Explain the potential causes of a Balance of Payments deficit on current account

a) Explain the potential causes of a Balance of Payments deficit on current account. [10] Mark scheme Students are expected to explain at least 3 factors that lead to a current account deficit. L3

Good explanation of the potential causes 2 causes fully elaborated, max 8 An explanation (of the 3 causes) which is somewhat elaborated 1 cause fully elaborated (showing clear understanding of the concept of C/A deficit), max 5 For an answer which contains definitions and listing of causes

L2

L1

8-10 4-7

1-3

Suggested answer Introduction  Define Balance of Payments – a statement of all transactions between one country and the rest of the world.  Define Current Account -- Transactions include merchandise trade, exchange of services [current account] and transfers of capital in both directions.  Interpret term “current account deficit” – when there is a net outflow of funds from the country through current account, mainly occurs when X < M Body Explain (any 3) potential causes of current account deficit, i.e. export revenue < import expenditure. Choose from a spread of price-related and non-price factors causing CA deficit (at least one from each category) Price/ cost-related causes of CA deficit 1. High domestic inflation 2. Overvalued Domestic Currency Change in Prices of a Dominant Export (or Import) Good 3. Loss of Export Competitiveness and Emergence of Low Cost Competitors

Non-price factors 1. Ambitious Development Programme 2. Low level of exports due to real factors 3. Country experiencing strong economic growth / trading partners facing a slow down in economic growth

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1. Loss of export competitiveness and emergence of low cost competitors 

  

America’s current account deficit may be due to the emergence of China with its low labour cost and relatively high productivity especially in the low end manufacturing sector. Result in a loss of export competitiveness of America’s products as the Chinese products are more preferred due to its low cost. Fall in the demand for its exports, assuming a high degree of substitutability between exports of China and US, export earnings will decrease. Imports will increase as residents switch their expenditure to the relatively cheaper imported goods and assuming price elasticity of demand for imports is greater than 1, the qty demanded for imports will increase by more than proportionate to the price reduction resulting in an increase in import expenditure.

2. Trading partners under-value their currencies US has accused its trading partners particularly many Asian countries such as China and Japan of keeping their currencies undervalued. e.g. under-valued yuan  US citizens find Chinese goods ________ while Chinese find US goods ______  for US, TRX ___ while TEM ____ • Assuming the ML condition is satisfied (____ + _____ > __) • Need to assume elastic dd so that a change in px will bring about … 3. Country experiencing strong economic growth (due perhaps to government’s MP and FP to stimulate economy) 

 

Monetary Policy: the interest rate cut means that the cost of borrowing is now lower relative to the expected rate of return. This will encourage borrowing and consumption of imports will increase. Fiscal Policy: tax cut increases the disposal income of the consumers which may further increase the consumption of imports. Expansionary MP and FP will cause the total expenditure on imports to increase, leading to a trade deficit assuming the export earnings remain constant.

4. Ambitious Development Programme  

More applicable for developing countries embarking on industrialization programme Large-scale imports of machinery, plant and equipment, raw materials and technical know-how, resulting in balance of payments deficit.

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Conclusion To sum up, the potential causes of a current account deficit are high domestic inflation, overvalued domestic currency and a change in prices of a dominant export (or import) price. A current account deficit could lead to a balance of payments deficit, ceteris paribus. Also, causes of C/A deficit vary between developing and developed countries: developing countries due to ambitious development programme while developed countries due to emergence of low cost competitors or manipulation of ER by trading partners. For reading US Trade deficit The U.S. current-account deficits of the past two decades were brought on primarily by a long downward trend in domestic saving as a percentage of GDP that began in the mid-1950s and accelerated in the early 1980s. The decline led to a shortage of funds for domestic investment, which in turn caused real (inflation-adjusted) interest rates to rise higher than they would otherwise have been. The higher interest rates attracted inflows of financial capital from abroad. The need to convert those inflows from foreign currencies into dollars increased the demand for dollars in foreign exchange markets and thereby put upward pressure on the value of the dollar relative to other currencies. As saving declined as a percentage of GDP, consumption consequently increased. The rise in consumption was larger than the decline in gross domestic investment that was induced by the higher interest rates. As a result, total domestic demand for goods and services--consumption plus investment-increased, putting upward pressure on the prices of U.S. output. The upward pressure on the dollar and the prices of U.S. output made U.S. imports less expensive for domestic purchasers and U.S. exports more expensive for foreigners. As a result, imports rose and exports fell relative to what they would otherwise have been, causing a chronic current-account deficit that equaled the net inflow of foreign investment. The larger supply of goods and services in the U.S. market partially alleviated the upward pressure on prices. Nevertheless, U.S. imports remained less expensive for domestic purchasers and U.S. exports remained more expensive for foreigners than before the drop in saving, and the deficit consequently continued. Extracted from Congressional Budget Office website

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b. Evaluate the relative effectiveness of devaluation and fiscal policy in correcting a current account deficit. [15]

Mark scheme Students are expected to explain and evaluate the 2 measures and conclude which is more effective in correcting a current account deficit (see if there is any conflict with other macroeconomic goals) Note: Effectiveness should only be measured by how much it is able to achieve its intended goal – to correct CA deficit. L3 L2 L1 E2

E1

Good explanation of both measures. Answer contains some elaboration but explanation of measures are not fully developed Listing of various measures. Undeveloped explanation of 1 measure Detailed evaluation of the measures Weigh the measures and come to the conclusion of which measure is more effective. Recognize that measures taken depend on the severity and causes of the deficit. To reduce deficit, all measures must run concurrently. Some attempt of evaluation for each of the measures

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1-2

4

Suggested answer Introduction • List some problems arising from C/A deficit  hence the need for govt intervention • To correct C/A deficit, the measures must aim to increase X revenue and/or decrease M spending Body Explain and evaluate the effectiveness of each measure 1.

Fiscal Policy CA deficit may be seen as the result of excessive spending  part of this spending spills over on M  the excessive spending fuels inflation and ____ export competitiveness It may thus be necessary to stimulate / curb* spending to correct the CA deficit  use of expenditure reducing policies This calls for the use of expansionary / contractionary* FP. This works in 2 ways: Contractionary FP, through an increase in direct tax and a reduction in G  decrease in AD (explain)  through the multiplier effect, NY declines  falling demand for all g&s including imports  TEM ______, CA ______ At the same time, the decrease in AD  reduce inflation rate in the country  improve export competitiveness  assuming dd for X to be elastic, a reduction in X prices will bring about a more than proportionate increase in quantity demanded  TRX ______, CA ______ Evaluation of fiscal policy (clever comments)

a.

Marginal propensity to import Where an increase in income tax is used to curb spending:

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The reduction in Yd may not have much impact of import demand if the marginal propensity to import (defined as the fraction of the change in Y that is diverted to imports) is small. b.

Possible reduction in export potential in the LR Rise in higher rates of income or corporate taxes may reduce people’s desire to work or invest respectively since more of their incomes or profits would be taxed away. People would prefer leisure to work, while firms may put off additional investments. Reduce AS  slows down LR growth & reduce SOL link back to effectiveness by noting that the disincentive effects of the tax increase may reduce the country’s export potential in the LR

c.

Inflexible nature of G Cuts in govt spending on social programmes e.g. assistance to low income households might be strongly resisted.

Another possibility Using Fiscal Policy as a ss-side policy A rise in government expenditure (G) on R&D and buying advanced technological capital equipment could increase the efficiency/ productivity hence improving our export competitiveness in the long run  increase export revenue (assuming dd for X to be elastic, a cut in price brings about a more than proportionate increase in quantity demanded)  R&D spending geared towards development of new / better products will also increase dd for country’s exports 

Evaluation  In the SR, a rise in G would cause AD to rise and via the multiplier, NY would rise. With higher incomes, dd for M will rise. The greater the MPM, the larger the rise in import expenditure. Ceteris paribus, current account deficit deteriorates. Other limitations include:  Long gestation period – it may take many years for the R&D to yield results Success of the policy depends on the country’s capacity to engage in R&D (e.g. Do they have the pool of scientists? Do they have the know-how) 2.

Devaluation CA deficit may arise from the preference for foreign-produced goods.  This calls for expenditure-switching policies to get consumers to switch from buying imports to buy locally-produced goods.

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

Examples of expenditure-switching policies include devaluation / depreciation and import restriction in the form of tariffs and quotas.

Using devaluation as an illustration: Devaluation of the US$  ___ PX and ____ PM  encourage ____, discourage ______  TRX ___, TEM ____, CA deficit ____ Evaluation of devaluation [clever comments] a.

b.

Elasticity consideration (very important, must learn) (i)

elasticity of dd  For a depreciation to correct the CA deficit, the ML condition (____ + _____ > __) must be satisfied. Demand must be elastic for a Δ in px to produce a ____________________ Δ in QD.  But dd is elastic only in the _____ run. (Reason: tastes and preferences do not change immediately and it takes time to source of substitutes)  In the SR, the ML condition may not be satisfied. So instead of improving the CA balance, the depreciation may worsen it in the SR!

(ii)

elasticity of ss  If local firms are unable to expand output sufficiently to meet rising dd (i.e. AS inelastic)  limits the ability to increase X while domestic crs continue to rely on M  depreciation unable to correct CA deficit

Imported inflation For industries that rely on imported inputs, a depreciation of the US$ ___ their COP  the imported inflation cancels out any price advantage for the exporters from the depreciation

c.

Competitive devaluation If major partners also devalue their currency, i.e. devaluation by one country triggers a bout of competitive devaluation, the advantages which the devaluation country hopes to achieve will be nullified. In 1967 when Britain devalued its sterling, most Commonwealth countries followed suit and UK’s trade position with them did not improve.

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d.

Loss of confidence Investors may see the country as one that employs devaluation as a quick-fix for its BOP problems  believe that it will resort to devaluation should similar problems occur in the future  unwilling to hold assets in the country for fear of exchange losses  effect on KA balance? Effect on AS & LR EG?  possibility of trade-off in the various economic goals

Comparison of the effectiveness of the 2 policies in correcting CA deficit Contractionary FP Contractionary FP effective as • decrease in Y (reduce M dd) • reduction inflation (improve X competitiveness) reinforce each other to correct CA deficit

Useful if the root cause of the CA deficit is due to excessive spending. If the root cause of the CA deficit is the loss of competitiveness with emergence of low-cost countries, FP as a ss-side policy, can help. E.g. govt spending on R&D or training of workers  higher levels of productivity  reduce unit cost of production  improves X competitiveness. [Note: recognize that this involves long gestation period & that devaluation may be a temporary measure to ‘buy time’ for the ss-side policy to make its effects felt.

Devaluation The policy may be less effective since the increase in import prices may raise COP and cancel out any advantage of devaluation on X prices. • This is particularly true of a country whose exports have high import content (limited natural resources). • Less problematic for countries that have a large service sector as this sector uses less imported inputs. Useful if the CA deficit is due to currency misalignment (e.g. overvalued currency) Not be useful if the root cause of the CA deficit is the loss of competitiveness with emergence of low-cost countries  requires ss-side policies to improve productivity and restructuring to move the resources into new areas of comparative advantage to avoid direct competition Devaluation only delays the restructuring process Not be useful if the root cause of the CA deficit is due to excessive spending. E.g. devaluation of the US dollar against the Chinese yuan only encourages its consumers to turn to imports from third countries.

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Conclusion For both measures, there are conflicts with other macroeconomic goals. Effectiveness of the measures taken will depend on the severity and the underlying cause(s) of the deficit as well as the current situation of the economy. In most cases, all the measures must run concurrently for the deficit to be solved effectively.

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Tampines Junior College 2008 JC2 Semestral Assessment Economics (H2) Markers’ Report for Essay (a)

Explain the potential causes of a Balance of Payments deficit on the current account. [10]

(b)

Evaluate the relative effectiveness of devaluation and fiscal policy in correcting a current account deficit. [15]

Part (a) Strengths: 1. Most students understand that the question is asking for the causes of current account deficit. 2. Many students are able to fully elaborate at least 1 cause. 1. 2. 3. 4. 5.

Weaknesses: Poor definitions in the introduction, with students using their own terminology for eg current account deficit is defined as the amount or numbers of exports minus the amount or numbers of imports. While many students could give at least 3 causes; the explanation could be more detailed. Many forgot to state the assumptions; Marshall-Lerner condition, high degree of substitutability between local and foreign goods and ceteris paribus. Quite a handful of students applied the Marshall-Lerner condition in their explanation of how high domestic inflation causes a current account deficit. Many students tend to consider the substitutability between exports and imports rather than locally produced goods (for local consumption) and imports. Part (b) Strengths: 1. Many students are able to explain how devaluation can correct a current account deficit.

1. 2. 3.

Weaknesses: Many students defined devaluation as depreciation of the currency and used the term depreciation rather than devaluation throughout the essay. Quite a handful of students did not explain correctly how fiscal policy can help to correct a current account deficit. Quite a number of students used expansionary fiscal policy (not as a supply-side policy), explaining that an increase in AD would stimulate production and hence there would be more exports produced.

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4. 5.

6. 7.

Many students did not elaborate on the limitations of the policy and link to how that may undermine the effectiveness of the policy in correcting a current account deficit. Limitations mentioned were those that were not so significant, such as how devaluation causes loss of confidence in currency and the presence of time lags, instead of more significant limitations such as the explanation of the J curve effect and the negation of advantage from cheaper exports due to higher prices of imported raw materials. Also, limitation is the in the context of correcting the current account deficit. A large majority did not weigh the measures and conclude on which is relatively more effective in correcting a current account deficit. The lack of proper time management was evident in many uncompleted scripts.

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