Balance of payments deficit

The balance of payments consists of the capital account, the current account and any errors/omissions.

While overall, the balance of payments will always balance due to its nature, parts of it can be in deficit. In the UK, for example, we have a current account deficit due to our large deficit of trade in goods; despite our considerable surplus in trade in services (mainly financial). This deficit is accounted for by a surplus on the capital account. The UK is a successful, developed economy which means that it attracts a large amount of foreign investment and flows of hot money. These lead to the surplus on the capital account which balance the UKs balance of payments.

The extent to which imbalances in the balance of payments matter depends on what causes the imbalance. The UK, despite having a current account deficit, would be seen as a relatively healthy economy in terms of the balance of payments. Lots of developed economies have similar deficits on their current account, especially if they are not export led economies. An imbalance is a worry if it stems from the over-importation of consumer goods such as toys etc. This can be more harmful than if a country is importing capital goods to increase employment or productivity. These types of current account deficit are known as benign and malign deficits. Malign deficits are difficult to justify - as they no doubt have to be offset by borrowing, which is clearly undesirable.

Problems with comparative advantage and specialisation

Comparative advantage is the economic theory of international trade developed by Ricardo. It says that even when one country can produce far more products than another country if it devotes all of its resources to one, the opportunity cost of those products may be higher in a developed country than in a developing country. So despite the USA being able to produce both more bananas and more cars than Brazil, Brazil would probably have to sacrifice less cars in order to make bananas than the USA. This is the theory that gives most countries a basis for trade. Trade should not take place where one country can produce more of both at the same opportunity cost as another country, eg. Where the USA can produce 100 bananas for every 10 cars, and Brazil can produce 10 bananas for every 1 car.
Comparative advantage, then, suggests that specialisation is the key to international trade success.

One of the problems with comparative advantage is that it assumes that there are no barriers to trade/protectionist measures or any transport costs. In reality, these two would add to or take away from the cost of trading, therefore making a weaker/stronger case for trade. The model of comparative advantage also assumes that there are only two countries involved, and they make only two goods, which is, of course, not the case. Similarly, Ricardo's theory assumes that countries can switch production from one thing to another without any sort of cost or time delay. It could be seen as a criticism of the theory of comparative advantage that it suggests that specialisation important for countries. While specialisation in some instances is good, it can mean that an economy becomes dependant on trade, and isn't self-sufficient. This may not be a problem, but if tastes change or if the market takes a turn for the worse for the country's main export, then the entire welfare of the country could be compromised.

The final criticism of the theory is that it leaves out the fact that international trade and international politics are strongly linked. The UK does lots of trade with the EU because of the lack of trade barriers; but another of the UK's main trade partners is the USA, who can implement as many trade barriers as they wish (not to mention that the US is around 4,000 miles away.) The reason for this is because international relations with the USA are strong, and as a strong trade partner, we would be inclined to continue trading with them so as not to compromise our relationship (even if that means real/opportunity cost to the UK.)

Analyse ways in which Spain can improve its long run growth potential.

Spain has experienced continuing losses of international competitiveness over the past decade or so, and it is clear that in order to regain competitiveness, they will have to impose measures to improve their long run growth.

The first way Spain can increase its long-run growth potential is to improve the human capital of its workers so that they are more productive in their current industries. The government could achieve this by training the population. A similar strategy would be to improve the education that the state provides. The effect of this would be to improve the adaptability of the work force, reducing unemployment due to labour immobility. Reducing unemployment should be seen as an important task for the government of Spain, as it has been very high for quite a long time, which can lead to serious social problems, as well as causing workers to become unemployable.

One of the main reasons why Spain has poor growth at the moment is that a large sector of its economy is based around construction, and industry in which there is currently large amounts of supply, but very little demand for the houses they are constructing. Therefore it could be a good idea for the Spanish government to subsidise a new type of industry, such as technology manufacturing, which clearly has a place in the future of global trade.

Spain, along with the rest of the PIIGS, has relatively high unit labour costs. This can be a cause of lack of international competitiveness, and it should be an objective of the government to reduce these costs if it wants to increase its long run growth potential. One way of doing this would be to reduce the National Minimum Wage (NMW), in order to reduce wages.

What is meant by real interest rates?

Real interest rates are interest rates - inflation

It is important to calculate real interest rates because if inflation is higher than the interest rates, then real interest rates may be negative (as described in the extract). When real interest rates are negative, people's money is losing value (even when in banks) which can lead to higher spending, as people want to spend their money before it de-values, which can be disastrous as it may lead to even higher inflation rates.

Explain the concept of a “loose monetary policy”.

The term "loose monetary policy" in this context describes how monetary policy (such as interest rates and quantitative easing) were geared more towards promoting growth than restricting it to control the price level, this would suggest that they had a low base rate of interest and were perhaps engaging in high levels of quantitative easing.

The problem with this was that Portugal, Italy, Ireland, Greece and Spain all experienced high levels of inflation which led to a loss of international competitiveness that can be traced back to 1999. The high inflation levels led to a lack of competitiveness as prices in those countries were rising faster than those in other countries, which meant that their goods were relatively more expensive and therefore less competitive. Normally, a country in this situation would opt to increase interest rates, however, as the interest rates for the euro area are set centrally, it can be difficult to cater for the needs of everyone.

Explain how, in normal circumstances, inflation results in a reduction in the exchange rate.

Inflation is defined as a sustained rise in the price level. Inflation is generally undesirable for a country; while low and stable inflation does little harm, high levels of inflation have many negative implications such as fiscal drag, price uncertainty and inflationary noise. Most central banks have an interest rate target that they use their control over monetary policy to achieve (changing interest rates, quantitative easing and OMOs).

One of the effects of inflation is also to reduce the exchange rate. This occurs in normal circumstances as international competitiveness reduces due to prices rising relative to other countries. As investment in the country decreases, the demand for the currency follows suit and the exchange rate deteriorates.

Another way in which the exchange rate and the inflation rate are related is when the exchange rates are fixed against another currency. Say the pound was fixed against the dollar, and the dollar's inflation increased, the inflation rate for the pound would increase the same amount, this is because as the value of the dollar falls, the value of the pound falls. The pound's inflation rates would also also, then, be tied to the dollar's.

The Stability and Growth Pact

The Stability and Growth Pact is an agreement between the 17 members of the euro area that aims to promote price stability as well as facilitate the growth of all of the members. The pact says that no one member should have a government spending deficit of more than 3% of GDP annually, and that total government debt not be more than 60% of GDP. The idea is that it limits fiscal irresponsibility that could lead to inflationary pressure on the euro.

There are many criticisms of the stability and growth pact, as some say that it lacks flexibility due to the fact that it is over a year rather than over the course of an economic cycle. This could be seen as unfair as governments regularly need to borrow more money during times of recession, money that they can then pay back during boom. Another criticism is that it seems to be somewhat unenforceable - especially in the larger countries like Germany and France who have both run "excessive" deficits for a long time.

Some of the difficulties of reducing government debt and spending deficits in the EU in order to comply with the stability and growth pact are outlined in the most recent post made on this blog. http://econ.economicshelp.org/

Why is it necessary for interest rates to be set centrally in a monetary union?

In a monetary union such as the eurozone, interest rates are always set by a central bank and the rate they choose applies for the whole area. The reason the rate has to be the same in each country is because if one country had a higher rate of interest than all of the others, then it could well lead to a lack of convergence of the economic cycles, as high levels of interest rates would restrict growth in one economy where another economy may have low levels and be growing quickly. The reason given by the ECB is that it is in their interest to promote "Price Stability" and a single interest rate makes this much easier, mainly because interest rates are a tool used to control inflation.

The characteristic features of a recession

A recession in economics is defined by a period of at least 2 quarters of negative GDP growth. There was a global recession between 2008-2009, which most countries are now out of - but there are a number still in recession, including Portugal.

A recession is caused by a fall in GDP, from a reduction in AS, AD or both. The causes of a reduction in AD are a reduction in any of the components of C+I+G+(X-M). A fall in AS comes from increases in the costs of production such as a rise in unit labour costs, or a fall in the quality of education/training, as well as a number of other factors.

Recessions tend to lead to reductions in confidence which can further reduce consumption or investment spending. In a recession, however, governments tend to borrow more money which leads to increased public spending in an attempt to offset the reduction in consumption or investment. Spain said during its recession that they feared the social consequences of high unemployment (one of the things caused by a recession) and therefore increased benefits, which put an extra strain on government spending. Sometimes recession is caused by a reduction in exports which may be due to a world recession or a drop in world confidence.This should lead to a reduction in exchange rates which would reduce the price of exports and hopefully lead to a boost in AD.

Prolonged recession may be due to a serious lack of international competitiveness such as was experienced in Portugal recently. This is most likely due to high unit labour costs resulting from either an unproductive workforce or an underdeveloped industrial sector. In Portugal, the rate of young people leaving school was around 60% which probably led to a reduction in productivity of the labour force, and therefore a reduction in international competitiveness.