The current account, exchange rates and correcting imbalances

Last time

Before we start: last time, in Macroeconomic objectives and fiscal, monetary and supply-side policy, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Money across borders

Every payment between a country and the rest of the world is recorded in its balance of payments. The current account records trade and income flows. Exchange rates link the currencies. This lesson covers both, and the policies to correct imbalances.

The current account

Trade in goods and trade in services: exports minus imports of each. Primary income: wages, interest, profits and dividends earned abroad, minus those paid abroad. Secondary income: current transfers, such as workers' remittances and foreign aid.

Deficits and surpluses

A current account deficit means more money flows out than in on these accounts. Causes: strong domestic demand sucking in imports, a high exchange rate, low productivity and uncompetitive exports. A surplus comes from strong exports, high saving, or weak domestic demand.

Is a surplus always an advantage?

A surplus brings in foreign currency, supports jobs in export industries, and builds reserves. But it may reflect weak domestic spending, means consumers enjoy fewer imports, and can push up the currency or trigger tension with trading partners. So it depends on its size, its cause, and whether it lasts.

Exchange rate systems

A floating exchange rate is set by demand for and supply of the currency. A fixed rate is set by the government or central bank, which buys and sells currency to hold it. A managed float floats, but the central bank intervenes to limit big swings.

Effects of a depreciation

A depreciation makes exports cheaper abroad and imports dearer at home. It worsens the terms of trade, as export prices fall relative to import prices. It may improve the current account if demand for exports and imports is price elastic enough, but it raises import costs and can cause cost-push inflation.

Expenditure-switching policies

Expenditure-switching policies switch spending from imports to domestic goods. A devaluation or depreciation makes imports dearer and exports cheaper. Protectionism makes imports dearer. Limits: retaliation, inflation, and they only work if elasticities are high enough.

Expenditure-reducing policies

Expenditure-reducing policies cut total spending, including on imports: contractionary fiscal and monetary policy. They reduce imports, but also cut growth and raise unemployment. So they conflict with other objectives.

Supply-side policies for the long run

Supply-side policies raise productivity and quality, making exports more competitive in the long run. They avoid the conflicts of expenditure reduction, but take a long time. A combination of policies is usually needed.

Mistakes that lose marks

Mistake one: confusing the current account with the government budget. Mistake two: saying a depreciation always fixes a deficit. Mistake three: mixing up expenditure-switching and expenditure-reducing. The fix: precise terms, and evaluation with elasticities and conflicts.

The full-marks tip

The full-marks tip: name the four parts of the current account precisely. Evaluate policies with elasticities, time lags and conflicts with other objectives.

On one card

So, on one card: the balance of payments. Keep it for revision.