Current Account Deficits Fit FINAL EXAM

Question 1

Consequences of persistent current account deficits

Answer 1

Central banks do not have an endless supply of foreign currency to balance a current account deficit

SO, governments must either:
- Borrow money from abroad
- Sell its assets abroad
Both solutions create their own set of problems if continued for too long

Question 2

Effects of persistent current account deficits

Answer 2

1. Increased borrowing from abroad leading to high indebtedness
   - Forces nation to use more c☹ntracti☹nary solutions
2. Increased sale of domestic assets to foreigners
   - Contractionary policy impacts AD, could cause recession
3. Drains foreign reserves
   - Can lead to both cost-push & demand-pull inflation
   - Depreciating currency may move current account towards surplus
4. Higher interest rates
   - May not be able to pay back all of debt, risk default
   - Sovereign credit rating falls
   - Financiers may lose confidence in currency & economy’s health
5. Depreciation of the currency
   - Opportunity cost = lost investment on merit, consumer, public, & imported capital goods
6. Fewer imports of capital goods
   - To repay debt w/interest, society will have to consume less than it produces
7. Lower economic growth in the future
   - Hard to regain ownership of domestic assets sold for revenue
8. Poor international credit ratings
9. Painful demand management policies

Question 3

Are current account deficits ALWAYS a problem?

Answer 3

Not if relatively small
- Deficit does not exceed 6% of country’s GDP
- Allows country to have higher SoL

If not persistent
- Could be temporary due to crop failure
- Could be b/c economy is booming increased expenditure on imports

Can lead to growth
- LEDCs may borrow funds to import capital goods for future industrial grow boosting LRAS & Yp

Question 4

Evaluating methods to CORRECT persistent current account deficits

Answer 4

Expenditure-switching policies
- Increased protectionism
- Exchange rate manipulation

Expenditure-reducing policies
- Contractionary fiscal policies
- Contractionary monetary policies

Expansionary supply-side policies to increase competitiveness
- Investments in education & health care
- Public funding for scientific research & development
- Investments in infrastructure

Question 5

Expenditure-SWITCHING policies

Answer 5

Designed to SHIFT CONSUMPTION from imports to domestic goods reducing trade deficit

Trade protection (tariffs, quotas, admin barriers)

Depreciation / Devaluation
- Makes exports cheaper, imports more expensive

Question 6

Expenditure-reducing polices (reductions in AD)

Answer 6

Contractionary fiscal policy
- increases taxes cuts income and reduces demand for imports
Contractionary monetary policy
- Higher interest % rates reduces demand for imports

Contractionary fiscal & monetary policies shrink current account deficit ☺
- BUT, contractionary higher % rates may lead to domestic recession ☹
- ALSO, higher % rates could cause currency appreciation
- Leading to greater imports & fewer exports!!!