Practice Problems on Current Account
1- List de categories of credit items and debit items that appear in a country’s current
account. What is the current account balance? What is the relationship between the
current account balance and next exports?
Credit items in the current account are exports of goods and services and income receipts
from abroad. Debit items in the current account are imports of goods and services,
income payments to foreigners, and net unilateral transfers. Adding all of the credit items
and subtracting all of the debit items gives the current account balance. The current
account balance equals net exports plus net factor payment plus net unilateral transfers.
2- What is the key difference that determines whether an international transaction appears
in the current account or the capital and financial account?
The current account includes only the trade of currently produce goods and services.
Trades of existing assets are counted in the capital and financial account.
3- An American publisher sells $200 worth of books to a resident of Brazil. By itself, this
item is a credit item in the U.S. current account. Describe some offsetting transactions
that could ensure that the U.S. current account and the capital and financial account
balances would continue to sum to zero.
The sale of books from United States to Brazil is a credit item in U.S. current account.
Offsetting transactions include anything that is a debit item in either the current account
or the capital and financial account. Some examples of offsetting transactions are: (1) A
U.S. citizen buys $200 worth of stock in a Brazilian company, so that the offsetting debit
item is an increase in U.S. –owned assets abroad, which is a debit in the capital and
financial account. (2) A U.S firms imports $200 worth of nuts from Brazil, so the
offsetting debit item is an import of goods, which is a debit in the current account.
4- How do a country’s current account, capital account and financial account balances
affect its net foreign assets? If country A has greater net foreign assets per citizen than
does country B, is country A necessarily better off than country B?
In any period, the net amount of new foreign assets that a country acquires equals its
current account surplus, which in turn must equal its capital and financial account deficit.
A country with greater net foreign assets than another is not necessarily better off. What
really counts is total national wealth, which consists of both net foreign assets and net
domestic assets. For example, the United States has lower net foreign assets than other
countries, but has one of the world’s highest levels of total national wealth per citizen.
5- Explain why, in a small open economy, (a) national saving does not have to equal
investment, and (b) output does not have to equal absorption.
In a small open economy, saving does not have to be equal to investment. Saving can be
used to finance domestic investment or it can be lent abroad. So saving equals investment
plus net exports.
Similarly, output need not equal absorption. Absorption is a country’s total spending on
consumption, investment, and government purchases. Absorption may be different from
output because some output may be exported. The difference between output and
absorption is net exports.
6- Generally, what types of factors will cause a small open economy to run a large
current account deficit and thus borrow abroad? More specifically, what two major
factors contributed to heavy LDC borrowing in the 1970s?
A small open economy is likely to run a large current account deficit and to borrow
abroad for two main reasons. First, there may be an increase in the expected future
marginal product of capital. This shifts the investment curve, reducing the current
account balance. The second reason for foreign borrowing is temporary supply shocks
that cause absorption to exceed output for a time.
In the 1970s both factors contributed to heavy borrowing by LDCs. Many were
borrowing to try to increase growth by increasing their capital stock, because they
believed the future marginal product of capital was high. Because the LDCs were poor
and had little domestic saving, they had to borrow from abroad to increase investment.
And the oil price shocks of 1973-1974 and 1979-1980 caused a further reduction in
national saving, so the LDCs had to borrow even more from abroad.
7- In a world whit two large open economies, what determines the world real interest
rate? What relationship between the current accounts of the two countries is satisfied
when the world real interest rate is at its equilibrium value?
In a world with two large open economies, the world real interest rate is determined such
that desired international lending by one country equals desired international borrowing
by the other country. When the world real interest rate is at its equilibrium value, the
current accounts of the two countries sum to zero.
8-How does an increase in desired national saving in a large open economy affect the
world real interest rate?
An increase in desired national saving in a large open economy reduces the world real
interest rate. The shift to the right in the saving curve increases the country’s current
account at the current world real interest rate, so the international asset market is out of
equilibrium. To restore equilibrium, the world real interest rate must fall.
9- A large country imposes capital controls that prohibit foreign borrowing and lending
by domestic residents. Analyze the effects on the country’s current account balance,
national saving, and investment, and on domestic and world real interest rate. Assume
that, before the capital controls were imposed, the large country was running a capital and
financial account surplus.
In Fig. 5.3, before the capital controls are imposed, the home country has a current
account deficit of the amount CA, while the foreign country has a matching current
account surplus. The effect of the capital controls is to make saving equal investment in
each country. In the home country, the real interest rate rises, investment declines, saving
increases, and current account balance increases to zero. The world real interest rate (the
interest rate in the foreign country) declines.
S
r
r
Sfor
-CA
CAfor
rw
I
Ifor
d
d
S,I
S
Sdfor’ Idfor
I
Figure 5.3
10- The chief economic advisor of a small open economy makes the following
announcement: “We have good news and bad news: The good news is that we have just
had a temporary beneficial productivity shock that will increase output; the bad news is
that the increase in output and income will lead domestic consumers to buy more
imported goods, and our current account balance will fall”.
Analyze this statement, taking as given that a beneficial productivity shock has indeed
occurred.
The shock shifts the saving curve to the right, with no change in the investment curve,
since the future marginal product of capital is unaffected. Since income rises and saving
rises, consumption rises, but less than income. Thus, although imports rise somewhat, the
amount is small, so that the current account increases, it doesn’t fall. The statement is
false.
11- The governments of developed economies in the early 1980's increased its
expenditures (that is G). This increased the government's budget deficit. Assume that the
real interest in these developed economies is equal to the world real interest rate. Answer
the question based only on the information provided in this question.
a. How the rise in the budget deficit will impact national savings of these economies?
The national savings will go down. National savings is equal to Spvt + Sgov.
A fall in Sgov due to the rise in the budget deficit lowers national savings.
b. How will the rise in the budget deficit impact the current account of these
economies?
The current account will go down. National savings have fallen with no change in the
investment demand schedule and as CA = S - I a fall in S with no change in I implies
a fall in CA.
c. How will the rise in the budget deficit impact the magnitude of the net international
debt position of these economies?
As the current account goes down the magnitude of the international debt has to rise.
Change in debt is equal to the current account.
12- East Asia Growth, Growth and Income Inequality
i) As discussed in class the level of income inequality has decreased in the HPAE
countries, on the other hand many countries in Latin America have seen a rise in their
level of income inequality. Provide an explanation regarding why income inequality
may have decreased in HPAE economies and increased in the Latin American
economies. [Additional Information: For the last 25 years the average growth rate of
percentage of people with basic education is much higher in HPAE economies
relative to Latin American economies
As discussed the real wage is equal to the marginal product of labor (w=MPN). In the
HPAE economies the rise in education, in particular of the less educated people,
lowers the dispersion on education across people – this makes the MPN across
individuals be more similar. This implies that the dispersion in real wages drop and
hence income inequality drops. On the other hand in Latin American economies the
rise in income inequality is due to two reasons (i) the education growth rate of lower
educated people is not high (ii) economic liberalization has lead to skill-based
technical change. Both these features lead to a bigger variance (dispersion) in real
wages.
ii) Average rates of Investment in new plant and capital is also much higher (40% of
GDP) in the HPAE economies relative to Latin American economies (20% of GDP).
How will the difference in the growth rate of educational attainment (as discussed in
part (i)) explain the differences in the average rate of Investment in these economies.
As the HPAE economies have had higher TFP growth due to greater education
growth, higher TFP growth leads to a rise in expected MPK that raises the incentive
to invest. As the TFP growth is higher for HPAE economies it also follows that
Investment will be higher in HPAE economies.
13- Suppose the U.S government raised its expenditures and did not change tax rates.
How will this policy affect the budget deficit? In particular, how will this change in
government policy affect real wages, employment and real interest rates?
The increase Government expenditures does not affect the underlying technology
and hence does not affect the MPN curve. Hence labor demand is unaffected. This
ensures that the real wages and the real GDP are unchanged.
The increase in the Budget deficit unambiguously lowers the aggregate savings in
the economy. The investment schedule is also unaffected by the change in the
government expenditures. However, the drop in aggregate savings causes the real
interest rate to increase if the economy is closed or if it is big compared to the
world economy. If so, the equilibrium level of investment will drop.
14- On the next page you will see graphs of real GDP growth, the current account, and
the net foreign assets of the U.S. The net foreign asset position (labeled U.S. net
investment position) is the holdings of foreign assets by U.S. residents minus the
holdings of U.S. assets by foreign residents. Note that real GDP growth is falling from
early 1990 to early 1991, and begins to rise after 1991.
a. From 1982, the net foreign asset position falls from a positive position to a
substantial negative position. Explain this movement in light of the observed
behavior of the current account during this time period.
Since 1982, the U.S. has had a persistent current account deficit. This means that
on the net it is borrowing from the rest of the world. Additional borrowings mean
that the rest of the world is accumulating more claims on the U.S. than the U.S. is
accumulating claims on the rest of the world, hence the net investment position
went from a positive number to a negative number.
b. Also recall that during the early 80's the budget deficit was increasing in the
U.S.. Further the real interest rates in the U.S. during the early 80's where also
very high. Using diagrams explain the relation between the budget deficit, the
large current account deficit, and the high real interest rates during the early 80's.
A rise in the budget deficit has the effect of lowering aggregate U.S. savings.
Further, as the U.S. is a large open economy this has the effect of raising the real
interest rates and increasing the Current account deficit (see Graphs).
c. Further, explain why the current account deficit shrunk during 1989-91 period.
The 1989-91 was a period of a recession. This can be viewed as a temporary
adverse productivity shock, which lowers the expected marginal productivity of
capital in the U.S., hence the incentive to invest and borrow is lowered, which
shrinks the current account deficit.
15- Consider a world economy where capital is free to move from one location to another
via international Financial Markets.
a. In such a world economy, what determines the world real interest rate? What
should be the relation between the marginal productivity of capital and the world
real interest rate? How is this relation changed if different locations in the Global
Economy have different risks of investment?
Ignoring risk, international capital will be allocated to ensure that all arbitrage
opportunities are exploited, hence expected MPK(i) = r for country i, where r is
the expected real interest rate. Finally, if different locations have different
magnitudes of risk, then this the international allocation of capital is determined
to satisfy the condition that expected MPK(i) = r +rp(i), where rp(i) is the riskpremium in a given location.
16- (Application to Brazil) There has recently (1998) been considerable economic
turmoil in Brazil. The stock index in this country sharply dropped and there was
considerable outflow of capital from Brazil.
Using ideas developed in class, provide an explanation regarding why the financial
market in Brazil dropped sharply and why there was an outflow of capital from Brazil.
A rise in the risk of investing in Brazil increases Brazil's rp, hence investors need
higher returns to invest in Brazil. To achieve higher expected returns on capital
(i.e., higher expected MPK), the stock of capital has to shrink – that is, there will
be outflow of capital or fewer projects undertaken in Brazil. This follows from the
key property of diminishing marginal product of capital. A rise in risk hence
lowers the amount of investment in new physical capital and raises the discount
rate for all projects in Brazil – this, in itself is enough to lower the stock market
value in Brazil.
17- German Reunification and the current account
On the next page is a graph of Germany's current account surrounding the period of
reunification in 1989. Provide an explanation of why Germany's current account went
from a surplus before reunification to a deficit after reunification. The current account
provided on the next page is for the combined Germany.
Unification rose the MPK, that is, the demand for Investment goods. This leads to a fall
in the current account surplus or a widening of the current account deficit.
18- From 1982-86 the U.S. had an increasing government budget deficits (due to higher
government spending and lower tax rates) and current account deficits, and the value of
the dollar was increasing. Provide an explanation, of this behavior of exchange rates,
government budget deficits, and current account deficits.
The combination of lower taxes and increased government expenditures raise current
demand for investment goods and lower current aggregate savings. This unambiguously
raises current real interest rates. As real interest rates increase in the U.S this causes the
dollar to appreciate. The current account deficit widens as the demand for investment
increased (because of lower corporate tax rates) and because the aggregate savings in the
economy dropped. This policy will also cause the growth rate of the economy to be
higher.
19- Globalization and developing economies.
Consider a small Eastern European economy, for example Hungary. Prior to 1990
Hungary was essentially a closed economy. In this closed economy the domestic real
interest rate was 0.5% per annum. Beginning from 1990 Hungary opened its economy to
international trade and allowed free mobility of international capital. The world real
interest rate is 3% per annum. Assume that the opening of the Hungarian capital market
has no effects on the investment schedule and the savings schedule.
The effect of opening the Hungarian economy in this problem is simply that the real
interest rate in Hungary is now higher (and equal to the world real interest rate) than it
was in a closed economy.
a. How will the opening of the Hungarian economy affect the magnitude of physical
investment in Hungary?
Magnitude of physical investment has to go down as the cost of borrowing increases.
b. How will the opening of the Hungarian economy affect the magnitude of
Hungarian national savings?
Magnitude of national savings will go up as households can earn a higher rate of
return on their savings.
c. How will the opening of the Hungarian economy affect the future Hungarian real
GDP?
The level of future real GDP will have to go down as the level of investment in new
plants and capital today dropped.
d. How will the opening of the Hungarian economy affect its current account?
The current account in Hungary will go up as savings rose and investments in
physical capital fell. Recall: CA = S - I.