Lecture 3 Flashcards
Why is it important to understand the balance of payments?
Persistent, large current account deficits, especially ones that are primarily consumer driven, are often associated with currency crises in which the currency of the country with the deficit depreciates substantially and the country suffers a severe recession. Massive increases in international reserves indicate that the central bank is resisting pressure for the currency to appreciate in value. Large capital account surpluses that are primarily driven by private sector investments indicate that foreigners find the assets of the country to be attractive investment opportunities.
Illustrate the role of a flexible exchange rate regime in maintaining balance of payment equilibrium.
A flexible exchange rate regime allows the exchange rate to adjust freely based on the forces of demand and supply in the foreign exchange market. Currency Depreciation: Boosts exports and reduces imports by improving the price competitiveness of domestic goods and services. Countries retain control over domestic monetary policy as exchange rates adjust to external shocks, avoiding the need to manipulate interest rates to maintain fixed exchange rates.
Explain the twin deficit hypothesis.
A relationship between a country’s fiscal deficit (government budget deficit) and its current account deficit (trade deficit), an increase in the fiscal deficit leads to a rise in the current account deficit. (X-M) = (Y-T-C) - I + (T-G). This therefore depends on Public saving (T-G) and private saving (Y-T-C). When the government runs a fiscal deficit, it borrows from the domestic or international market, reducing private savings. Country may attract foreign capital. Currency appreciation. Exports less competitive widening CA deficit.
Explain the relationship between the different accounts of the balance of
payments.
The Balance of Payments (BOP) is a comprehensive record of all economic transactions between residents of a country and the rest of the world over a specific period. The current account records the flow of goods, services, income, and current transfers such as exports and imports. The capital account records one-time transfers of assets and liabilities. Current Account + Capital Account = 0. If there is a CA surplus there must be a KA deficit. They have to balance.
What is the J-curve condition? How relevant is the concept for post
Bretton Woods exchange rate systems?
The J-curve condition refers to the short-term and long-term effects of currency depreciation on a country’s trade balance. It illustrates how, initially, depreciation worsens the trade balance before improving it over time. The price of imports rises in domestic currency terms. The value of exports remains constant in the short run. Increase in the value of imports relative to exports, worsening the trade balance. Over time Exports become cheaper for foreign buyers, increasing demand for domestically produced goods. The Marshall-Lerner Condition must hold: The sum of the absolute values of the price elasticities of demand for exports and imports must exceed one for depreciation to improve the trade balance.
Why are the absorption and the elasticities approaches are known as traditional
theories of balance of payment determinants?
Absorption: Assumes that prices remain constant and emphasizes changes in real domestic income, if a nations real income exceeds the amount of goods and services that it absorbs, then the nation will run a current account surplus. a = c+ i + g + im. Policies that reduce absorption an improve the trade balance by lowering imports.
Elasticities: Focuses on the price responsiveness of exports and imports to exchange rate changes. εX: Price elasticity of demand for exports. When foreign exchange demanded by U.S. residents exceeds the one supplied by U.S. producers, the U.S. will have a deficit.
These approaches were developed during the Bretton Woods era, a period when fixed exchange rates and trade imbalances were central policy concerns. heir applicability has diminished in modern economies where financial flows dominate.
