The late economist Herbert Stein described the accounts that comprise a country's balance of payments: A country is more likely to have a deficit in its current account the higher its price level, the higher its gross [domestic] product, the higher its interest rates, the lower its barriers to imports, and the more attractive its investment opportunities - all compared with conditions in other countries-and the higher its exchange rate. The effects of a change in one of these factors on the current account balance cannot be predicted without considering the effect on the other causal factors. a. Briefly describe the transactions included in a country's current account. b. Briefly explain why, compared to other countries, a country is more likely to have a deficit in its current account, holding other factors constant, if it has each of the following. i. A higher price level ii. An increase in interest rates iii. Lower barriers to imports iv. More attractive investment opportunities

Step by step solution

01

Understanding the Current Account

A country's current account records the transactions involving goods, services, income, and current transfers between residents of the country and the rest of the world. It includes the balance of trade (export minus import of goods and services), net income or earnings (from abroad) and net current transfers.

02

Higher Price Level and Current Account Deficit

A country with a higher price level relative to other countries is more likely to have a current account deficit. This is because the goods and services in this country become more expensive, leading to a decrease in exports (since foreign buyers can find cheaper options) and an increase in imports (since the residents can find cheaper foreign goods). This results in a trade deficit, a significant component of the current account.

03

Increase in Interest Rates and Current Account Deficit

Higher interest rates increase borrowing costs, discouraging investment in the domestic economy. However, it also attracts foreign capital, leading to an appreciation of the domestic currency. The stronger currency makes imports cheaper and exports more expensive, which can lead to a current account deficit.

04

Lower Barriers to Imports and Current Account Deficit

Lower barriers to imports, such as tariffs and quotas, make foreign goods cheaper and more accessible to residents. This often leads to an increase in imports. If the import growth surpasses that of exports, it can lead to a current account deficit.

05

Attractive Investment Opportunities and Current Account Deficit

Greater investment opportunities attract foreign capital. This leads to an appreciation of the country's currency. As a result, imports become cheaper, and exports become more expensive, possibly leading to a current account deficit.

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