Chapter 17.4 Flashcards
Consequences of Persistent Current Account Deficits
What is the main reason for most balance of payment problems?
The current account deficit which arises from an excess of imports over a long period of time
Consequences of Persistent Current Account Deficits
What are the consequences of the exchange rate in current account deficits?
-Depreciating exchange rate as the current account deficit puts a downward pressure on the exchange rate.
Consequences of Persistent Current Account Deficits
What are the consequences of interest rate in current account deficits
-There is a need to increase interest rate in order to attract FDI. However, can lead to recession
Consequences of Persistent Current Account Deficits
What are the effects of the level of debt in current account deficits?
-The level of debt increases as countries borrow over long periods of time and are unable to pay them back, leading to difficulties in getting more loans as well as painful demand side policies
Consequences of Persistent Current Account Deficits
What is the effect on the international credit ratings in a current account deficit?
-Low credit ratings, making it more difficult to get more loans in the future
Consequences of Persistent Current Account Deficits
What is the effect on the standards of living in current account deficit?
-Local population will at some point have to consume less, so that the country is able to pay back loans decreasing the standards of living
Policies to Correct Persistent Current Account Deficits
How do expenditure reducing policies correct current account deficits?
Lowering disposable income to limit AD and import expenditures
Policies to Correct Persistent Current Account Deficits
What are the 2 types of expenditure reducing policies?
Contractionary monetary and fiscal plocies
Policies to Correct Persistent Current Account Deficits
How does contractionary fiscal policy aid in solving the current account deficit?
Higher taxes and lower government spending to reduce consumption
Policies to Correct Persistent Current Account Deficits
How does contractionary monetary ploicy aid in solving the current account deficit?
Higher interest rates make new and existing loans more expensive, so both households and firms reduce demand for imports.
Policies to Correct Persistent Current Account Deficits
What are the disadvantages to expenditure reducing policies?
-Recession
-Currency depreciation
Policies to Correct Persistent Current Account Deficits
How do expenditure switching policies correct current account deficits?
Switching consumption from imported to domestically produced goods
Policies to Correct Persistent Current Account Deficits
What are the 2 types of expenditure switching policies?
Trade protection and currency depreciation
Policies to Correct Persistent Current Account Deficits
How do trade protection policies correct the current account deficit?
Trade protection policies restrict imports, however can cause higher domestic price and inefficiency in global and domestic allocation of resources
Policies to Correct Persistent Current Account Deficits
How does currecny depreciation aid in correcting the current account deficit?
Currency depreciation disourages imports as higher import prices can cause domestic inflation and higher costs of production for producers
Policies to Correct Persistent Current Account Deficits
How can the different types of supply side policies help in correcting the current account balance?
-Market based supply side policies are intended to lower cost of production of firms and can make the firms more competitive in global markets
-Interventionist policies promote industries that produce to export
Policies to Correct Persistent Current Account Deficits
What is a disadvantage of supply side policies?
Take a long time for effects to be felt
Marshall–Lerner Condition
When does the devaluation of a currency improve the current account deficit?
When the sum of elasticities of demand for exports and imports is greater than 1
Marshall–Lerner Condition
What is the Marshall-Lerner condition?
-If PEDm + PEDx > 1, devaluation/ depreciation will improve the trade balance
-If PEDm + PEDx < 1, devaluation/depreciation will worsen the trade balance
-If PEDm + PEDx = 1, devaluation/depreciation will leave the trade balance unchanged.
Marshall–Lerner Condition
What is the relationship between the size of the PED of exports and imports and the amount depreciated?
The higher the PEDs, the smaller the devalluation needed to obtain trade balance improvements
The J-Curve
What is the J-curve effect?
It is an economic model that shows that following a currency depreciation, the balance of trade worsens before it gets better.
The J-Curve
What causes the J-curve effect?
-Limited access to information
-Ongoimg contracts
-Existing habits and tastes
The J-Curve
What happens in the short term in the J-curve effect?
The lower exchange rate will cause the price of imports to increase and the price of exports to decrease, leading to a worsening of the deficit
The J-Curve
What will happen in the long term in the J-curve effect?
PEDx and PEDm will increase as households and firms adjust to relative price changes
The Relationship Between the Current Account and the Exchange Rate
When does a current account surplus exist?
When the sum of the inflows from the account exceeds the outflows from the account
The Relationship Between the Current Account and the Exchange Rate
What causes a surplus of the current account?
-Higher demand for exports
-Reduced demand for imports
The Relationship Between the Current Account and the Exchange Rate
What does a current account surplus mean?
The country is earning more than it is spending, hence there is a greater upwards pressure on exchange rate as exports increase
Peoblems of Persistent Current Account Surpluses
What are the problems of a persistent current account surplus?
-Low doemstic consumption
-Insufficient domestic investment
-Appreciation of domestic currency
-Reduced export competitiveness
