Current account deficit and exchange rate relationship

Current Account Deficits: Is There a Problem? - Back to Basics: Finance & Development

current account deficit and exchange rate relationship

Find out how the balance of trade affects a country's exchange rates and When a country's trade account does not net to zero – that is, when. between growth rate and current account deficit is not always necessarily true. constant correlation between current account deficit, real exchange rate, and. current account deficit on the exchange rate, and, in so doing, advances the debate on the What is the relationship between the BOP and the exchange rate ?.

Exchange Rate and Current Account | Economics Help

One point that the savings-investment balance approach underscores is that protectionist policies are unlikely to be of much use in improving the current account balance because there is no obvious connection between protectionism and savings or investment. Another way to look at the current account is in terms of the timing of trade. We are used to intratemporal trade—exchanging cloth for wine today. But we can also think of intertemporal trade—importing goods today running a current account deficit and, in return, exporting goods in the future running a current account surplus then.

  • Current Account Deficits: Is There a Problem?

Just as a country may import one good and export another under intratemporal trade, there is no reason why a country should not import goods of today and export goods of tomorrow. Intertemporal theories of the current account also stress the consumption-smoothing role that current account deficits and surpluses can play. For instance, if a country is struck by a shock—perhaps a natural disaster—that temporarily depresses its ability to access productive capacity, rather than take the full brunt of the shock immediately, the country can spread out the pain over time by running a current account deficit.

Conversely, research also suggests that countries that are subject to large shocks should, on average, run current account surpluses as a form of precautionary saving. When persistent is too persistent Does it matter how long a country runs a current account deficit? When a country runs a current account deficit, it is building up liabilities to the rest of the world that are financed by flows in the financial account.

current account deficit and exchange rate relationship

Eventually, these need to be paid back. Common sense suggests that if a country fritters away its borrowed foreign funds on spending that yields no long-term productive gains, then its ability to repay—its basic solvency—might come into question.

For example, if demand for UK exports is very inelastic. They a depreciation will lead to only a very small increase in quantity demand. A depreciation means exports can be cheaper. However, a UK firm may decide to keep the same foreign price and just make a bigger profit margin.

current account deficit and exchange rate relationship

This often occurs in the short term. This is one reason why a movement in the exchange rate often takes time to affect the current account.

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Time period The J Curve effect states how a depreciation can worsen current account in the short term because demand is inelastic, but, over time, demand becomes more elastic and therefore the current account improves following a devaluation. One reason was the sluggish global growth.

current account deficit and exchange rate relationship

There was little foreign demand for UK exports despite the fall in price. However, a UK firm may decide to keep the same foreign price and just make a bigger profit margin. This often occurs in the short term. This is one reason why a movement in the exchange rate often takes time to affect the current account.

Exchange Rate and Current Account

Time period The J Curve effect states how a depreciation can worsen current account in the short term because demand is inelastic, but, over time, demand becomes more elastic and therefore the current account improves following a devaluation. One reason was the sluggish global growth. There was little foreign demand for UK exports despite the fall in price. A key determinant of the current account is domestic spending.

When consumer spending is growing, countries will be buying more imports.

current account deficit and exchange rate relationship

In a recession, with falling consumer spending, the current account tends to improve lower deficit.