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5a) Explain the potential causes of a balance of payments deficit on current

account. (10m)

A nations balance of payments measures the balance of the net payments

abroad. It constitutes of both a current account, that measures the balance of

trade, as well as the balance of income, and the financial account, that includesthe financial flows of money into the country, ie- short term investments, as well

as long term financial investments into the country.

When there is a deficit accrued to the balance of payments, it could be a balance

of payment current account deficit, or a capital account deficit. In this case, when

caused by a current account deficit, we are looking at the factors that affect the

economys balance of trade and income balance.

A potential cause would be an overappreciated currency, where the exchange

rate of the economy is very strong relative to its trading partners. This wouldlead to an increased propensity to import, as in comparison, overseas goods

become cheaper in terms of the stronger currency. As illustrated below, when a

currency is stronger, it can purchase more foreign currency, allowing it to

purchase goods and services more cheaply overseas, as consumers and

producers alike aim to maximize their benefits per unit cost.(diagram) An

alternative perspective would also be that the level of exports would fall, as the

locally exported good would be more expensive to import for the foreign nations.

As such this would have a double whammy effect on the balance of trade for the

nation, causing a current account deficit.

Another potential cause would be the loss of comparative advantage to foreignnations. According to the theory of specialization, nations should specialize in

the good that they have a comparative advantage in. ie lowest opportunity cost

wrt trading partners. A loss in comparative advantage would lead to other

nations being able to produce the same good with lesser cost, leading to a loss in

demand for the good locally. As a result, if this happens in a major industry that

bolsters a nations economy, a balance of payment deficit on the current account

might happen. (substitute goods diagram)

Another potential cause could be the degree of development the country is at.

Supply side policies might be implemented by developing nations to improve the

nations potential to grow. As a result they might borrow money to import

expensive high technology capital goods to train and expose their economy to

more advanced methods of production. To reap the returns of these long term

plans would mean that in the short run, the nation would have to bear with a

current account deficit. However this is a nonissue as if the nations productive

capacity eventually increases, it will resolve the deficit.

Ultimately a balance of payments deficit can result from either weak economic

fundamentals or an intended long term plan ofgrowth. If a nations economic

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fundamentals are strong, and they are not looking towards long term growth,

there should not be a current account deficit.

5b) Discuss which measures, if any a government should adopt when

confronted with a current account deficit (15m)

A current account deficit indicates that either the trade balance or income

balance is skewed towards a deficit. The trade balance, however is much more

influential on the current account than the income balance, and consists of the

monetary value of a nations Exports Imports. A current account deficit

indicates that an economy spends more on imports than exports. In order to

improve a current account deficit, governments can implement policies that

either increase exports, or decrease imports into the country.

For open economies heavily reliant on trade, an expansionary monetary policy

can be adopted where the interest rates set for financial capital is low. This will

increase the supply of money in the market, and result in a depreciation of the

currency. (diagram USD vs China) The depreciation of the currency serves a

twofold purpose. It will decrease the amount of imports into the country as it

makes foreign goods more expensive in comparison. Conversely, it increases the

nations exports as its goods become cheaper in terms of foreign currencies,

improving the current account.

However, this policy may backfire depending on the economys marginalpropensity to import. This is because the higher availability of capital due to the

expansionary fiscal policy might be used by consumers to purchase big ticket

items. This would increase the imports, and would not reduce the current

account deficit.As such, the government could sell its currency to the

foreign market instead of lowering the interest rates.

A cause for the decrease in exports could have roots in the erosion of a nations

comparative advantage. This would mean that other nations are producing

goods of a similar quality at a lower opportunity cost. Naturally consumers

around the globe will prefer the cheaper good, and as a result, the exports for a

nation that has lost comparative advantage in its major industries would be

severely affected. As such, policies to cure structural changes should be put into

place. Supply side policies to develop new comparative advantages or to improve

current industries would eventually cause export levels to rise, and the trade

balance to be maintained.

However in this case, supply side policy is a long-term policy which effect is

indeterminate. There is no guarantee of success for supply side policies. As such,

in the short term the economy might have to bear the brunt of the trade deficit,

and if it causes cyclical unemployment/structural unemployment, the effects of

those issues as well.

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Other more external-focused policies governments could adopt would be the

striking of trade agreements with foreign counterparts. Voluntary export

restraints could help mitigate the levels of imports in the country, and new Free

Trade Agreements could expand the market for the economys goods and

services.

However, voluntary export restraints might not be effective, as the foreign

nations may adhere to the amount of goods exported, but might instead only

export high value, expensive goods, which might cause the trade balance to

remain in deficit. Trade agreements take time, and may lead to additional

competition, which might lead to erosion of competitive advantage.

Another policy that could be used would be an expansionary fiscal policy, to

reduce specifically corporate income taxes. This would attract foreign investors

and multinationals to set up operations in the country, and serves to train and

hire the workers of the economy. It is an extremely long term policy that

ultimately results in a more skilled workforce that can ultimately carve out a

competitive advantage for an economy. Multiple economies in the past have used

this policy to achieve long term competitive advantages. An example would be

Japans automobile industry, which brought in Ford motors, and subsequently

adopted the best practices.

However, this might also be detrimental for the economy in the short run, as the

income balance of the current account might be put into deficit, as foreign

workers repatriate their incomes abroad, and the foreign multinational firms

their profits to their parent companies.

Ultimately the long term view of a solution to the issue would be to focus on

economic fundamentals on productive efficiency, innovation, comparative

advantage and trade. Prevailing conditions of the economy play a major role,

such as within an open economy that has a high marginal propensity to import

goods, and thus the crux of the issue would be to focus on both cultivating and

maintaining a comparative advantage for the economy, as well as reducing

imports.