IB Econ Study Guide Internationals - Sunny Hills High School

116
Current
problems of the economy. These are indeed serious as . Note that this policy implies slower groMh and thus
they reflect a 'sick' economy. To understand the issue,
consider an economy with chronic inflation as a result
higher unemployment.
of highiy uncompetitive product markets (with strong Expenditure-switching policies
oligopolies in many markets being able to raise prices)
and rigid labour markets (with powerful labour unions
able to increase wages). International competitiveness of
exporls wil be lost and spending on imports wi I increase
as many domestic households will turn to better and
cheaper imports. Some claim that this describes Greece
with the current account deficit equalto 13.7Vo of tts
GDP Or consider an economy which is growing but as
a result of excessive spending by both the government
(deficit spending) and by the private sector (low private
savings rate). lmport absorption and the resulting current
account de|cit may be unsustainable. Some claim that
this is the case of the U5.
. These are policies aiming at switching spending away
from imporls toward domestically produced goods and
services by rendering imports more expensive and thus
less attractive.
. A devaluation (or a rapid deprecialion) of the exchange
rate is one such policy choice. lf the price of a currency
decreases then foreign goods and services (imports)
become more expensive in domestic currency. lf the dollar
rapidly depreciates then the price of Chinese and other
imports will rise in dollars and spending by US househoids
will be switched away from imports. In addition expofts
will become cheaper abroad and may rise tn value. Both
effects will tend to correct the foreign deficit.
How can a curlent account deficit be financed?
A potential problem of rapid depreciation or devaluation
is that inflation may accelerate. First of all a rise in export
Deficits can be initially financed:
demand will tend to increase AD. Whether this increase in
. by runninq down official reserves;
AD proves inflationary depends on whether AD, and thus
. by official borrowing;
. or by attracting private financial capital inflows.
the economy, is export-driven or whether it mostly relies
on domestic consumption (and investment) spending. lt
None of these can continue indefinitely:
. Foreign exchange reserves are limited.
. Official borrowing may lead to a foreign debt problem as
it imposes future interest costs.
. Short-term private financial capital inflows may require
high interest rates which dampen domestic demand and,
most importantly, are very volatile. Such short-term capital
may flow out of a country literally at the click of a mouse.
also depends on whether the economy is operating close
to capacity (full employment) level of output. Remember
also that since import prices increase, the cost of living
immediately increases. In addition, if domestic firms
rely on imports of raw materials and of intermediate
products their production costs will rise and could prove
inflationary
Instead of the exchange rate adjusting, policymakers
could render imports more expensive through
An unsustainable deficit can and will not last forever Some protectionism. Tariffs, for example, increase the price of
adjustment process will restore balance. But adjustment rmports and lower import spending. Such protectionist
may be abrupt and unpleasant. Correcting a current
policies may first of all invite retaliation and also run
account deficit may require either expenditure-changing or against WTO membership rules.
expenditure-switching policies.
. Note that certain expenditure-changing policy may also
Expenditure.changing policies
end up switching expenditures. For example, a tight
monetary poliry will decrease national income and
These include policies that change the level of aggregate
demand and thus the level of national income (real
output Y).
Policies that change the level of AD are the demand
thus imports, induce capital inflows which could help
finance the current account deficit but also decrease the
price level thus leading to increased competitiveness of
domestic products compared to impoars.
management policies already discussed and include fiscal
policy and monetary policy.
Supply-side policies
Since the level of national income will be affected . Solutions of a more long-run nature include certain
it follows that imporls will be affected and thus the
supply-side policies aimed at raising the competitiveness
trade balance. For example, to decrease the value of
of the economy and especially of the export sector.
imports of goods and services the government must
It is more difficult for a more competitive and flexible
adopt contractionary policies shifting AD to the left and economy to face a fundamental current account deficit
lowering national income Y The lower level of Y will lead
to fewer imports which will help corred the deficit.
More generally, the nation3 saving rate must somehow
rise: the government must run a budget surplus and the
private sector must be induced to spend less.
problem.