BALANCE OF PAYMENTS
PROBLEMS
Current Account Deficit
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Current Account Deficit-net outflows on current account
greater than net inflows.
Made up on the capital account (since current account
deficit=capital account surplus…current account +
capital account=0 {theoretically})
Current account deficit can be covered by (i) loans
from abroad and (ii) investment from abroad.
There are several negative effects of having current
account deficits in the long run for a debtor nation.
Negative effects
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To cover the current account deficit, the country can take loans
from abroad. However, by borrowing from abroad, the loans will
have to be paid back with interest.
Continuous current account deficits will be looked upon harshly
by the international business and financial community. The
ability to pay off foreign debts will be questioned. Investors
choose to avoid weak economy. In such a scenario, foreign
countries would be unwilling to give loans to the domestic
country thereby making covering current account deficits
difficult.
Downward pressure on currency.
Domestic economy vulnerable to international business cycles
and interest rates.
Negative Effects
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Country may be forced to raise interest rates to attract more
foreign investment and to keep a desired exchange rate.
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Foreign firms ultimately fund more and more of domestic
investment, making the domestic economy vulnerable.
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Sale of domestic assets to foreigners causes outflow (in the
form of repatriated incomes, dividends etc) thereby intensifying
current account deficit even further.
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Increasing interest rates deflationary effect on domestic
economy.
Negative effects
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Incoming funds on capital account may be
speculative inflows in which case recipient
country headed for trouble.
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Risk of foreign capital exiting- if this happens
in domestic economy unemployment rises as
capital leaves. Significant reduction in
imports.
Benefits
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A current account deficit allows a country to enjoy
greater consumption than production-even on
borrowed money.
If deficit is relatively short-lived-less chance of
damage ,if inflows on capital account are used
for investments.
For example; The difference with the USA capital
account deficit is that it does not threaten to collapse
the American economy.
As long as the funds go towards investment, the
debt will have to be paid by future generations of
Americans who enjoy increased living standards as
a result of using the loans.
Current Account Surplus
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Current Account Surplus  net outflow in capital
account.
Gains:
The increase in foreign holdings will in time generate
income in the forms of profits, interest received and
dividends.
Enabled future consumption the net foreign assets
are another form of saving which can be used in the
future.
Enhanced resource allocation and increased profits
for domestic firms Capital will flow to countries with
a higher rate of return than home country. Thus,
less competition in domestic market.
Current Account Surplus
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Possible disadvantages:
Current investment possibilities for the home country
decrease as resources as diverted abroad.
Diverting investment from the domestic to foreign
market leading to loss of jobs (contentious), skills
and technology gains.
Degree of tax loss as portion of tax bases taxed
outside country.
Methods of correction (of current
account deficits)
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Current account deficit is looked upon as a balance
of payments disequilibrium, thus it needs to be
corrected using economic policies.
Short run policies intervene on the market to lower
the ratio of price of domestic goods to imported
goods-take up protectionist methods so that import
spending falls, deficit is corrected.
Long run policies enhancing domestic competitive
abilities i.e. increasing R&D, productivity and
introducing innovation and improvements in quality
etc.
Managing changes in exchange rates
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A country operating under a managed currency
regime can devalue its currency to correct the
current account deficit.
Devaluation Px  X volume  X revenue
(assuming price elastic exports)
Devaluation PM  M volume  M spending
(assuming price elastic imports)
Thus, devaluation can correct a current account
deficit.
Expenditure switching policies
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Policies which divert/substitute expenditure
away from imports towards domestically
produced goods are expenditure-switching
policies. Trade barriers and/or intentionally
lowering the exchange rate (devaluation or
depreciation) are examples of such policies.
Disadvantages: retaliatory protectionism and
reciprocal devaluations.
Expenditure reducing policies
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Contractionary policies such as increased
interest rates and/or decreased government
spending will cause a reduction in
expenditure (national income) and lower the
demand for imports.
Disadvantages: possibility of a trade off in
accomplishing both macro goals of high
growth/employment and external balance.
Change in supply side policies to
increase competitiveness
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Reducing labor costs, adding to labor skills,
creating incentives for investment in
technology and generally increasing
productivity will increase international
competitiveness.
Ultimately, increased imports and diverted
spending also towards domestic goods.
However, these policies take time to show an
effect on the balance of payments.
MARSHALL-LEARNER CONDITION
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A devaluation would help improve the current
account only when P. e. d x + P .e. d m>1
J-CURVE
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A devaluation might actually worsen the
current account initially because;
Exports and imports are likely to be inelastic
in the short run.
Firms are locked into contracts.
What about elasticity of supply of exports and
imports.