bop adjustment policies - as level

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Balance of Payments Adjustment Policies

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Deficits and Surpluses as a share of GDP

Current account deficit as a percentage of GDP

Current Account Balances - Deficits and Surpluses

GermanyIrelandJapan

SpainUnited KingdomUnited States

West Germany

Source: OECD

98 99 00 01 02 03 04 05 06 07 08

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

   P   E   R   C   E   N   T

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

7.5

10.0

Why might the deficit

as a share of GDPbe a better guide to

the size of a trade

imbalance?

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 Are deficits self-correcting?

• Some partial self-correction 

• Economic slowdown and recession

 – Squeeze on real incomes and output 

 – Fall in import demand 

 – Releases capacity for exporting 

• Deficit might lead to depreciation in theexchange rate 

 – Change in relative prices of exports andimports 

 – Expenditure-switching towards exports andaway from imports 

 – Depends on price elasticity of demand for Xand M and also elasticity of supply

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The US trade deficit and their recession

$ billion per month

United States Balance of Trade in Goods

Annual growth of real GDP Trade balance in goods and services $bnSource: Reuters EcoWin

01 02 03 04 05 06 07 08

   b   i   l   l   i  o  n

  s

-70

-65

-60

-55

-50-45

-40

-35

-30

-25

   U   S   D

   (   b   i   l   l   i  o  n  s   )

-70

-65

-60

-55

-50-45

-40

-35

-30

-25

-4

-2

0

2

4

6

8

   P  e  r  c  e  n   t

-4

-2

0

2

4

6

8

Note the steep fall in

the trade deficit as the

economy hit recession.

Why is income

elasticity of demand

important in this chart?

But what are the wider 

economic effects?

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Expenditure switching

• Expenditure switching: 

 – Change in relative prices of X and M 

 – Changes incentives for consumers 

 – Changes profitability of exporting 

 – Can be caused by 

• Movement in the exchange rate 

• Introduction of import tariffs and other forms

of protectionism 

• Period of high or low relative inflation 

 – Key point is whether trade volumes respond

to changing prices 

 – I.e. price elasticity of demand for X and M

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 Any evidence for the UK?

Quarterly trade balance, £ billion (bottom pane) and exchange rate index

UK Trade & the Sterling Exchange Rate

Effective Exchange Rate Index Balance of Trade in Goods and Services

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

   b   i   l   l   i  o  n  s

-15.0

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

   Q  u  a  r   t  e  r   l  y   b  a   l  a  n  c  e

   £   (   b   i   l   l   i  o  n  s   )

-15.0

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

70

75

80

85

90

95

100

105

   S   t  e  r   l   i  n  g   i  n   d  e  x

70

75

80

85

90

95

100

105

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The J Curve

• Effect of a depreciation on the trade deficitdepends on price elasticity of demand.

• In the short term, demand is often inelastic  – limits extra revenue from exports 

• Demand for M is inelastic  – higher prices causea rise in total spending on imports 

• The J Curve effect says a trade deficit canworsen after a depreciation, but get better in thelong term provided that the elasticity of demandis high enough 

• Marshall-Lerner condition: Trade balance willimprove if Ped X + Ped M . 1 

• Elasticity of supply of domestic producers isalso important (often forgotten) 

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The J Curve effect

Tradesurplus

Trade

deficit

 A

Time

B

C

Ped X + Ped M > 1 for 

the trade balance to

improve

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Expenditure Reduction

• Expenditure reduction 

 – Cutting aggregate demand

 – Direct effect on consumption and thereforedemand for imports: 

 – Possible routes: • Higher direct taxes  – lower disposable

income 

• Low taxes on saving 

• Increased interest rates  – to dampen

consumption • Cut in government spending 

 – Focus here is on income elasticity of demand for imports

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Supply-side policies

• To rebalance trade over the medium term 

• Focus on 

 – Improving competitiveness in global markets: 

• Innovation 

• Research and development 

• Product quality / design 

• Infrastructure to support trade sectors 

 –  Attracting inward investment  – producing outputdomestically and then exporting 

 – Raising productivity / lowering unit costs 

 – Developing areas of new competitive advantage 

 – Raising foreign income elasticity of demand for exports 

 – Reducing foreign price elasticity of demand for exports

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Weaknesses on supply-side and UK trade

• Persistent productivity gap 

• Low business investment as a share of 

GDP 

•

Low levels of research anddevelopment 

• Loss of capacity in manufacturing

industry 

• Evidence that UK exports have lower income elasticity of demand than our 

income elasticity of demand for imports

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The Productivity Gap

95

100

105

110

115

120

125

130

135

140

1992 1994 1996 1998 2000 2002 2004 2006

Source: ONS

France

Germany

UK

US

GDP per hour workedComparison, 1996-2007

Index, UK = 100

Source: UK competitiveness indicators, Feb 2009

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Investment Gap?

Business investmentComparison, 1992-2007Per cent of GDP in current prices

8

10

12

14

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Germany

France

UK

US

Source: OECD

Source: UK competitiveness indicators, Feb 2009

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Research Gap?

1.5

2.0

2.5

3.0

  1   9   9   2   1   9   9   3   1   9   9  4   1   9   9   5   1   9   9   6   1   9   9   7   1   9   9   8   1   9   9   9    2   0   0   0   2   0   0  1   2   0   0   2   2   0   0   3   2   0   0  4   2   0   0   5   2   0   0   6   2   0   0   7

Source: OECD

France

Germany

UK

US

Gross domestic expenditure on R&DComparison, 1992-2006Per cent of GDP

Source: UK competitiveness indicators, Feb 2009

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UK Exports and Imports

 Annual value of trade - £billion at current prices

UK Exports and Imports of Goods and Services

Source: Reuters EcoWin

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07

   b   i   l   l   i  o  n  s

100

150

200

250

300

350

400

450

   G   B   P

   (   b   i   l   l   i  o  n  s   )

100

150

200

250

300

350

400

450

Imports

Exports

Balance of Payments: Exports: Total Trade in Goods & Services 368.337G

Balance of Payments: Imports: Total Trade in Goods & Services 415.817G

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Summary points

• Some trade deficits are partially self correcting 

• But recession and a depreciation arenot enough if the root causes lie on thesupply-side of the economy 

• Ultimately BoP adjustment requires: 

 – Period of below trend growth 

 – Improvement in investment in traded goodsindustries 

 –Control of price and cost inflation relative tothat of our competitors 

 – Open trade to drive better exportperformance 

 – Protectionism is not the answer 

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