Balance of Payment
Effect of current account deficit on exchange rate
A current account deficit arises when a country imports more than exports - the country with the current account deficit is selling less to the world than its buying from the rest of the world. This creates downward pressure on the importing country's currency.
What is Marshall - Lerner condition and J curve
A persistent CA deficit should put downward pressure on the country's exchange rate and in case of floating exchange rates, fluctuation should help correct the imbalance in the current account. However such shifts do not always occur. Whether or not depreciation of a country's currency reduces a trade deficit depends on the combined elasticity of demand for imports and exports. If the combined elasticity of demand for exports (PEDx) and imports (PEDm) is elastic (i.e. the coefficient is greater than 1) or PEDx + PEDm > 1, then depreciation in the currency will move a country's current account towards surplus. This is known as the Marshall - Lerner condition (MLC). If the MLC is not met means that demand for exports and imports are not responsive to changes in price (inelastic), brought on by changes in exchange rates. In this case depreciation of a nation's currency will worsen a country's current account deficit. In order for depreciation of a country's currency to improve it's balance of trade - increase in revenues from exports must exceed the decrease in expenditure on imports. MLC is basically an application of the total revenue test of elasticity i.e. if demand for exports is inelastic a fall in price will lead to a decrease in total revenues from sale of exports. Similarly, if imports are inelastic then price of imports will rise, worsening the CA deficit.
Types of Protectionisim
1. Tariif
Benefits of reducing current account deficit
Reducing CA results in - 1. stronger currency -ensures price stability 2. low interest rates - allows economic growth and less money being paid as interest to foreign creditors. The govt has a number of options - but supply side policies are clearly the most efficient and economically justified method for correcting a current account deficit.
What is comparitive advantage
Specializes in a good that a country can produce with lower opportunity costs
what is balance of payment
Summarizes the economic transactions of an economy with the rest of the world for a specific time period
What is the effect of current account surplus on the exchange rate
The exchange rate of the country with current account surplus will eventually rise and appreciate since the country consistently sells more of its output to foreigners that it demands of foreign output. Since the surplus nation demands little foreign goods the supply of its currency in foreign exchange markets will fall, contributing to the currency's appreciation. Over time an appreciating currency will reduce the export industry's competitiveness with the rest of the world and force domestic produces to become more efficient or shut down as foreign demand falls. The above adjustment assumes that exchange rates are floating and the currency is allowed to appreciate. Example China which has the largest current account surplus prevents its currency from appreciating by intervening in the forex market. Under a system of floating exchange rates, current account surpluses should be kept in check by the appreciation of the surplus nations currency. However if govts intervene these imbalances can persist for years
Why should the BoP always balance
The reason is simple - every unit of currency that a country spends on foreign goods and services must ultimately end up being spent again on something from the country. The country's currency cannot be spent by foreigners on anything but the goods and services of that country. If the foreigners don't spend on the country's goods and services, then they are spent on financial or real assets (recorded in the financial account). In this way, a current account deficit is offset by a financial account surplus hence the balance of payments.
The J curve
Consumers over a period of time are able to change their behavior to consume either more or less of the product depending on how the price changed. This means that the PED for both imports and exports increases over time. Therefore due to depreciation of a nation's currency it is likely that in the short run demand for imports and exports will be inelastic i.e. the MLC will not be met but over a period of time consumers begin to alter their demand based on changing price and therefore PED becomes more elastic and since MLC is met, the nation (whose currnecy has weakened) moves towards a current account deficit. This is called the J curve.
What is Absolute advantage
Produces the same amount of goods with fewer factors of production.
Benefits of Trade
1. Countries produce goods that are efficient and have comparitive advantage. 2. The world market also gets access to cheaper goods than they can produce domestically (they have relatively higher opportunity costs) 3. Foreign Exchange - The exchange rate is also favourable if the amount of exports are significant since currency value appreciates making imports cheaper. Also more foreign exchange helps you buy more imports. 4. Consumer have greater purchasing power and choice. 5. Domestic firms often face direct competition with foreign firms - incentive to reduce costs, prices but still maintaining profits. 6. Exporting industry firms also gain economies of scale as market size expands.
Components of BoP
1. Current Account - measures the balance of trade in goods and services and the flow of income between a nation and other nations. 2. Capital account - involves ownership of capital, forgiveness of debt, sale or purchase of intangibles - patents, copyrights, trademarks, transfer of financial assets by migrants, inheritance taxes, tangible assets like rights to natural resources. "The capital account is a misc account. Combined with the financial account it represents the transfer of capital to help pay for the current account - which includes the trade of goods and services". 3. Financial Account - Portfolio investment transactions - bonds, shares, derivatives. Foreign Direct Investment - FDI - setting up factories by foreign companies in another country, Reserves - currency, gold
methods to correct a persistent current account deficit
1. Expenditure switching policies: Govt policy aimed at reducing imports and increase spending on domestic goods and services is called expenditure switching policy or protectionist policy. This is done by Exchange Rate manipulation and increasing barriers to trade - tariffs etc. 2. Expenditure -reducing policies: (i) Includes - contractionary fiscal polices - raising taxes will reduce disposable income and overall AD including imports. The resulting lower rate of inflation or deflation (if decline in AD is significant) could make exports more attractive. (ii) Contractionary monetary policies: Increase interest rates to discourage consumption of imported durable goods (finance by borrowing). Raising interest rates will also have disinflationary (or deflationary) effect, making exports attractive as well. Expansionary supply-side policies: Whilst Contractionary fiscal and monetary policies reduce overall demand and therefore reduce current account deficit - it is likely that the costs of such policies outweigh the benefits - since domestic employment, output and economic growth suffer due to reduced spending. In the long run the best way for a nation to reduce a current account deficit is to allocate resources towards economic activities in which it can most effectively compete in the global economy. Supply side policies that promote more balanced global trade and long-run economic growth include the following - (i) investment in education and healthcare (ii)Public funding for scientific R&D. (ii) investment in modern transportation and communications infrastructure.
Case against Protectionisim
1. Misallocation of resources: Countries that protect declining industries compel their consumers to pay higher prices. This is an unnecessary misallocation of income to inefficient producers. 2. Escalation to a trade war: Dispute over subsidies can quickly degenerate quickly into a damaging trade conflict. 3. Domestic complacency causes higher prices and costs: Protected firms have little incentive to modernize or innovate for greater efficiency since they put in most of their energy into persuading the public and politicians of their case. 4. Higher import costs: Impact consumers and firms that buy imported goods. The higher prices might drive some imports out of the market entirely relegating domestic producers and consumers to higher prices and possibly inferior quality goods. 5. Corruption: Higher tariffs on imported goods means greater revenue for the domestic producers which creates a large incentive for them to bribe lawmakers and politicians. 6. Reduced Export Competitiveness: Firms that export suffer the harm of having workers and resources (capital) drawn away by inefficient producers. They also suffer if they are using imported goods (and paying high costs) as input for producing for the export market.
What are the implications of current account deficit
1. Ownership of assets: A country with a large current account deficit which cannot export goods and services to make up for its spending on imports ends up exporting ownership of it's financial and real assets - in the form of FDI in domestic firms, portfolio investment by foreigners, foreign ownership of govt debt or build up of foreign reserves of the deficient country's currency. 2. Effect on interest rates: Adverse impact on interest rates and investment in the deficit country. CA deficit puts downward pressure on nations exchange rate making imports expensive, causing inflation. In order to prevent massive currency depreciation the central bank may be forced to tighten money supply and raise domestic interest rates to attract foreign investors and hence foreign currency into the economy. Alternatively, since a current account deficit must be offset by a financial account surplus the government may need to offer higher interest rates on govt bonds to attract foreign investors. 3. Effect on indebtedness: A current account deficit is synonymous with a large financial account surplus with a significant source of credit in the financial account being foreign ownership of govt debt. The opportunity cost of foreign owned debt is that the money paid as interest could be invested in the domestic economy to promote economic growth and development. 4. Effect on international credit ratings and demand management: Over time current account deficits financed through foreign borrowing could reduce the attractiveness of the borrowing country's government bonds harming its international credit rating.
Arguments for Protectionism
1. Protect Infant industries - give them space and room (by protectionism). These industries should be sheltered until they can face on more equal terms the powerful multinational corporations of rich countries. Give space to get EOS, also compete against low cost labor in developing countries. 2. Dumping - sell them at a price below average costs (excess products/surplus goods - after having extracted higher prices in their domestic market ) sold in developing countries. Usually industries supported by subsidies who produce quite a lot, often decide to sell them below cost of production - to sell in bulk and gain profits, erodes competition from domestic firms as well. 3. Protect domestic jobs - unemployment generated from industries earning less profits and shrinking due to import competition. Structural unemployment if workers don't have the skills to gain other jobs, protect primary industry. COUNTER - just delaying the degradation of that industry 4. To counteract relative domestic tax differences: Some economists argue that domestic tax policies can reduce or enhance the competitiveness of a country's exports and hence extra levies merely equalize tax differences and make competition fairer 5. To raise government revenue. 6. To protect against unfairly low labour costs: Many imported products by wealthy countries are produced at wage rates far below those paid in their countries at working conditions and would be unacceptable. 6. To protect strategic industries: For example defence or military needs 7. To overcome a balance of payment deficit: Expenditure - switching 8. To improve "terms of trade" Terms of trade is the ratio of export prices to import prices, The ideas is that a large country might block access to its market with a tariff that could harm import demand enough to reduce demand for the imported good and reduce the price of those imports.
What is current account deficit
If the total spending by a nation's residents on imported goods and services exceeds the revenues earned by the nations producers from exports, the nation is likely experiencing a current account deficit.
Evaluate the global trade imbalance
Large imbalances exists in nations current and financial accounts. A handful of exporting countries have nearly 3 trillion dollar surplus corresponding to equally large deficits of a handful of importing countries. 1. Continued decline in secondary and tertiary sectors in west - the continued dependence on imports will completely wipe out any remaining manufacturing in the US, Western Europe. There continues to be a growing trend in outsourcing and off-shoring jobs in secondary and tertiary sectors from the deficit countries to the surplus nations. 2. Persisting poverty in the developing world: For exporting countries, trade surplus support economic growth but such growth may come at the expense of improvements in households standard of living if this growth is continuously fueled by more and more investment abroad. Financial account deficits in these nations mean that households are forced to consume less than they would be able to if their currencies be allowed to appreciate and current account were in better balance. Increased imports to countries in Asia would mean slower growth as their exports adjust to competition from abroad but it would also mean higher standards of living for the households in these regions as they begin to enjoy the increased purchasing power of their stronger currencies. 3. Threat to economic sovereignty: Perhaps most worrying especially in the US is the continued increase in foreign ownership of assets and the corresponding threat to economic sovereignty that is resulted. America's growing financial account surplus means that ownership of American corporations, factories, buildings and national debt is in the hands of foreign interest. Additionally, the build up of US dollars with Asian banks increases the risk of the US dollar massively depreciating if the Asian banks were to reduce their holding of US dollars, resulting in an increase in supply of the US currency in the foreign exchange markets. In order for a better balance to be achieved, China should relinquish control over the value of its currency. China competes for business not only with other low income countries but with manufacturing giants. A weak China currency hurts American producers since it becomes harder to compete with Chinese products, whose costs are kept low artificially. To compete with China, other low income countries have had to further devalue their currency further exacerbating the problem for developed countries. When the Chinese currency is allowed to appreciate against the US dollar and other trading partner currencies, the price of Chinese goods would rise in the short run but over time, the other low income countries (Cambodia, Bangladesh etc.) will begin to meet the global demand for low cost, labour intensive goods. Also, the high-tech industries would stop moving from western countries to China, helping retain jobs and provide growth in the economy. China can also benefit - revaluing the currency would improve buying power, making imported goods much cheaper. This could also reduce inflation as China seeks to import greater raw materials to feed its manufacturing. Unless China revalues the currency, the imbalances will continue with decline in manufacturing in the West and the corresponding increase of foreign indebtedness and reliance on imports.
What is the effect of current account surplus on domestic consumption and savings
Persistent current account surplus imply that households in the surplus country are consuming at a lower level over time than households in countries with current account deficit. Essentially the high level of investment in foreign assets plus the large reserve of foreign exchange held by the central bank of the surplus nation add up to form forced saving amongst the surplus country's households. The high level of saving and investment in home and abroad necessary to maintain a country's current account surplus results in less of the country's hard earned income going towards domestic consumption or spending on imports.
