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Q.40 current-account-deficit-bop-deficit-and-economy

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  • 1. (a) Suggest reasons for a current account deficit. [10] (b) Discuss whether a balance of payments deficit is undesirable for the economy. [15] (a) The current account records the flows of goods, services, incomes and current transfers between the residents of the economy and the rest of the world over a period of time. The current account balance is the sum of four balances: the goods balance, the services balance, the income balance and net current transfers. A current account deficit occurs when the sum of the four balances is negative. A current account deficit could be due to a trade deficit. Most economies experience a current account deficit due to a trade deficit. The trade balance is the sum of the goods balance and the services balance and is computed by subtracting imports of goods and services from exports of goods and services. A trade deficit occurs when imports of goods and services exceed exports of goods and services. For instance, the US has a large current account deficit due to its large trade deficit. A trade deficit could be due to low exports or high imports. Exports may be low due to a recession in the trading partners, high inflation, a strong domestic currency, a loss in comparative advantage in the industries that produce goods for export or the increased use of protectionist measures by foreign governments. For instance, in the subprime mortgage crisis, Japan’s exports plummeted due to a recession in her trading partners, such as the US and China. Imports may be high due to a culture of extravagance, a high national income, high inflation, a strong domestic currency or a loss in comparative advantage in the industries that produce goods that compete with imports. For instance, the imports of the US are high due to its culture of extravagance and high national income. A current account deficit could be due to an income deficit. The income balance is computed by subtracting outward income remittances from inward income remittances. Income refers to wages, rent, interest and profits. An income deficit occurs when outward income remittances exceed inward income remittances. For instance, Australia has a large current account deficit mainly due to its large income deficit. An income deficit could be due to high outward income remittances or low inward income remittances. High outward income remittances could be due to a large presence of foreign workers and foreign firms in the economy or a high foreign debt. For instance, Singapore has high outward income remittances due to a large presence of foreign workers and foreign firms in the economy and Australia has high outward income remittances due to its high foreign debt. A current account deficit could be due to negative net current transfers. Net current transfers is computed by subtracting outward current transfers from inward current transfers. Negative net current transfers occurs when outward current transfers exceed inward current transfers. Currents transfers are government contributions to and receipts from other economies and international transfers of money by private individuals and firms. In reality, net current transfers is a small item in the current account and no © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 2. economy in the world has a current account deficit that is due to negative net current transfers. In conclusion, a persistent current account deficit may lead to adverse consequences for the economy. Therefore, the government should ensure a healthy current account to maintain the good health of the economy. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 3. (b) The balance of payments (BOP) is a record of all the transactions between the residents of the economy and the rest of the world over a period of time. In other words, the BOP records all the money flows between the economy and the rest of the world. A BOP deficit occurs when money outflows exceed money inflows. Whether a BOP deficit is undesirable for the economy depends on whether it is persistent or non-persistent. Under the flexible exchange rate system, a persistent BOP deficit may lead to high imported inflation, high cost-push inflation, falling national income and rising unemployment. When money outflows persistently exceed money inflows, the supply of domestic currency persistently exceeds the demand and this leads to a persistent downward pressure on the exchange rate. Under the flexible exchange rate system, this will cause domestic currency to depreciate persistently. A persistent depreciation of domestic currency will lead to rising prices of imported goods and services, which include both consumer and intermediate goods, which may lead to high imported inflation. Further, the rising prices of imported intermediate goods may lead to high costpush inflation which may make domestic goods and services relatively more expensive than foreign goods and services. If this happens, the resultant decrease in net exports will worsen the BOP which may become a vicious cycle. A persistent depreciation of domestic currency may induce people to sell it in anticipation of further falls in the exchange rate. If this happens, the resultant currency instability may lead to falling inward foreign direct investments. Aggregate demand is the total demand for the goods and services produced in the economy over a period of time and is comprised of consumption expenditure, investment expenditure, government expenditure on goods and services and net exports. When investment expenditure falls, aggregate demand will fall which will lead to a multiple decrease in national income due to the reverse multiplier effect. Further, since national income is equal to national output, the decrease in national income will lead to a fall in the demand for labour resulting in a rise in unemployment, assuming the size of the labour force remains the same. Under the fixed exchange rate system, a persistent BOP deficit may lead to rising foreign debt, falling national income and rising unemployment. Under the fixed exchange rate system, when money outflows persistently exceed money inflows, the central bank will continually intervene in the foreign exchange market to eliminate the persistent downward pressure on the exchange rate of domestic currency. In other words, the central bank will continually buy domestic currency and sell foreign currency to prevent domestic currency from depreciating. However, in time to come, the central bank will run out of foreign exchange reserves and hence will have to start borrowing foreign currency from foreign banks which will lead to rising foreign debt. Further, if the central bank continually buys domestic currency, the money supply will fall continually which will lead to rising interest rates. The resultant falling investment expenditure and consumption expenditure will lead to falling aggregate demand resulting in falling national income and hence rising unemployment. A non-persistent BOP deficit will not cause problems in the economy and may be desirable due to several reasons. If a BOP deficit is due to an increase in the imports of capital goods, the production capacity in the economy will increase which will © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek
  • 4. lead to a rise in economic growth. If a BOP deficit is due to an increase in the imports of consumer goods, the amount of goods and services available for consumption will increase which will lead to a rise in the standard of living. If aggregate demand and hence the general price level is rising rapidly, a BOP deficit which occurs due to a decrease in net exports may cool down the overheating economy. If a BOP deficit is due to an increase in capital outflows such as hot money outflows or outward foreign direct investments, the resultant increase in inward income remittances in the form of interest and profit in the long run will lead to an improvement in the BOP. In the final analysis, a persistent BOP deficit was a severe problem for an economy before the early 1970s when the Bretton Woods Agreement was still in force and the global capital market was not yet developed. Since the end of the Bretton Woods Agreement, and with the development of the global capital market, it is less of a concern for an economy today. Nevertheless, there are several measures that the government can take to correct a persistent BOP deficit: devaluation, protectionism, contractionary demand-side policies and supply-side policies. However, these measures may lead to problems that are more detrimental than a persistent BOP deficit. Therefore, if the government deems necessary to correct a persistent BOP deficit, it should take into consideration the limitations of the measures. © 2011 Economics Cafe All rights reserved. Written by: Edmund Quek