Macroeconomics: imbalances in the balance of payments

Current account deficit:

this will cause a currency depreciation, as the demand for imported goods is bigger than the foreign demand for exported goods. This will make it easier for domestic producer to exports their goods as they, the goods, become relatively cheaper on the foreign market.

A deficit in the balance of trade implies that the financial account must be positive (remember Xn= S-I). In order to pay for the imported goods, it must be the case that foreign entities own more domestic financial assets. Furthermore, foreign countries will buy domestic government debt.

The central bank can try to offset inflation by raising the interest rate which can then attract foreign capital (i.e money). However, in the short term, this will be a monetary contractionary policy.

Current account surplus:

The domestic currency will appreciate, since foreign demand for exported goods is bigger than the domestic demand for imported goods. Note that domestic savings are then used to finance foreign consumption.

Stronger currency implies that people can more easily import foreign goods as they are relatively cheaper.

If a nation heavly relies on exports, a strong currency may have an decrease the standard of living of the country's domestic consumers.

Methods for correcting imbalance in the balance of payments:

exchange rate intervention: to correct a trade deficit, the government wants to devalue its currency in order to make its export more attractive to foreign consumers. To correct a trade surplus, a government needs to appreciate its currency, in order to make its export more expensive.

Note that naturally, a current account balance, overtime, moves toward 0 (i.e it is balanced). This is due to the exchange rate responding to the difference between the demand for imported and exported goods.

Monetary policies: contractionary policies (i.e raise interest rate) aims to appreciate a country's currency whereas an expansionary policy (i.e lowering interest rate) aims to depreciate the domestic currency.

Protectionist policies (tariffs, quotas, and subsidies): these policies aims at promoting domestic industries, thereby reducing reliance on imported foreign products. This method is usually implement in order to obtain a trade balance surplus.

Reference: Welker, Jason. AP Maroeconomics Crash Course. Research & Education Association (2014). p 246-250.

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