IBDP Economics 4.6 Balance of payments HL Paper 1- New Syllabus

(a) Answer:

The current account records transactions involving trade in goods and services, primary income and secondary income between a country and the rest of the world. A current account deficit occurs when the value of current account payments exceeds receipts. If the deficit is persistent, it can have several important implications for the economy.

1. Pressure on the exchange rate

A persistent current account deficit means that the country is spending more foreign currency on imports and other current account payments than it receives from exports and other receipts. This creates a greater demand for foreign currency and supply of the domestic currency in the foreign exchange market.

Under a floating exchange rate, this may place downward pressure on the value of the domestic currency, causing a depreciation. A weaker currency makes imports more expensive in domestic currency terms and can make the country’s exports cheaper to foreign buyers.

However, the extent to which the depreciation corrects the deficit depends on factors such as the price elasticities of demand for exports and imports. If demand is sufficiently elastic, the lower relative price of exports and higher relative price of imports can eventually improve the current account balance.

2. Increased foreign ownership and external debt

A persistent current account deficit must be financed through corresponding financial-account inflows, such as foreign direct investment, portfolio investment or borrowing from abroad. As a result, a country may accumulate greater external liabilities or experience increased foreign ownership of domestic assets.

For example, foreign investors may purchase domestic companies, property or government securities to provide the capital needed to finance the deficit. While these inflows can finance investment and economic activity, a prolonged dependence on foreign finance can increase debt-servicing obligations and make the economy more vulnerable to changes in investor confidence.

Therefore, a persistent current account deficit may put downward pressure on the exchange rate and increase a country’s dependence on foreign capital and external financing. The consequences depend on how the deficit is financed and whether the borrowed or foreign-funded resources contribute to productive investment.

(b) Answer:

A current account deficit occurs when a country’s payments on the current account exceed its receipts. A fall in the exchange rate, particularly a depreciation under a floating exchange rate system, can potentially correct the deficit by changing the relative prices of exports and imports.

How depreciation can correct a current account deficit

When a country’s currency depreciates, its exports become cheaper in terms of foreign currency, while imports become more expensive in terms of domestic currency. This can increase the quantity demanded for exports and decrease the quantity demanded for imports.

Therefore, export revenues may increase while import expenditure falls, improving the current account balance. This is known as an expenditure-switching policy because expenditure is shifted away from foreign goods towards domestically produced goods.

Depreciation can also increase aggregate demand (AD). Higher exports increase the export component of AD, while lower import demand reduces import expenditure. Consequently, net exports may increase and AD may shift to the right, potentially increasing real output and employment.

However, the effectiveness of depreciation depends on the Marshall-Lerner condition. For a depreciation to improve the current account balance in the longer term, the sum of the absolute values of the price elasticities of demand for exports and imports generally needs to be greater than one.

If export and import demand are sufficiently price elastic, the quantities traded respond strongly to changes in relative prices and the current account is more likely to improve. If demand is price inelastic, the value of imports may rise significantly while the quantity demanded changes little, potentially worsening the deficit.

The J-curve effect also means that depreciation may initially worsen the current account balance before improving it. In the short run, contracts and existing trading relationships mean that quantities of imports and exports may not adjust immediately. Because imports become more expensive immediately, the value of import expenditure can rise before quantities respond. Over time, consumers and firms may adjust their demand, allowing the current account balance to improve.

Real-world example: Japan

Japan has experienced periods of significant yen depreciation. A weaker yen can improve the international competitiveness of Japanese exports and increase the domestic-currency value of foreign earnings. However, Japan also relies on imported energy and raw materials, so depreciation can substantially increase import costs. This illustrates that depreciation can improve export competitiveness while simultaneously increasing the cost of imports.

Inflationary consequences

A depreciation increases the domestic price of imported goods and raw materials. This can create cost-push inflation, particularly in economies that depend heavily on imported energy, food or intermediate goods.

Higher import prices reduce the purchasing power of households and increase production costs for firms. Therefore, although depreciation may improve the current account, it can conflict with the government’s objective of maintaining low and stable inflation.

Impact on different sectors and stakeholders

Export-oriented firms are likely to benefit because their products become more price competitive in international markets. Import-dependent firms, however, face higher costs for foreign inputs. Consumers may also lose from higher prices of imported goods.

The overall effect therefore depends on the structure of the economy. An economy with a strong export sector and relatively low dependence on imported inputs may benefit more from depreciation than an economy heavily dependent on imported energy and raw materials.

Alternative policy: expenditure-reducing policies

A government could use contractionary fiscal policy to reduce a current account deficit. Higher taxes or lower government expenditure reduce aggregate demand and household incomes. This can reduce demand for imports and therefore reduce import expenditure.

However, this approach may reduce real output and increase unemployment. It can therefore correct the current account deficit at the expense of domestic economic activity.

Alternative policy: trade protection

Governments can impose tariffs, quotas or other trade restrictions to reduce imports directly. This may improve the current account balance by lowering import expenditure and protecting domestic producers.

However, protectionism can increase domestic prices, reduce consumer choice and cause retaliation from trading partners. Retaliatory measures may reduce the country’s exports, so protectionism is not necessarily an effective long-term solution.

Alternative policy: supply-side policies

Supply-side policies can increase productivity and reduce firms’ production costs. Improved productivity can make domestic goods more internationally competitive without requiring a depreciation of the currency. This can increase exports and reduce the need for imports over time.

However, supply-side policies can take considerable time to produce results and may require significant government expenditure, particularly when they involve education, infrastructure or research and development.

Real-world evaluation: The experience of countries with substantial currency depreciations demonstrates that a weaker exchange rate does not automatically eliminate a current account deficit. For example, if a country is highly dependent on imported fuel and other essential inputs, depreciation can increase the value of imports substantially. The improvement in exports may therefore be insufficient to offset the higher import bill.

Overall evaluation: A fall in the exchange rate can be an effective way to correct a current account deficit when export and import demand are sufficiently price elastic, domestic firms can respond to increased export demand and the economy has the capacity to expand production. The Marshall-Lerner condition and the J-curve effect are therefore crucial in determining its success.

However, depreciation is not necessarily the “best” solution. It may initially worsen the deficit, create cost-push inflation and reduce real household incomes. Its effectiveness is also limited when exports and imports are price inelastic or when the country relies heavily on imported inputs.

Therefore, depreciation can be an effective method of correcting a current account deficit, particularly in the long run when demand becomes more responsive to price changes, but it should not be regarded as universally the best policy. In many cases, a combination of depreciation with supply-side policies to improve international competitiveness is likely to provide a more sustainable solution, while expenditure-reducing policies may be appropriate where excessive domestic demand is the main cause of the deficit.