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Chapter 29: Problem 5

According to an article in the Economist, "countries with persistent current- account deficits tend to have higher real interest rates than surplus countries." What do high interest rates have to do with current account deficits??

Short Answer

Expert verified
High interest rates attract foreign capital leading to an appreciated domestic currency. This in turn makes imports cheaper and exports more expensive resulting in an increased current account deficit due to increased imports and decreased exports.

Step by step solution

01

Understanding Concepts

The first step is to understand the key concepts. A current account deficit means that the value of goods and services a country imports is greater than the value of goods and services it exports. Interest rate is the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding.
02

Explaining the Link

High interest rates typically attract more foreign investors as they seek to get better return on their investments. When investors bring in more foreign capital to take advantage of these high interest rates, the value of the domestic currency is likely to rise or appreciate. Now, when a country’s currency appreciates, its exports become more expensive for other countries to buy and its imports become cheaper.
03

Impact on Current Account

As imports become cheaper and exports become more expensive due to a rise in the value of the currency, the result is an increased imbalance between exports and imports. More specifically, imports are likely to increase and exports likely to decrease, leading to a larger current account deficit.

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Most popular questions from this chapter

(Related to the Don't Let This Happen to You on page 1033) In 2016, Germany had a balance of trade surplus of \(€ 253\) billion and a current account surplus of \(€ 266\) billion. Explain how Germany's current account surplus could be larger than its trade surplus. In \(2016,\) what would we expect Germany's balance on the financial account to have been? Briefly explain.

Suppose that Federal Reserve policy leads to higher interest rates in the United States. a. How will this policy affect real GDP in the short run if the United States is a closed economy? b. How will this policy affect real GDP in the short run if the United States is an open economy? c. How will your answer to part (b) change if interest rates also rise in the countries that are the major trading partners of the United States?

An article in the Economist quoted the finance minister of Peru as saying, "We are one of the most open economies of Latin America." What does he mean by saying that Peru is an "open economy"? Is fiscal policy in Peru likely to be more or less effective than it would be in a less open economy? Briefly explain.

Why does monetary policy have a greater effect on aggregate demand in an open economy than in a closed economy?

In discussing the U.S. financial account surplus, a Wall Street Journal editorial made the following observations: [Much] of it goes to finance an investment shortfall in the U.S., especially government borrowing. Yet Americans are making millions of individual decisions about how much to save, and foreigners are not forcing Washington to borrow. If government weren't gobbling up that capital, more of it would go into the private economy. a. What does the editorial mean by an "investment shortfall in the United States"? In what sense does a financial account surplus finance that shortfall? b. What does the editorial mean by asserting that if the government weren't "gobbling up that capital," it would go into the private economy? c. Is there a connection between the federal budget deficit and the financial account surplus?
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