower AD (Diagram showing a decrease in AD) lower real GDP, less spending on M. Cons: Lower real GDP, lower econ growth, conflicting with another macro econ obj (maintain economic growth). Limitation: Time lag – it takes time for people to adjust to the change in taxation / interest rate, they may not reduce their spending immediately. There is a time lag between the implementation of the policy and the effects to be seen, only works in the LR 3)Supply side policy, Aim: Improve exports revenue by increase the export competitiveness. Way: Supply side policy to increase efficiency. Market-oriented policy – competition based, reduce regulation, easier for firms to start up, increase competition in the market, firms have a higher incentive to increase their efficiency, reduce cost of production, improve the quality of exports. Interventionist policy – investment on education, technology, increases productivity. Con: competition less competitive firms may shut down. Interventionist opportunity cost of government spending. Limitation: Time lag 4) Exchange rate policy (expenditure switching), Devaluation. Price of export (in foreign currency) decreases, demand for export increases, higher export revenue, Price of import (in domestic currency) increases, demand for import decreases, lower import expenditure Limitation:Whether devaluation can improve current account deficit depends on the size of PED (X) and PED (M)It only works when the Marshall Lerner condition is satisfied, that PED (X) + PED (M) > 1. In the short run, the Marshall Lerner condition is not satisfied, that PED (X) + PED (M) < 1 since there is a time lag that people takes time to adjust to the change in exchange rate. When the government starts to devalue the currency at time X, devaluation would worsen the current account deficit. The policy would only work in the long run at time Y that the Marshall Lerner condition is satisfied. (J-curve)

Trade bloc – member countries form trade agreement to promote trade by eliminating trade barriers

Level 0 Preferential trade agreement: It gives preferential access to certain products by certain countries by eliminating trade barriers. Bilateral – between 2 countries e.g. CEPA between HK and China. Multilateral – among more than 2 countries e.g. WTO. Level 1 Free trade area: It is a trade bloc that member eliminate most goods (if not all) while individual member can retain their own external policy. Level 2 Customs union: Level 1 + members follow the common external policy (set higher tariff on imports from non-members)Level 3 Common market: Level 2 + allows free movement of factors of production among member countries. Level 4 Monetary Union: Level 3 + Common central bank + common currency E.g. Eurozone. Pros of trading agreement: 1) Increase competition from foreign import, Increasing efficiency 2)Trade creation. When the members form trading blocs, they would eliminate the tariff placed on the import, increasing the quantity of import and amount of trade. More trade is created between members. More efficient member countries replace the less efficient domestic producers (trade creation diagram). 3) Consumers choices 4) Exporters now access to a larger market — increasing the production scale enjoy EOS, (sphere LRAS curve, AC decrease, Q increases). Cons: 1) Import competing sectors may suffer from intense competition 2) Unemployment 3) M increases worsen current account balance  4) Trade diversion (for customs union or above) Germany used to trade with NZ, enjoying cheap import price. After joining the EU, Germany has to follow the common external policy against NZ. Placing a tariff on the imported beef from NZ. The supply from NZ would shift from SNZ to SNZ + t The import price increases from Pw + t  Quantity of import decreases to (Q4-Q3). Some trade is diverted from trade with non-members to members. Less efficient producers in member countries replaces more efficient producers in non-member countries.