6HLThe accounts and the exchange rate

SL readers can stop here. Everything from this point is HL extension material.

The accounts and the currency push each other around, and the guide asks for both directions.

From the current account to the exchange rate. A country with a current account deficit is buying more from abroad than it sells. To pay for those imports, its importers must sell their own currency and buy foreign currency, which raises the supply of the domestic currency on the foreign exchange market. At the same time weaker export sales mean foreigners need less of the currency, so demand for it is lower. Under a floating exchange rate, where the price of the currency is set by demand and supply with no official intervention, that combination pushes the rate down. Figure 5 shows the supply of Solvaran dollars shifting right, moving equilibrium from A to B and the rate from e₁ down to e₂: a depreciation, a fall in the value of a currency against another under a floating rate.

From the exchange rate to the current account. Now run it the other way. After the depreciation, each Solvaran dollar buys less foreign currency, so imports cost Solvarans more, and each unit of foreign currency buys more Solvaran dollars, so Solvaran exports are cheaper to foreigners. Export volumes rise and import volumes fall, and the current account deficit narrows.

Put the two directions together and you get a loop, drawn in Figure 6, which under a floating rate works as a self-correcting mechanism: the deficit weakens the currency, and the weaker currency shrinks the deficit. Say "tends to" rather than "will", because section 9 shows how long the second half takes, and because a country with a fixed or managed exchange rate has blocked the first half deliberately.

From the financial account to the exchange rate. The financial account pulls the other way, and this is the part students leave out. Foreigners who want to buy Solvaran shares, bonds, factories or government debt must first buy Solvaran dollars, so every inflow raises the demand for the currency. Figure 7 shows demand shifting right and the rate rising from e₁ to e₂: an appreciation, a rise in the value of a currency under a floating rate.

The link works in reverse too. A rise in domestic interest rates, or a reputation for safety, attracts portfolio investment and pushes the currency up; a loss of confidence sends money out and pushes it down. Which is why a country can run a current account deficit for years without its currency falling: financial account inflows are holding the currency up, and that appreciation keeps exports expensive and imports cheap, which keeps the current account in deficit. The two accounts are not two separate stories. They are one market with two sets of customers.

7HLWhat a persistent current account deficit does

A persistent current account deficit is one that lasts for years rather than a season. The guide names seven consequences, drawn in Figure 8. Learn them as pressures, not as certainties, because the evaluation marks come from saying when each one bites.

Exchange rates. Downward pressure on a floating currency, for the reasons in section 6. A falling currency raises the price of imported goods and inputs, which is imported inflation, though it also helps exporters.

Interest rates. To keep financing the deficit, a country needs foreign money to keep arriving. Raising interest rates attracts it. But higher rates make borrowing dearer for domestic households and firms, so investment and consumption fall.

Foreign ownership of domestic assets. The deficit is financed partly by selling assets. Land, buildings, firms and infrastructure pass into foreign hands, and the profits they earn leave the country afterwards as income debits, which makes next year's current account slightly worse.

Debt. Financing by borrowing rather than by selling assets builds up external debt, and the interest on it is another income debit in future years. A deficit financed by borrowing therefore tends to feed itself.

Credit ratings. Lenders judge a country by its ability to repay. A long deficit and rising external debt invite a downgrade, and a downgrade raises the interest the government must pay on new borrowing, which tightens the squeeze.

Demand management. A government that decides the deficit must come down will usually cut aggregate demand, and contractionary fiscal or monetary policy costs output and jobs. That is a real cost, not a side note.

Economic growth. Two ways round, and a good answer says both. If demand management is used, growth is lower now. If nothing is done and the debt keeps building, the interest payments and the eventual adjustment lower the economy's capacity to grow later.

Now the evaluation, because an AO3 line needs it. A deficit is not automatically a problem. Its size relative to the economy matters, so a deficit worth 2% of GDP is a different creature from one worth 12%. How it is financed matters: FDI that builds a factory is more comfortable than short-term portfolio money that can leave in a week. What it pays for matters most of all. A country importing machinery and technology is borrowing to raise its future productive capacity, and the deficit may be repaid out of the growth it buys. A country importing consumer goods on credit is not.

8HLCorrecting a persistent deficit, and whether it works

The guide names three methods. Each has a case for and a case against, and an evaluation question wants both.

Expenditure switching means policies that make domestic goods more attractive than foreign ones, so spending switches from imports to home production. The usual tools are a deliberate depreciation or devaluation of the currency, tariffs, quotas and other trade protection.

For: it can work without cutting total spending, so output and employment need not fall, and a depreciation acts on every import at once. Against: it only improves the current account if demand is elastic enough, which is section 9; a weaker currency raises the price of imported food, fuel and components, so it is inflationary; trade barriers invite retaliation and break trade agreements; and if other countries devalue too, nobody gains.

Expenditure reducing means policies that lower aggregate demand so that total spending, including spending on imports, falls. Higher income tax, lower government spending, higher interest rates. Figure 9 draws it: AD shifts left, real output falls from Y₁ to Y₂, and the fall in incomes drags imports down with it.

For: it is fast, it is under the government's direct control, and it lowers the price level, which helps export competitiveness over time. Against: it works by making the country poorer. Output falls, unemployment rises, and if the deficit is caused by weak export quality rather than by excess demand, the deficit comes back as soon as demand recovers. It also worsens the government's budget position through lower tax revenue.

Supply-side policies attack the cause rather than the symptom: education and training, investment in infrastructure, research and development subsidies, deregulation, and anything else that lowers unit costs or raises quality so that exports sell better and imports face real domestic competition.

For: it is the only approach that fixes the underlying problem, and it raises growth and the current account at the same time, with no unemployment cost. Against: it is slow, taking years or decades to show up in the trade figures; it is expensive, and the spending itself may widen the government's deficit; and its results are uncertain, since no minister can be sure which training scheme will produce exportable skills.

The judgement examiners reward: expenditure reducing buys time, expenditure switching buys competitiveness at the price of inflation and possible retaliation, and only supply-side policy changes what the country is actually able to sell. Most governments use a combination, and the right mix depends on whether the deficit comes from spending too much or from producing the wrong things.

9HLThe Marshall-Lerner condition and the J-curve

These two belong together. The condition says when a depreciation improves the current account. The J-curve says when it starts to.

The Marshall-Lerner condition states that a depreciation or devaluation will improve the current account balance only if the price elasticity of demand for exports plus the price elasticity of demand for imports is greater than one.

PED for exports + PED for imports > 1

The logic is short. A depreciation lowers the foreign price of exports and raises the domestic price of imports. Whether that improves the balance depends on how much the quantities respond. If demand is inelastic on both sides, quantities barely move, and the country simply pays more for the same imports, so the balance gets worse. If demand is elastic enough, export volumes rise and import volumes fall by enough to outweigh the higher price of each import, and the balance improves. Figure 10 puts the three cases on one line.

Work it through with numbers. Solvara starts with exports of $200bn and imports of $240bn, so the current account is −40. The dollar depreciates by enough to raise the dollar price of imports by 10% and cut the foreign price of exports by 10%. Exports are priced in dollars, so their value moves only with volume; imports are priced in foreign currency, so their dollar cost rises with the price as well as the volume.

In the first few months the elasticities add to 0.5, the condition fails, and the deficit widens from 40 to 52.7. After two years they add to 1.3, the condition holds, and the deficit narrows to 34.8.

That is the J-curve effect: after a depreciation the current account first gets worse and only later gets better, so the path traced over time looks like the letter J. Figure 11 draws it, with time on the horizontal axis and the current account balance on the vertical.

Read Figure 11 point by point. At A the depreciation happens, with the balance at b₁. Between A and B the account worsens, because contracts were signed at old prices and volumes have not adjusted, so the country pays more for much the same imports. B is the trough. Between B and C buyers on both sides find alternatives, elasticities rise, the sum passes one, and the account climbs back to where it started. Past C the improvement continues, and at D the account has crossed into surplus.

Why elasticities rise with time, in one list: contracts already agreed have to be honoured; consumers take months to notice and change habits; exporters need time to build capacity to serve new orders; and firms that use imported inputs need time to find domestic suppliers. All four are reasons the short run is inelastic and the long run is not.

10HLWhat a persistent current account surplus does

A surplus is the mirror image, and the guide names five implications, drawn in Figure 12. The reason it asks is that students assume a surplus is good news. Some of it is, and some of it is not.

Domestic consumption and investment. A surplus means the country is sending abroad more output than it takes in. Those goods are enjoyed by foreigners, not by its own households, and the money earned is lent overseas rather than invested at home. Living standards now are lower than the country's production would allow.

Exchange rates. Foreigners buying the country's exports must buy its currency, so a persistent surplus puts upward pressure on a floating rate.

Inflation. Strong export demand is an injection into aggregate demand, and if the central bank buys foreign currency to hold the exchange rate down, it puts more domestic money into circulation. Both add to demand-pull inflationary pressure.

Employment. Export industries hire, so employment is high while the surplus lasts. The exposure is the other side of it: the more jobs depend on foreign demand, the harder a recession abroad hits.

Export competitiveness. Here the tension bites. The appreciation caused by the surplus makes exports dearer abroad and imports cheaper at home, which over time eats away the competitiveness that created the surplus. A surplus, like a deficit, contains the seed of its own correction.

The evaluation is the same shape as before. Scale matters, cause matters, and duration matters. A surplus built on genuinely competitive industries is a different thing from one built on holding a currency artificially low, and one country's persistent surplus is another country's persistent deficit, which is why surpluses draw political complaints from trading partners.