150.TherelationshipsbetweentheaccountsItem150–Grade3

! Thecurrentaccount= Capitalaccounts+Financialaccounts(+errorsandomissions)

*Errorsandomissions"Notonlyisestimationofcreditsanddebitsintoandoutof a country imprecise but there are always unrecorded illegal cross-borderactivities,forexampleinvolvingdrugsorweapons.

! Currentaccountandthefinancialaccountareinterdependentbecause…• Ifthereisacurrentaccountdeficit,theremustbeafinancialaccountsurplus

(the capital account being very small), which provides it with the foreignexchangeitneedstopayfortheexcessof importsoverexports.Thesurpluson the financial accountmayarise from investments inphysicalor financial

capitalbyforeigners,includingloansfromforeigners.• If there is a current account surplus, the country is accumulating foreign

exchange(asitearnsmoreforeignexchangefromexportsthanitpaysoutto

buy imports), which it can use to buy assets abroad (direct or portfolioinvestments,includingloanstoothercountries).

• In fact, most economists believe that the surplus or deficit of a financial

accountofacountryistheresultofhatishappeninginthecurrentaccount.

Ibquestion

•Explainthatthecurrentaccountbalanceisequaltothesumofthecapitalaccountandfinancialaccount

balances(seetheappendix,“Thebalanceofpayments”atendofthisdocumentpage62).

•Examinehowthecurrentaccountandthefinancialaccountareinterdependent.

151.TherelationshipsbetweenthecurrentaccountandtheexchangerateItem151–Grade3

• Adeficitinthecurrentaccountofthebalanceofpaymentsmayresultin

downwardpressureontheexchangerateofthecurrency. (Thisismoreofaprobleminafixedexchangeratesystemthaninafloatingexchangeratesystem.)

• Fixedexchangeratesystem:Thedeficitimpliesthatahighexchangeratehas

beenset.Intheshort-run,thedeficitmaybecoveredbyincreasesinthe

capitalandfinancialaccountsorbythegovernmentusingreserveassetstobalancetheaccounts,However,thiscannotgoonindefinitely,sincethereserveassetswillrunoutandso,intheend,theexchangeratewillneedtobe

depreciated.• Floatingsystem:Thedeficitimpliesthatthereisanexcesssupplyofthe

currencyontheforeignexchangemarketsduetofallingdemandforexports

andthecurrency,orthedemandforimportshasincreased,leadingtomoredemandforforeigncurrenciesansoagreatersupplyofthedomesticcurrencyontheforeignexchangemarkets.Ineithercase,inafreelyfloatingexchange

ratesystem,theexchangerateshouldfall,increasingthedomesticpriceofimports.

• Arisingcurrentaccountdeficitwillexertpressureontheexchangerateto

depreciate(inafloatingexchangeratesystem)ordevalue(inafixedsystem).Thisisbecauserisingforeignimportdemandmeansthatresidentsareofferingintheforeignexchangemarketmoreoftheircurrencywhile

decreasingexportrevenuesmeansthatforeignersaredemandinglessofthecurrencyinthemarket.

Ibquestion

• Explain why a deficit in the current account of the balance of payments may result in downward

pressureontheexchangerateofthecurrency.

152.Implicationsofapersistentcurrentaccountdeficit(HL)Item152–Grade3

! TheconsequencesofcurrentaccountdeficitThisismainlyduetoanexcessofimportsoverexportsoverlongperiodsoftime.

1) Foreignownershipofdomesticassets2) Exchangerates3) Indebtedness

4) Internationalcreditratings5) Demandmanagement

Ibquestion

•Discuss the implications of a persistentcurrent accountdeficit, referring to factors including foreign

ownership of domesticassets, exchange rates, interest rates, indebtedness, international credit ratings

anddemandmanagement.

1) ForeignownershipofdomesticassetsIt may be that a high level of buying assets for ownership is financing thecurrent account deficit. Foreign investors may be purchasing such things as

property,businesses,orstocksorsharesinbusinesses.Inthiscasethisinflowintothecapitalaccountisfundingthecurrentaccountdeficit,butasitmustbebaseduponforeignconfidenceinthedomesticeconomyitisnotconsideredto

be harmful.However, there are sometimes fears that if foreign ownership ofdomestic assets were to become too great than this may be a threat toeconomicsovereignty.Moreover, if there isadrop inconfidence then foreign

investorsmightprefertoshifttheirassetstoothercountries.Sellingtheassetswouldresultinanincreaseinthesupplyofthecurrencyandafallinitsvalue.

2) [Depreciating]exchangeratesA current account deficit puts a downward pressure on the exchange rate.Largedepreciationscanleadtoimportedinflation.Ifthereisariskofdefault,

thedownwardpressureon thecurrency ismuchstrongerbecausepeopledonotwant to hold currencieswhose value is expected to fall further, and thecurrencybecomesvulnerabletospeculativeattacks.

3) [High]indebtedness

Ifacountryborrowsoverlongperiodoftime,itrunstheriskofaccumulating

somuchdebtthatitmaybeunabletopayitback;thisiscalledariskofdefault.Risksofdefault, alongwithactualdefaut, somewithmanyproblems, suchassignificantcurrencydepreciation,difficultiesofgettingmoreloansandpainful

demand-sidepolicies.4) [Poor]internationalcreditratings

Internationalagenciesrankcountriesaccordingtohow‘credit-worthy’theyare,meaninghowlikelytheyaretorepaytheirloansinfullandontime.Countrieswith large and persistent current account deficits have low credit ratings,

makingitoredifficulttogetmoreloansinthefuture(noonewantstoendtoacountrythatmaybeunabletopaybackitsloans).Undersuchcircumstances,acountrymayhavetoraiseitsinterestratesveryhightoattractforeignfinancial

capital, and this can createa serious recessionormakeanexisting recessiondeeper.

5) [Painful]demandmanagementCountries with serious current account deficits must often pursuecontractionaryandotherpolicies.

153.Methodstocorrectapersistentcurrentaccountdeficit(HL)Item153–Grade5

! Methodstocorrectapersistencecurrentaccountdeficit• Expenditureswitchingpolicies

• Expenditurereducingpolicies• Supply-sidepolicies

"Increasingcompetitiveness

1) Expenditureswitchingpolicies

• It attempts to switch theexpenditureofdomestic consumers away from

importstowardsdomesticallyproducedgoodsandservices.• If successful, then expenditure on imports will fall and so the current

accountdeficitshouldimprove

Examples- Adevaluationoftheexchangerate:Thiswillmakeexportstobecomeless

expensive and imports to become more expensive. This should see animprovement in the current account as export revenue rises and importexpenditurefalls.(Effective!!)

"HOWEVER,thereisapotentialriskofinflationtoaccelerate.- Protectionist measures: The government may attempt to restrict the

importsofproductseitherbyreducing theiravailabilityusingembargoes,

quotas, voluntary export restraints, and administrative their prices usingtariffs. If this happens then domestic consumers will switch theirexpenditurefromimportstodomesticproducts.

Ibquestion

•Explainthemethodsthatagovernmentcanusetocorrectapersistentcurrentaccountdeficit,including

expenditure switching policies, expenditure reducing policies and supply-side policies, to increase

competitiveness.

•Evaluatetheeffectivenessofthepoliciestocorrectapersistentcurrentaccountdeficit.

" HOWEVER, governments are often reluctant or unable to use suchmeasures because they tend to lead to retaliation and are often againstWTOagreements.Also,protectingdomesticindustriesreducescompetition,

whichmayencouragethemtobeinefficient.Thereforeit isnotalong-runsolution(Notthateffective!!)

2) Expenditurereducingpolicies• PoliciesthatdecreasethelevelofAD(ShiftingADtotheleft)• If thisoccurs thenexpenditureonallgoodsandservicesshould falland,

since this would include expenditure on imports, the current accountdeficit should improve. (The sizeof fall in importswill dependupon thelevelofthemarginalpropensitytoimport)

• However,thereisaconflictherebetweenexternalandinternalobjectives.Deflating the economy may reduce the current account deficit but thepolicy is likely to lead to a slow down of growth or even turn negative,

Incomesandoutputwill decrease. Firmswill contractor shutdownandunemploymentwillemerge.

Examples- Deflationary (Contractionary) fiscal policies: Increasing direct tax rates

and/or reducing government expenditure. Clearly, these would be

politically unpopular and a governmentmight be reluctant to use such apolicy

- Deflationary (Contractionary) monetary policies: Increasing the rate of

interest and/or reducing the money supply. Interestingly, the higherinterestratesshouldalsoincreasecapitalflowsfromabroad,asforeignersput money into financial institutions attracted by the higher rates. This

would lead to a surplus on the capital account, which helps to offset thecurrent account deficit. This type of policy would also be politicallyunpopular as higher interest rates will increase people's mortgage, loan,

and credit card payments. Moreover, the higher costs of borrowing as aresult of higher rates of interest may act as a disincentive to domesticinvestmentandlimitpotentialgrowth.

3) Supply-sidepolicies• It is a solution of a more long-run nature, aiming at increasing the

competitivenessoftheeconomyandespeciallyoftheexportsector

• Apersistentcurrentaccountdeficitmaybearesultofuncompetitiveproductmarketscharacterizedbyahighdegreeofmonopolypoweradofrigidlabourmarkets with high laboutr costs and low labour productivity. Supply-side

policiescanproveusefultorestorethecompetitivenessofanailingeconomyandcureafundamentaldisequilibriuminthecurrentaccount

• Drawbacks: (*Itisthesameasthedrawbacksforsupply-sidepolicies)

154.TheMarshall-LernerconditionandtheJ-curveeffect(HL)Item154–Grade3

! TheMarshall-Lernercondition

• It tells us how successful a depreciation or devaluation of a currency’sexchangeratewillbeasameansto improveacurrentaccountdeficit inthebalanceofpayments

• Itstatesthatreducingthevalueoftheexchangeratewillonlybesuccessfulofthe total value of the price elasticity of demand for exports and the priceelasticityofdemandforimportsisgreaterthan1.

• Equation:PEDexports+PEDimports>1

Ibquestion

•StatetheMarshall-Lernerconditionandapplyittoexplaintheeffectsofdepreciation/devaluation.

•ExplaintheJ-curveeffect,withreferencetotheMarshall-Lernercondition.

Diagrams

#Themorepriceelastic thedemand for importsadexports, thegreaterwillbethe fall in demand for imports and the increase in demand for exports and the

greaterwillbetheimprovementonthecurrentaccount

P1=Priceafterdepreciation

P=Pricebeforedepreciation

• The current accountimproves as less is spent in

revenue terms afterdepreciation than before i.e.0P1×0Q1<0P×0Q

• Thecurrentaccountworsensas

more is spent in revenue termsafter depreciation than beforei.e.0P1×0Q1>0P×0Q

We know that one of the determinants of elasticity of demand is the time

period under consideration. Remember that demand becomes more elasticover a longer period of time. This applies to the elasticity of demand forexportsandimports.

P1=Priceafterdepreciation

P=Pricebeforedepreciation• Thecurrentaccount improvesas less

is spent in revenue terms on exports

afterdepreciationthanbeforei.e.0P1×0Q1>0P×0Q

• The current accountworsens as

more is spent in revenue termson exports after depreciationthanbeforei.e.0P1×0Q1<0P×

0Q

Short-runandlong-runPEDvaluesintheG-7countries

Country Short-run

PEDexports

Short-run

PEDimports

Total

short-runPED

Long-run

PEDexports

Long-run

PEDimports

Total

long-runPED

Canada 0.5 0.1 0.6 0.9 0.9 1.8

France 0.1 0.1 0.2 0.2 0.4 0.6

Germany 0.1 0.2 0.3 0.3 0.6 0.9

Italy 0.1 0.2 0.3 0.3 0.6 0.9

Japan 0.5 0.1 0.6 1.0 0.3 1.3

UK 0.2 0.0 0.2 1.6 0.6 2.2

US 0.6 0.5 1.1 1.5 0.3 1.8

Thetableshows:1. Inalmostallcases theshort-runelasticityvaluesare lowerthanthe long-run

values. This is exactly what wewould expect to find from the theory stated

previously,thatpriceelasticityvaluesincreaseovertime2. OnlytheUSwouldmeettheMarshall-Lernerconditionintheshort-run,butall

countries,otherthanFranceandGermany,meettheconditioninthelong-run

! TheJ-curve• Ifagovernmentisfacingacurrentaccountdeficit,itmayreducetheexchange

rate of its currency in order to make exports relatively less expensive andimports relativelymore expensive. If this happens and theMarshall-Lernercondition is satisfied, thenwewould expect an improvement in the current

accountdeficit.• However,intheshort-run,thisisnotthecaseandthecurrentaccountdeficit

actuallygetsworsebeforeitgetsbetter"J-Curveeffect

• J-Curveshowswhathappenstoacurrentaccountdeficitovertimewhentheexchangerateisdevaluedordepreciated.

• This is because in the short-run, therewill be few extra exports soldwhen

prices fall-peopleoverseasdonotreact immediatelyandsoexportdemandwill take time to change. However, extra money will have to be paid forimports immediately and so the current accountwill tend todeteriorate. In

themediumterm,however,thelowerexportpriceswill leadtoanincreaseeindemandfor

TheJ-Curve

Ibquestion

•ExplaintheJ-curveeffect,withreferencetotheMarshall-Lernercondition.

Explanation• Assume that a country’s current account deficit is at X ad the government

lowerstheexchangerate

155.TherelationshipbetweenthecurrentaccountandtheexchangerateItem155–Grade3

Thecurrentaccountsurplus

• Itmayresultinupwardpressureontheexchangerateofthecurrency. • Fixedexchangeratesystem:Thesurplusimpliesthattheexchangeratehas

beensetattoolowavalue.Intheshortrunthismaybeoffsetbydeficitsonthecapitalandfinancialaccountsorbyincreasesinthereserveassets.Inthelongrun,however,itislikelythatothercountrieswillbeunhappywiththe

artificiallylowexchangerateandwilldemandhigherratesorwillthreatenprotectionistmeasuresagainstthecountry’sexports.ThishasoftenbeenthecasewiththeexchangerateoftheChinesecurrency,whichispeggedtotheUS

dollar,andChina’stradingpartners.

• Floatingsystem:Thesurplusimpliesthatthereisanexcessdemandforthecurrencyontheforeignexchangemarkets.Thismaybebecausethedemandfortheexportshasrisen,ashasthedemandforthecurrency,orthedemand

forimportshasfallen,leasingtolessdemandforforeigncurrenciesandsoalowersupplyofthedomesticcurrencyontheforeignexchangemarkets.Ineithercase,inafreelyfloatingexchangeratesystem,theexchangerateshould

rise,decreasingthecompetitivenessofthecountry’sexportsandloweringthedomesticpriceofimports.

Ibquestion

•Explainwhyasurplusinthecurrentaccountofthebalanceofpaymentsmayresultinupwardpressure

ontheexchangerateofthecurrency.

Notes• Acurrentaccountsurplusexistsifthesumofnetexportsofgoodsand

servicesplusnetincomeandnetcurrenttransfersispositive

• Onemayarguethatifthesurplusissmallortransitoryitisnotconsideredanissue.Also,ifitispartofagrowthanddevelopmentstrategyknownasexport-orientedgrowthitsbenefitsmayexceeditscosts

• Apersistentcurrentaccountinvolvessomerisks:1)Itimpliesthattheeconomyisconsuminginsideitsproductionpossibilities

156.ImplicationsofapersistentcurrentaccountsurplusItem156–Grade4

! Theconsequencesofapersistentcurrentaccountsurplus

1. Lowerdomesticconsumptionandinvestment2. Appreciationofthedomesticcurrency

"Thecurrentaccountsurplusimpliesanincreaseindemandforthecurrency

3. Reducedexport"Asaresultofanincreaseindemandforthecurrency,itwillmakeimportscheaper so reducing inflationary pressures, butwill alsomake exportsmore

expensive,harmingexportersNotes

• Acapitalaccountsurplus,baseduponthepurchasingofassetsforownership,ismainlyapositivethingforthecountryandallowsacurrentaccountdeficit.However,acapitalaccountsurplusbaseduponhighlevelsofborrowingfrom

abroadistheoppositeandisnormallyaresponsetoacurrentaccountdefict.

Ibquestion

• Discuss the possible consequences of a rising current account surplus, including lower domestic

consumptionandinvestment,aswellastheappreciationofthedomesticcurrencyandreducedexport