Balance of Payments

Exchange Rates, Consequences, and Correcting

Learning outcomes:

Current Account Deficit - Exchange Rates

Current Account Deficit:
Debits > Credits
Outflows > Inflows
Imports > Exports
Since imports > exports, Japan must
supply Yen into the market to pay for
the imports from the USA resulting in
downward pressure of the Yen and
depreciating the currency.

Consequences of a Current Account Deficit

1.

2.

Effect of Foreign ownership of Domestic Assets: a current account deficit

must be complemented with a capital/financial surplus. This capital/financial
surplus results in foreign entities owning capital, investment and reserve asset
of the domestic country.
Effect on Interest Rates: a current account deficit can put downward
pressure on the domestic currency which could cause inflation due to
increasing cost of imported goods (goods, services & raw materials). Could
result in tightening monetary policy - increasing interest rates - to attract
foreign investment in order to keep exchange rate stable. Also, to offset the
current account deficit, the domestic country may have to increase interest
rates to attract foreign investment.

Consequences of a Current Account Deficit

3. Effect on indebtedness: a current account deficit result in foreign governments
purchasing domestic government debt (bonds) - essentially the domestic country
is going into debt to the foreign country.
Benefit to domestic country: high demand for domestic government debt
(bonds) keeps interest rates low resulting in a smaller interest payment to foreign
entities.
Drawback to domestic country: the opportunity cost of foreign owned debt is the
public goods that could be provided with interest payments made to foreign
governments.

Consequences of a Current Account Deficit

4. International Credit Rating & Demand
Management:

Current account deficits financed through

foreign ownership of government debt
reduce the attractiveness of the debt
(bonds).
Forces domestic government to increase
interest rates to attract foreign purchase
of the government debt in order to
maintain financial account surplus.
Result in a reduction of the domestic
countrys credit rating.

Methods to Correct Current Account Deficit

Expenditure Switching: a policy aimed at reducing domestic spending on
imports and increasing spending on domestically produced goods & services.

Exchange Rate Manipulation:

Central bank intervenes in the forex market by supplying the domestic
currency in the market and demanding foreign currencies resulting in a
depreciation of the domestic currency.
Makes imports less attractive and more expensive
Can lower domestic interest rates making foreign investment less
attractive
Results in less demand for domestic currency - places downward
pressure on the domestic exchange rate.

Methods to Correct Current Account Deficit

Expenditure Switching - Increased Protectionism
Domestic country introduces trade barriers
Makes domestic goods more attractive to domestic consumers thus reducing the
demand for imports.
Consequences:
Short-run: net exports may rise moving current account towards surplus or
reduction in deficit.
Long-run: promotes inefficiency among domestic producers. Leads to a
misallocation of resources ultimately the costs to society are greater than the
benefits it brings.

Methods to Correct Current Account Deficit

Expenditure Reducing Policies: Policies aimed at reducing the overall
expenditure by firms and households in a country.
Contractionary Fiscal Policy
Raising taxes - reduction in disposable income - decreases AD
including the demand for imports
Reduction in Government Spending (G) - reduces disposable
income - decreases AD
The reduction in import demand lowers the rate of inflation which
in turn could lead to exports being more attractive to foreign
consumers resulting in a reduction in the current account deficit

Methods to Correct Current Account Deficit

Expenditure Reducing Policies - Contractionary Monetary Policy

Increase in interest rates - decreases consumption on durable goods & firms

investment in imported capital goods
Higher interest rates also reduce the pressure on inflation thus reducing it
making exports more attractive to foreign consumers
However, higher interest rates may attract foreign investment into the country
shifting the financial account further towards surplus thus appreciating the
currency.
May have opposite effect than intended by the central bank
Stronger currency makes imports cheaper thus more attractive offsetting the
improvement in the current account.

Methods to Correct Current Account Deficit

Expansionary Supply-Side Policies
Most effective way in combatting a current account deficit
Aim is to make the domestic country better equipped to compete in
the global economy
Investment in education and healthcare
Public funding for scientific research and development
Investment in modern transportation and communication
infrastructure

Policies to Reduce Current Account Deficit

Contractionary Fiscal and Monetary Policy

Reduce overall demand in an economy thus resulting in a reduction in
the current account deficit
In the short-run this may work, but in the long-run the costs of these
policies will outweigh the benefits
Reduction in domestic employment
Reduction in overall output and growth of a nation

Supply-Side Policies

Most effective way of reducing the Current Account Deficit

Increase AD
Increases employment
Increases a countrys ability to compete in the global economy