7. Current Account: Causes, Consequences, Policies

Demand Side Causes of a Current Account Deficit

Strong Domestic Growth

Recession Overseas

Strong Exchange Rate

Supply Side Causes of a Current Account Deficit

Low Investment

Low Productivity

High Relative Inflation

High Unit Labour Costs

Poor Quality/Reliability

Depletion of Resources

Evaluation of a Current Account Deficit

Depends on the size of the deficit - doesn’t matter as much if it is small

Depends on the cause of the deficit - Supply side is deadly

Could be the income section of the current account and not the trade part - this means that X-M would not be affected

Demand Side Causes of a Current Account Surplus

High Incomes Abroad

Low Incomes at Home

Weak Exchange Rate

Supply Side Causes of a Current Account Surplus

Low Relative Inflation

Low Unit Labour Costs - High productivity, weak trade unions, low minimum wages mean that exports are price competitive

Strong Investment - Capital and Technology

Gains in Comparative Advantage

New Resource Discoveries

Consequences of a Current Account Surplus

Increase in Net Exports, Increase in AD, Increase in Growth, Decrease in Unemployment, Increase in Demand Pull Inflation

Appreciation of the Exchange Rate

Financial Account Deficit

Can Harm International Relations - Retaliation

Sign of an unbalanced economy - Export Dependency

What are Expenditure Reducing and Expenditure Switching Policies

Expenditure Reducing - Policies to reduce the amount of spending of imports in an economy by reducing aggregate demand, reducing incomes and hence the marginal propensity to import

Expenditure Switching - Policies to switch consumer spending from foreign goods to domestically produced goods

What are the Expenditure Reducing Policies

Contractionary Monetary Policy

Contractionary Fiscal Policy

Evaluation of Expenditure Reducing Policies

Conflict of Objectives

Consumer and Business Confidence

Size of the Output Gap

Marginal Propensity to Import

What are the Expenditure Switching Policies

Protectionism

Weaker Exchange Rate (by either and/or reducing the interest rate, increasing the money supply or selling domestic currency reserves)

Evaluation of Protectionism (Expenditure Switching Policy)

Retaliation

WTO Rules

Inflationary - Tariffs increase the price of imports

Higher Prices for Consumers

Loss of Efficiency

Evaluation of Weaker Exchange Rate (Expenditure Switching Policy)

Elasticity

Inflation

Retaliation and Currency Wars

What is a more general policy to reduce a current account deficit (could be considered as expenditure switching)

Supply Side Policy to Increase International Competitiveness (of domestic goods and services)

Consumers can switch to buying domestic goods and services instead of imports as the quality of domestic goods and services would increase

Eval: Time, Cost, No guarantee of success, Need to be heavily targeted

General Evaluation Points of Expenditure Reducing and Expenditure Switching Policies

Conflict of Objectives

Cause of the Current Account Imbalance - e.g. no point doing expenditure reducing policies if the cause is supply side

Time Lags/Cost

Is the Current Account Deficit Really a Problem - It is only a problem if the current account as a percentage of GDP is greater than the rate of real gdp growth annually then it is a problem