IB Economics - Correcting a Persistent Current Account Deficit

This study note for IB economics covers Correcting a Persistent Current Account Deficit

A current account deficit occurs when a country's imports of goods, services, and transfers exceed its exports. It indicates that a country is spending more on foreign trade than it is earning, and it may need to borrow capital from foreign sources to cover the gap.

Persistent current account deficits can lead to increasing foreign debt, currency depreciation, and potential loss of investor confidence.

Methods to Correct a Persistent Current Account Deficit

1. Expenditure Switching Policies

• Objective: Shift consumption from foreign to domestic goods to reduce imports and increase exports.
• Policies:
  • Devaluation/Depreciation of the Currency:
    • Devaluation (in a fixed exchange rate system) or depreciation (in a floating exchange rate system) makes domestic goods cheaper for foreigners and foreign goods more expensive for domestic consumers.
    • Example: The UK’s Brexit vote in 2016 led to a depreciation of the pound, which made UK exports cheaper.
    • Marshall-Lerner Condition: For devaluation to improve the current account, the sum of the price elasticities of demand for exports and imports must be greater than one.
  • Tariffs and Quotas:
    • Imposing tariffs or quotas on imports makes them more expensive or limits their quantity, encouraging consumers to buy domestically produced goods.
    • Example: The US imposed tariffs on Chinese goods in recent years as a way to reduce the trade deficit with China.
  • Subsidies for Exporters:
    • Providing subsidies to domestic exporters can help lower their costs and make their products more competitive in the global market.

2. Expenditure Reducing Policies

• Objective: Reduce overall expenditure in the economy, including spending on imports.
• Policies:
  • Fiscal Policy:
    • Cutting government spending or increasing taxes to reduce the disposable income of consumers, leading to lower consumption, including imports.
    • Example: Austerity measures in Greece during the Eurozone crisis aimed at reducing the country’s current account deficit.
  • Monetary Policy:
    • Increasing interest rates to reduce borrowing and spending. Higher interest rates also attract foreign investment, leading to a higher demand for the domestic currency.
    • Example: Turkey raised interest rates in 2021 to combat a current account deficit and inflation.

3. Supply-Side Policies

• Objective: Improve the competitiveness of domestic industries by enhancing productivity, reducing costs, and encouraging innovation.
• Policies:
  • Investment in Infrastructure:
    • Improving transportation, communication, and energy infrastructure to reduce production costs and increase export competitiveness.
    • Example: China’s Belt and Road Initiative aims to improve infrastructure to facilitate trade.
  • Education and Training:
    • Investing in human capital to enhance labor productivity and competitiveness in high-value industries.
  • Deregulation:
    • Reducing regulatory burdens on businesses can lower costs and encourage investment and exports.

Evaluation of Policies

• Expenditure Switching Policies:
  • Pros: Can quickly adjust the trade balance; effective if Marshall-Lerner Condition is met.
  • Cons: Can lead to retaliation (e.g., trade wars); may cause inflationary pressure due to more expensive imports.
• Expenditure Reducing Policies:
  • Pros: Directly reduce import demand; can stabilize the economy if managed well.
  • Cons: Can lead to recession, higher unemployment, and social discontent; reduces economic growth.
• Supply-Side Policies:
  • Pros: Enhance long-term competitiveness without immediate negative side effects on consumers.
  • Cons: Slow to implement; benefits may take years to materialize.

The Marshall-Lerner Condition and the J-Curve Effect

Marshall-Lerner Condition

• States that a depreciation or devaluation of a currency will only improve the current account balance if the sum of the price elasticities of demand for exports and imports is greater than one.
• Application: If demand is inelastic, a weaker currency increases import costs without significantly boosting export volume, worsening the deficit.

The J-Curve Effect

• Describes the short-term worsening of a current account deficit following a depreciation, before it improves.
• Explanation:
  • In the short term, contracts and habits mean import costs rise immediately, but export volume takes time to respond, causing the deficit to worsen initially.
  • Over time, exports become more competitive, imports decrease, and the current account balance improves.
• Example: After the 1997 Asian financial crisis, many Asian countries saw an initial worsening of their trade balances before eventual improvement as their currencies depreciated.

Relationship Between the Current Account and the Exchange Rate

• Surplus and Exchange Rate:
  • A current account surplus indicates high demand for a country’s exports, which can lead to an appreciation of the domestic currency due to increased demand.
  • Appreciation makes exports more expensive and imports cheaper, which can eventually reduce the surplus.
• Example: Germany’s persistent current account surplus contributes to the strength of the euro, making German exports relatively more expensive.

Implications of a Persistent Current Account Surplus

• Reduced Domestic Consumption and Investment:
  • A country with a surplus may be saving more than it is spending, potentially leading to lower domestic demand and investment.
• Currency Appreciation:
  • Sustained surplus leads to upward pressure on the domestic currency, which can harm export competitiveness over time.
• Global Imbalances:
  • Persistent surpluses in some countries can lead to deficits in others, contributing to global economic imbalances.
• Example: China’s surplus has led to significant currency appreciation pressures and trade tensions, particularly with the US.

Glossary of Key Terms

• Current Account Deficit: A situation where a country's total imports of goods, services, and transfers exceed its exports.
• Devaluation: A deliberate downward adjustment to the value of a country's currency in a fixed exchange rate system.
• Depreciation: A decrease in the value of a currency relative to other currencies in a floating exchange rate system.
• Elasticity: A measure of how much the quantity demanded or supplied of a good responds to a change in price.
• Expenditure Reducing Policies: Measures that reduce overall spending in the economy, including on imports.
• Expenditure Switching Policies: Measures that shift consumption from imported to domestically produced goods.
• Marshall-Lerner Condition: States that a currency depreciation will improve the current account if the sum of the elasticities of demand for exports and imports is greater than one.
• J-Curve Effect: A theory suggesting that a country's trade deficit will initially worsen following a depreciation before it starts to improve.
• Supply-Side Policies: Economic policies aimed at increasing productivity and competitiveness, typically through investment in infrastructure, education, and deregulation.

Possible IB Economics Essay Questions

1. Discuss the effectiveness of expenditure switching and expenditure reducing policies in correcting a persistent current account deficit.
2. Evaluate the impact of a persistent current account surplus on an economy.
3. Explain the J-Curve effect and how it relates to the Marshall-Lerner condition. Use real-world examples to illustrate your points.
4. To what extent are supply-side policies effective in addressing a persistent current account deficit?

Recent Data and Examples

• US-China Trade Deficit: In 2023, the US continued to run a significant trade deficit with China, highlighting the challenges of expenditure switching policies in the face of global supply chains.
• Germany’s Surplus: Germany's current account surplus was around 7.4% of GDP in 2022, contributing to the strength of the euro.
• Turkey's Interest Rate Hikes: In 2023, Turkey's central bank raised interest rates to tackle its current account deficit and high inflation rates, a clear example of expenditure reducing policies.

Retrieval Questions

1. What are the main methods used to correct a persistent current account deficit?
2. How does the Marshall-Lerner condition relate to currency depreciation?
3. Describe the J-Curve effect and its implications for a country’s current account balance.
4. What are the potential consequences of a persistent current account surplus?
5. How do expenditure switching policies differ from expenditure reducing policies?

These notes provide a comprehensive guide to understanding and addressing current account deficits and surpluses, complete with real-world applications, key terms, and potential essay questions for deeper exploration.