Correcting Current Account Deficits & Surpluses Flashcards
What causes a current account deficit?
- Demand-Side reasons such as strong domestic growth, strong exchange rate and recession abroad.
- Supply-Side reasons such as Low investment, low productivity, high relative inflation, poor quality exports.
What is a good evaluative point for the current account deficit?
- It depends upon whats causing it i.e demand-side versus supply-side, if its supply-side longer term compared to demand-side could exasperate consequences.
- Depends upon the size of the deficit. is it a low proportion of GDP.
Why is a current account deficit bad for an economy
- Result in deflation
- Less economic growth
What are the ways that a current account deficit can be corrected?
Through the 3 D’s:
1. Deflation - e.g any policy that reduces aggregate demand –> the idea is that this reduces import expenditure e.g increase in taxation.
2. Devaluation - e.g any policy that deliberately weakens the ER e.g cutting interest rates….
3. Direct controls - e.g protectionist measures like tariffs.
Deflation - Evaluation
- However, the government may not desire to reduce the current account deficit through tax reforms such as increasing the rate of income tax.
- This is because it can cause conflicts in macroeconomic objectives. If the government increases the rate of income tax, consumers will have less income after tax, which leads to average disposable incomes falling around the economy (ceteris paribis).
- Consequently, the level of consumption in the economy may fall which is a component of aggregate demand.
- As a result, aggregate demand will shift leftwards from AD1-AD2, thus reducing real national output and incomes (Y1-Y2).
- In addition to this, since incomes and general demand in the economy have fallen from AD1-AD2, this may mean that (potential) investment in the economy falls as firms do not need to invest in capital goods to increase spare capacity to meet demand.
- Consequently, this may trigger a “negative” accelerator effect, resulting in a further shift in aggregate demand from AD2-AD3, thus reducing real national output and incomes further from Y2-Y3.
- This demonstrates how there is an opportunity cost in macroeconomic objectives as by the government trying to correct the current account deficit through higher taxation, in turn, they decrease economic growth which is not desirable due to issues such as decreased living standards and increased relative poverty.
- However, this may not necessarily be a problem. For instance, if economic growth is already high then it would make sense for the government to focus on improving other macroeconomic objectives.
Direct Controls - Evaluation
This is to do with protectionist measures, so I would evaluate this via the deadweight welfare loss under a tariff or retaliation or both or the martial lerner condition.
Standard An - Devaluation
- Another way in which the current account deficit can be corrected is through the government decreasing interest rates in order to influence the exchange rate.
- If the government decrease the interest rate, so that it is now lower relatively to other countries, this can depreciate the exchange rate.
- This is because, investors chase the highest rate of return on their investments. As a result, they will move their “hot money” from the UK into other countries that have relatively higher interest rates meaning the reward is greater.
- Consequently, in doing so, investors have to change their pounds sterling into the other foreign currency.
- This decreases demand for pound sterling, shifting it leftwards from D1-D2. Investors compete to sell off pound sterling driving down the price from P1-P2 due to excess supply of sterling.
- If the exchange rate is now relatively lower than other countries at P2, then ceteris paribus, imports are now more expensive for UK consumers and exports are now cheaper.
- Due to the law of demand, this can improve the current account deficit position. UK import expenditure will fall, while simultaneously increasing exports for the UK.
- As a result, the value of trade in goods and services will rise, which is one component of the current account, and therefore, ceteris paribus, the deficit on the current account of the balance of payments is reduced.
Devaluation - Evaluation
- However, perhaps devaluation may not be as effective due to the fact that the extent to which the volume of exports rise and imports fall depends upon the price elasticity of demand.
- In order for devaluation to be successful, the marshall-learner condition states that the sum of the PED of imports and exports must be greater than 1.
- This is particularly unlikely in the UK. For instance, the UK imports a lot of food which is price inelastic due to being a luxury and exports technical goods such as engines which likely has very few substitutes so demand is also likely to be price inelastic.
- As a result, there will be relatively small changes in the volume and therefore value of imports and exports.
- Furthermore, it is likely that in the short-run, PED is price inelastic. For instance, firms are bounded by fixed contracts, and so the Marshall-Lerner condition will not be met, as firms will continue to buy the some volume of imports even though price has effectively risen.
- Consequently, the trade deficit will worsen before expenditure-switching takes place as demonstrated by the J-Curve relationship therefore deflation may not necessarily be the best way to reduce a trade deficit/current account deficit.
- However, in the long-run, if the marshall-lerner condition is met then the current account deficit will fall (ceteris paribus)
Budget Deficit - Essay Plan
This includes the pros, cons and evaluative points if you get a question on the budget deficit:
Pros & Cons:
* Higher growth and lower unemployment –> under a budget defict the government spends more than they gain in taxation –> increased economic growth and higher living standards…..EV: Inflation? and the impact on material living standards/conflict of macroeconomic objectives.
* Benefits of governent spending –> increased education/healthcare/infastucture etc and how that benefits the economy e.g lower unemployment…EV: for each of these I have seperate evaluation e.g opportunity cost, crowding out effect.
* Incentives of tax cuts on LR economic growth…../accelerator effect/ricardian equivalence.
Evaluative points
* Depends upon the current state of government finances –> if government finances are already poor this could emphasise the issues associated with the cons.
* SR vs LR impacts? –> LR returns from tax cuts & government spending
* Stage of the economic cycle?
Budget Surplus - Essay Plan
This includes the pros, cons and evaluative points if you get a question on a budget surplus:
Pros & Cons
* Less crowding out and crowding in of the public sector, this increases investment boosting growth potentially. However, this is unlikely to occur because there may not be incentive to actually invest.
* Improvement in the confidence of government finances. if there is higher confidence in gov finances –> AAA rating on gov bonds –> lower cost of borrowing –> in the future if the government want to borrow then it is cheaper and less of a burden on gov finances. Furthermore, if there is greater budget surplus provides greater fiscal stability in times of crisis/recession. Confidence in government finances is particularly important for macroeconomic stability as demonstrated in September 2022. Lizz Truss’s mini budget caused chaos in the bond market due to lack of confidence, interest rates went up 3% in 5 days!
* Budget surplus is associated with contractionary fiscal policy. Reduction in inflation. Benefits?
* Laffer curve disincentives? –> tax avoidance/tax evasion?
* Lower economic growth and consequences.
Evaluative Points
* Depends upon stage of economic cycle - boom vs recession
* How bad the implications on economic growth are
* Spare capacity?
Marshall-Lerner condition and J Curve - Evaluation for prices of imports and exports changing
- However, it may not necessarily be the case that the current account deficit is reduced via a weakening of the exchange rate is it depends upon the price elasticity of demand for imports and exports.
- The Marshall-Lerner condition states that in order for devaluation (or any other policy) to be sucessful at reducing import expenditure and increasing the value of exports the sum of the PED of imports and exports must be greater than 1.
- This is particularly likely in the UK. For instance, the UK imports a lot of food which is a necessity and thus is likely to have price inelastic demand. Similarly, the UK exports technical goods e.g engines to where there is relatively few substitutes and has price inelastic demand therefore devaluation is unlikely to be effective as the Marshall-Lerner condition is unlikely to hold true.
- Furthermore, in the short-run demand is likely to be price inelastic. This is because,
