Chapter 72: HL extension Implications of a current account deficit/surplus (3.3)

Transcription

1 Chapter 72: HL extension Implications of a current account deficit/surplus (3.3) HL extensions Calculating current account balance Effects of a persistent deficit in current account Correcting a current account deficit Effects of a long run current account surplus The components of the balance of payments accounts Implications of a persistent current account deficit Methods to correct a persistent current account deficit Calculate elements of the balance of payments from a set of data Discuss the implications of a persistent current account deficit referring to factors including foreign ownership of domestic assets, exchange rates, interest rates, indebtedness, potential output, international credit ratings and demand management Explain the methods that a government can use to correct a persistent current account deficit, including expenditure switching policies, expenditure reducing policies and supply-side policies to increase competitiveness Evaluate the effectiveness of the policies to correct a persistent current account deficit Implications of a persistent current account surplus Discuss the possible consequences of a rising current account surplus including lower domestic consumption and investment as well as the appreciation of the domestic currency and reduced export competitiveness

2 Calculating current account balance In figure 72.1 you will find a simplified current account. Do the standard-issue fill-in-the-blanks and address the questions further on. Note that I forego the balancing version where the current and capital/financial accounts are sideby-side since the version given here is in all likelihood the one you will see in your exams. Answers are in the end of chapter summary. Figure 72.1 Fictitious current account Current account m Exports of goods x Imports of goods 480 Visible trade balance -20 Exports of services x Imports of services 260 Balance of trade in services 80 Income receipts from abroad 160 Income payments abroad x Net income from abroad -60 Current transfers from abroad 150 Current transfers paid abroad 100 Net transfers from abroad x Current account balance x Capital account m Net capital transactions 5 Financial account m Net FDI flows x Net portfolio investment -200 Net Other Investment 30 Reserve assets 20 Financial Account balance 85 Balancing item/stat. Discrepancy x Capital and financial account balance x (Rory, you d best check and see that it s indeed possible to fill in all the blanks.) 1. How does it seem that this economy is funding the trade deficit primarily? (Since there is a current account deficit, it must be made up for by a capital/financial account surplus. The large net inflow in FDI explains this. There is also the possibility of speculative inflows in Net other investment.) 2. GDP for this economy is 3,400 million. Is the current account situation alarming? (No, it s just under 1.5% of GDP which is historically low.) 3. Would you think that GNP might be larger than GDP for this economy? (Highly unlikely since there is a net income outflow (debit) in current account.) 4. Assume that this economy has a floating exchange rate. What is the possible effect on the exchange rate? (If exports continue to exceed imports, it is likely that the supply of the Home currency is increasing. This can cause a depreciation of the exchange rate.) 5. Assume instead that the exchange rate is pegged to another currency. What actions might the central bank be taking right about now? (A current account deficit would put downward pressure on the exchange rate. In order

3 for the central bank to retain the peg towards the foreign currency it might raise interest rates and/or intervene on the Forex market by support-purchasing its own currency.) 6. Does this economy seem strongly export orientated? (I would say so since almost 15% of GDP comes from export revenue. For comparison I point out the corresponding figure for Japan has been between 13 and 16% for over 20 years.) 7. Have the economy s foreign reserves increased or decreased? (Decreased since there is a net inflow in reserve assets which means a decrease in net foreign assets, e.g. in the foreign reserves held by the central bank.) Effects of a persistent deficit in current account If something cannot go on forever, it will stop. Herb Stein, Chair, Council of Economic Advisers, A country running a current account deficit will of course have a corresponding capital/financial account surplus the country is in effect selling domestic assets to the foreign sector. However, it is far too simple to label a current account deficit as bad or harmful and a current account surplus good or beneficial; it depends on why there is an imbalance. EXCHANGE RATE EFFECTS Perhaps the most immediate and visible effect of a current account deficit is the effect it has on the exchange rate. As explained in Chapter 71 a current account deficit means larger import expenditure than export revenue, there will be downward pressure on the exchange rate. FOREIGN DEBT ISSUES Borrowing from abroad means that the loans will ultimately have to be repaid with interest. Continuous current account deficits will be looked upon harshly by the international business and financial community, and ultimately the ability to pay off foreign debts might be questioned. Ratings agencies such as Moody s and Standard and Poor are quick to downgrade bad debtors! Wary investors might choose to avoid a weak economy and this will result in less demand for the home currency as fewer investors/loan-givers are willing to risk putting assets into the country, putting downward pressure on the currency. INTEREST RATE ISSUES In the event that the home currency indeed depreciates, the debtor nation could suffer a severe shock as debt servicing becomes more costly. The home country will have to offer even higher interest to foreign lenders which together with a depreciated currency can make future debt payments a serious issue. It also puts the domestic economy somewhat at the mercy of international business cycles and interest rates something a good many developing countries learned the hard way during the 1970s and 80s. The domestic economy might in essence be forced into raising interest rates in order to attract continued foreign (portfolio) investment and keep a desired exchange rate. In essence, the domestic economy is letting foreign firms fund domestic investment. Ultimately, the sales of domestic assets to foreigners will cause outflows in the form of repatriated profits and dividends which will in fact intensify the current account deficit. DEMAND SIDE ISSUES If an economy is financing a current account deficit primarily by way of attracting foreign deposits from abroad, then it has to offer an attractive rate of interest. As explained in the previous two points, a debtor nation will in the long run probably have to offer ever higher interest to foreign speculators/investors a risk premium if you will. Higher interest rates will have a contractionary effect on aggregate demand and the contingent macro objectives of growth and high employment. SPECULATIVE BUBBLES The incoming funds on capital account might be due to speculative inflows in which case the recipient country could be in for some serious trouble when these inflows cease. (See Case study on South East Asian Crisis following.) If foreign investors/speculators start to fear that the often highly speculative assets they are buying (such as property, shares and currency) in the host country are overvalued, they will leave. As foreign capital starts to exit and FDI and portfolio investment seek other markets, then the recipient country can find itself in a very serious situation where stock markets

4 and/or property markets crash, aggregate demand plummets and domestic unemployment rises drastically. There will, however, also be a significant reduction in imports but saying this is a positive is a bit like saying Well, cancer cured my smoking! THE IRISH COLLAPSE IN 2008/ 09 The result of investment inflows that suddenly dry up is something that the Irish became painfully aware of during the credit crisis of 2008/ 09. Ireland has long attracted a great deal of foreign direct investment (FDI) over the past 20 years by granting firms tax holidays initial periods during which foreign firms pay no taxes on profits of up to 10 years, and ultimately a low 12.5% corporate tax rate. In addition to this, Ireland has strong historical/cultural ties with the US and an abundant, young, well-educated English-speaking workforce. This attracted FDI in massive amounts and US multinational companies (MNCs) accounted for 16% of Ireland s GDP by By 1998, Irish GDP at PPP 2 had gone from less than 65% of the EU average to over 100% of the EU average. 3 The over 1,100 foreign companies operating in Ireland generated a great deal of profit which was repatriated abroad rather than re-invested in Ireland. It also provided one of the main tax bases for the Irish government income tax was a low 26% of government revenue by Ireland was also part of the EURO-zone and therefore enjoyed low interest rates set by the European Central Bank (see Chapter 74). Unemployment was around 4 5% and the economy grew by almost 70% between 1996 and 2001 hitting over 10% per year towards the end of the 1990s and never falling below 4% per year between 1995 and So; high growth, low taxes, massive inward flows of FDI, low unemployment, low interest rates and we add in government subsidies for building and you get a building boom! By the peak of the boom period in 2006/07, some 23% of Irish GDP was composed of construction. Add in housing speculation and high inflation and you get a highly overheated economy and huge amounts of household debts people were buying houses to flip them a few months later for a profit. Then the recession hit US and spread to Ireland. FDI and other investment flows to Ireland plummeted, growth turned negative, unemployment skyrocketed and government debt skyrocketed since such a large proportion of tax revenues came from profits generated by foreign firms subsidiaries in Ireland. How did this affect the Irish balance of payments? Figure 72.2 illustrates this like no words possibly could. As FDI flows to Ireland dried up and Irish consumption fell due to falling property prices, rising unemployment and falling incomes, the previous trend in current account deficits was immediately broken. Seldom does one see such stark correlation backing up economic theory as the two curves showing falling GDP and improvement in current account. FDI decreased, the Irish decreased import spending and thus the capital/financial account surplus started to decrease. This of course meant that the current account deficit decreased and by 2011 became a surplus. 1 Worldwide Capital Shares and Rates of Return to Corporate Capital: Evidence from U.S. Multinationals, Mihir A. Desai, Harvard University and NBER, November Purchasing power parity see Chapter Taxation and foreign direct investment in Ireland, Brendan Walsh, This is an update of Stabilisation and Adjustment in a Small, Open Economy: Ireland, ; Oxford Review of Economic Policy 12, 3. (October): ) 4 National Income and Expenditure 2002, Irish Central Statistics Office, and Ireland s Economic Crisis: A brief summary, 12/08/2010.

5 Figure 72.2 Irish growth and current account, xxxx (Rory, man, I hate to ask but this has taken me much too long already. Could you make a neat, smallish, diagram putting a GDP axis on the right ( billions) and a current account axis on the left, colour coding two curves; one for GDP and one for curr acc. They are, largely, inverted. (Don t include the value of exports and imports curve.) I ve covered the relevant area (from 2004 to 2011) in a red hazy thingy. Cheers! Source; Central Statistics Office of Ireland, National Income and Expenditure Accounts. ) However, on the other side of the fence that s Atlantic, the US has run a current account deficit every year since 1991, shown in figure Basically, foreign investors considered the risks smaller, and the returns greater, in investing in the vibrant and innovative US economy than at home. In other words, foreign capital flows have benefited the US economy by creating funds for investment which served to lower unemployment and increase GDP considerably during the 1990s. A current account deficit allows a country to enjoy greater consumption than production even though it might be on borrowed money. If the deficit is relatively short-lived, a few years or so, then there would be little economic damage quite the opposite if the inflows in capital account are partially used for investment. Even long run current account deficits may have relatively little impact on the domestic economy. A good many

6 countries have run current account deficits for many years in a row without any seeming ill effects. A main reason is that while a current account deficit of hundreds of millions of dollars/euros sounds ominous, it must be related to the countries fundamental ability to pay the money back i.e. the size of national income. In the case of the US, which has now broken every record in the book concerning current account deficits, the current account deficit bottomed out in 2006 at around USD875 billion 7% of GDP. In testimony before the US Budget Committee in 2007, the Peterson Institute for International Economics put forward the view that the deficit was clearly unsustainable. 5 It was pointed out that any form of overspending means that one has to in some way finance the debt. To uphold such a current account deficit the US had to attract foreign capital to the tune of close to USD4 billion every working day! 5 The Current Account Deficit and the US Economy, by C. Fred Bergsten, Peterson Institute for International Economics, Testimony before the Budget Committee of the United States Senate February 1, 2007 (See

7 This was, and is, in all likelihood unsustainable. Trace your ruler across figure 72.3 and think about the correlative issues you have read about in this chapter. The shaded pillars represent US recessions which clearly indicate that when US income fell the current account improved however briefly! Again, not much correlation between the exchange rate and current account over the entire period but after 2001/ 02 the massive current account deficits clearly take a toll on the US dollar exchange rate. Huge increases in government spending under president Bush II 2002 resulted in some of the largest deficits in US history. Ultimately this would have to affect US citizens demand for imports and foreign demand for exports by 2006 the current account was improving and three years later the current account was back to levels not seen for almost 10 years. The moral of the story here is that there is indeed a relationship between the exchange rate and the balance of payments but it is extremely difficult to accurately predict what causes what and when. Figure 72.3 US current account and US dollar (trade weighted), 1990 to 2010 xxxx (Rory: Please erase or something the blue line in the BoP diag. Keep only the red which is linked to the scale on the right. Could you make it un-dotted? The US dollar curve could you put it in blue and stick the scale on the right in the

8 BoP diag on the leftplease to Erase my louse one! Sources: BEA and Barchart.com) POP QUIZ 4.5.1: BALANCE OF PAYMENTS 1. A firm in Argentina sells $US250,000 worth of beef to Canada and then the firm buys $US50,000 worth of machines for slaughterhouses from Brazil. What is the net effect on each country s balance of payments due to these two transactions? 2. What is the result of a country s capital/financial account balance minus the invisible trade balance? 3. We have the following figures in the balance of payments (billions) for a country; exports = 340, imports = 380, net invisibles = + 50, net flows in capital/financial account = What is the current account balance? 4. The US current account deficit is increasing all the time and it s China s fault they are stealing our jobs. This oft-heard statement provides you with a clue as to the state of China s current account. Explain. 5. How would a visit to Thailand by Italian IB students affect both countries balance of payments? 6. Explain how a capital account surplus in Kenya might create jobs and increase national income. 7. Why might a country have a persistent current account deficit for many years? 8. Scrapped! Correcting a current account deficit While there is no general rule stating that a current account deficit is harmful to the economy, many countries have considered this to be a form of balance of payments disequilibrium and thus something to be dealt with using various policies. When a country shows an alarming current account deficit and there is little agreement as to what alarming means there are a number of economic policies which might be used to alleviate the situation. Short run policies invariably government/central bank intervention on the market in such a way as to lower the ratio of the price of domestic goods to imported goods. One possibility is to manage the exchange rate in order to make domestic goods cheaper for foreigners. Another method is of course protectionism; if domestic goods are subsidised and/or tariffs levied on imports then import spending will fall and improve the current account. Contractionary policies aimed at reducing overall demand e.g. aggregate demand serve to lower overall expenditure, which includes imported goods. Long run policies commonly focus on enhancing domestic competitive abilities, i.e. increasing productivity, increasing R&D and introducing innovation, improvements in quality and the like. These are looked at under supply-side policies further on. MANAGING THE EXCHANGE RATE A country operating under a managed currency regime, e.g. a pegged exchange rate system, can devalue its currency in order to alleviate a persistent current account deficit. By pegging the home currency at a lower exchange rate, the relative price of domestic goods falls. (Recall that a lower price does not necessarily mean more revenue! A fall in export prices might actually mean that while export volume increases, export revenue does not. HL, see Marshall-Lerner condition further on.) The same basic outcome is possible in a floating exchange rate regime which would of course then be a depreciation rather than a devaluation of the currency. The central bank of a country operating under a floating exchange rate system could sell home currency on the foreign exchange market in order to increase supply and lower the exchange rate.

9 PROTECTIONISM EXPENDITURE SWITCHING POLICIES Recall that protectionism can be broadly defined as any policy where the ratio of the price of domestic goods to imported goods falls, i.e. imports become relatively more expensive. Devaluation and interventionist depreciation both serve to decrease the home country s demand for imports, which means that demand for goods is diverted from imports towards domestic goods. This substitution effect is known as expenditure switching. Another method which is actually illegal for WTO members to use 6 is the use of tariffs and quotas to limit imports and force home citizens to consume domestic goods. Definition: Expenditure-switching policies Policies which divert substitute domestic 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. However while devaluation and tariffs work well in countries which have a high propensity to import, the former is a bit like opening eggs with a katana (Japanese long-sword) while the latter is more like using a sledgehammer. In other words, countries increasingly consider such methods a trifle heavy-handed, and while the egg won t fight back, expenditure switching policies frequently invite retaliatory protectionism and/or reciprocal devaluations. REDUCING AGGREGATE DEMAND EXPENDITURE REDUCING POLICIES Household spending is greatly influenced by income, which of course means that a degree of income will be spent on imports. An overall reduction in aggregate demand will lower incomes and reduce imports. Therefore, deflationary fiscal and monetary policies can be implemented in order to adjust a current account deficit by reducing imports this is an expenditure-reducing policy. (HL will recall from Chapter 47 that the marginal propensity to import MPM is defined as the change in imports over a change in income; M / Y = MPM. The higher the MPM, the larger the effect on current account will be due to an expenditure reducing policy.) Definition: Expenditure-reducing policies Contractionary policies such as increased interest rates and/or decreased government spending will cause a decrease in aggregate demand and a general reduction in expenditure (national income). Overall lower expenditure levels will also decrease the demand for imports. It is worth noting that there is also an expenditure-switching element in deflating an economy. Lower relative inflation might cause home citizens to substitute imports with domestic goods. It is also possible that a reduction in aggregate demand lowers inflation (relative to trade partners) and thus further improves the current account by increasing demand for exports. However by lowering aggregate demand in order to improve the current account, there will be secondary negative effects on employment and growth in the economy. The use of deflationary policies to correct a current account deficit once again illustrates conflicts which arise in macro issues, i.e. the possibility of a trade-off in 6 But of course, anti-dumping tariffs are allowed.

10 accomplishing both macro goals of high growth/employment and external balance. SUPPLY-SIDE POLICIES There are a number of policies which will increase long run aggregate supply by increasing the ability and propensity of firms to produce and labourers to supply. (See Chapters 60 to 62.) By reducing labour costs, adding to labour skills (human capital), creating incentives for investment in technology and generally increasing productivity, a country can increase its international competitiveness. This would ultimately increase exports and also divert some spending towards domestic goods rather than imports. However the problem is that such supply-side policies commonly take several years to implement and even longer before the effects are visible in the balance of payments. POP QUIZ 4.7.1: BALANCE OF PAYMENTS AND EXCHANGE RATES 1. How will the current account be affected if a country supports its exchange rate so that it is above the free market equilibrium? 2. Why might a country raise interest rates in order to sustain a current account deficit? 3. What are the possible long run benefits of a current account surplus? 4. Which measures imposed by a country to reduce a current account deficit would be described as expenditure switching? 5. Why might an increase in personal income tax in an economy improve the current account in balance of payments? 6. Say a government wished to improve a current account deficit immediately; would you recommend devaluation or supply-side policies? Explain your choice. Effects of a long run current account surplus A current account surplus means that there is a net outflow in capital/financial account, i.e. the home country s net foreign assets have increased. There will be a number of gains for such a net creditor nation: The foreign assets can be viewed as another form of saving for the home country which will enable increased future consumption. Capital will flow to countries with a higher rate of return than the home country. This enhances resource allocation and increases profits for domestic firms. The increase in foreign holdings will in time generate income in the form of profits, interest received, and dividends. (Inflows in current account.) In spite of these there are several possible disadvantages in having sustained current account surpluses:

11 Current consumption possibilities for the home country decrease as resources are diverted abroad. A current account surplus means that there is a degree of diverting investment from the domestic to the foreign market. This could lead to a loss of jobs (yet this is highly contentious), skills and technology gains. There will be a degree of tax loss, as a portion of tax bases investment, output and wages will be taxed outside the home country. There is also a political element in running continuous current account surpluses for many years. This was a main ingredient in trade friction between the US and Japan during the 1980s and between the US and China during the 2000s. Guess which of these countries were running large current account surpluses? (See footnote. 7 ) (TYPE 3 MEDIUM HEADING) GENERAL EXTERNAL EQUILIBRIUM The link between equilibrium in the balance of payments and equilibrium in the exchange rate is very strong. The two concepts are technically two sides of the same coin; when there is no pressure on the exchange rate to change, there will theoretically be a balance of payments equilibrium. If the value of exports expressed in a currency is equal to the value of imports, then there will be no excess demand or supply for the currency. Should the home economy become more efficient and thus more internationally competitive, exports will rise and so too will the demand for the home currency. Naturally, the opposite holds true. However as we have seen, in reality a currency can easily appreciate for lengthy periods while consistent current account deficits rise. This is primarily due to investment and speculative demand for the home currency. We have looked at the former so now let us have a look at how general disequilibrium can arise due to speculation in the case study below. CASE STUDY; SOUTH EAST ASIAN CRISIS OF 1997/98 By 1997, the situation in Asia was basically the following: The Tiger economies (Thailand, Taiwan, South Korea, Hong Kong, Malaysia, Indonesia, Singapore) were growing at an annualised rate of between 5 12%. Massive FDI was pouring in from OECD countries, primarily EU countries and Japan, (USA at a lower level) as the successful resolution of the Mexican economic crisis in 1995 plus the fall/death of communism (and thus the threat of a take over of private property) made investment in LDC s safe. The 3 rd world, or developing nations, was re-dubbed Emerging Markets by the Marketing Babble Section of Very Large American Investment Firms. The flow of private funds from Europe and Japan to developing nations increased by about 400% during the period 1990 to 1997! The Bubble-Baht: This is how funds got from Japan/Europe to Thailand (where the crisis started): A) A Japanese bank would make a loan to a Thai finance company which is an institution that acts as a go-between for foreign capital. 7 China and Japan. The all too common view was that China has been growing at the United States expense. See a good high level debate at

12 B) The finance company then had Yen which it would lend to a local real estate developer (= construction firm). However, the developer needed baht, (= Thai currency) not yen, to pay the construction crew/land etc. The developer would go to the foreign exchange and buy baht. C) Result; the demand for the baht increased and thus thebaht appreciated. D) Now, the central bank of Thailand had committed itself to maintaining astable (= pegged) exchange rate to the USD. To offset the increase in demand for the baht, the central bank had to increase the supply of baht i.e. print more baht. The result now was that the Thai central bank had larger currency reserves and the money supply increased. E) Credit was now easy, investment soared and foreign investment and monies (speculative now!) continued to pour in. Why didn t the Thai government simply abandon the peg to the USD and let the baht assume a higher exchange rate? Answer: because this would have damaged Thai exports. F) Thailand started to see a larger and increasingcurrent account deficit remember, FDI and other inflows of currency on capital account necessarily entail a deficit on current account. Is a large current account deficit necessarily evil? It depends on what the inflow on capital account is used for. G) In the case of Thailand (and indeed Indonesia) a good deal of the foreign funds were leant to high-risk projects with very questionable securities. Basically, the finance company that borrowed the yen in the first place, was nothing more than an institution run by a relative/friend of the government! This is where cronycapitalism comes in. H) Foreign investors and lenders (= banks) to the finance company, would not ask for the normal securities of such loans the company was, after all, run by the nephew/friend/schoolmate of the minister of finance. How risky could the loan be?! I) So, the nephew would get a low interest loan from abroad and then lend the money to his friend the real estate developer who s planning a new Mega Tower. If the Tower was successful, everybody wins. If the Tower is a total disaster (= no renters/ buyers) then the taxpayer will lose as the finance company will be bailed out by Uncle Finance Minister: Heads, I win; tails, you taxpayers lose. Now we have a speculative bubble economy! J) Ultimately, firms started incurring losses; finance companies and real estate companies started to go bankrupt. Foreign investor confidence started to decline and less money flowed in. The baht started to lose value. K) The government had two alternatives: 1) Protect the baht by reducing the supply of baht and raising interest rates. The Thai government waited (as this would cost them foreign reserves and the interest rise would hurt the already ailing economy) and the market started to regard the baht as soon to leave the peg to the USD. But as long as the exchange rate remained, one could borrow baht and in ANTICIPATION of the baht being devalued! That s what the market did; borrowed baht and exchanged theseimmediately for USDs, thereby increasing the supply of baht even more!

13 2) Let the currency float and accept a lower exchange rate and the Thai government still waited as this would have meant that hundreds of domestic firms already in trouble would have to pay far more baht to service foreign debt in US dollars! So the government defended the baht and failed. Ultimately, the peg to the US dollar was abandoned and the baht fell by 50% in a few months taking the Indonesian rupiah, Malaysian ringit, Korean won and Hong Kong dollar with it. The devaluation thus caused a string of devaluations in South East Asia. As the Thai foreign currency reserves the war chest were depleted, the only option left to keep an element of foreign confidence in the baht was to raise the interest rates and reduce the supply of baht. This further aggravated an economy under severe recessionary pressures. This was the 1997 meltdown of South East Asian economies. It was basically caused by speculation and resulting bad debt, and furthered by lack of liquidity, high interest rates and economies in deep recession. Again, we are dealing with economic basics;expectations and confidence. The financial crisis can be seen as a negative self-reinforcing loop a vicious circle; loss of confidence in Asian economies currency values plummet, interest rates rise and Asian economies suffer from recessionary pressure financial problems for Asian banks/firms/ households loss of confidence in the Asian economy..etc.

14 Answers 1. Since there is a current account deficit, it must be made up for by a capital/financial account surplus. The large net inflow in FDI explains this. There is also the possibility of speculative inflows in Net other investment. 2. No, it s just under 1.5% of GDP which is historically low. 3. Highly unlikely since there is a net income outflow (debit) in current account. 4. If exports continue to exceed imports, it is likely that the supply of the Home currency is increasing. This can cause a depreciation of the exchange rate. 5. A current account deficit would put downward pressure on the exchange rate. In order for the central bank to retain the peg towards the foreign currency it might raise interest rates and/or intervene on the Forex market by support-purchasing its own currency. 6. I would say so since almost 15% of GDP comes from export revenue. For comparison I point out the corresponding figure for Japan has been between 13 and 16% for over 20 years. 7. Decreased since there is a net inflow in reserve assets which means a decrease in net foreign assets, e.g. in the foreign reserves held by the central bank. Summary and revision 1. A persistent current account deficit can result in: a. A depreciation of the exchange rate (large imports increase the supply of the Home currency) b. Large foreign debt (due to inflows in the financial account) c. Higher interest rates (as increased foreign debt means the debtor nation must offer a risk premium to foreign creditors) d. Higher interest rates can have a contractionary effect on the Home economy e. Speculative bubbles can arise due to the inflows on financial account 2. A current account deficit might be corrected by: a. Devaluing/depreciating the home currency (making exports cheaper and imports dearer) b. Expenditure switching policies, e.g. protectionism (tariffs, quotas and subsidies lower imports) c. Expenditure reducing policies such as raising interest rates to curb AD and thus import spending d. Supply-side policies (increased international competitiveness this is not a short run solution since supply-side policies take considerable time to kick in) 3. Positive effects of a long run current account surplus include: a. Higher consumption for the Home economy b. Improved resource allocation for domestic firms as current account inflows enable foreign investment c. Increased future profits and income for the Home economy as investment abroad creates repatriated profits 4. Negative effects of a long run current account surplus: a. Diverting resources abroad means a loss of current consumption at Home b. Investment is diverted from the Home economy c. Possible tax losses due to lower investment levels at home d. Political issues arising as trade partners battle with current account deficits