Economics Assignment: USA Current Account Deficit & Its Related Policies
Submit an economics assignment report that addresses the below two questions. The report should have a cover, table of contents and the references at the end. Citations along the text that indicate where the information used comes from are necessary.
Part 1: The USA has had a significant current account deficit for several decades now. Explain why this may be the case for the last two decades and explain the consequences for the USA of this current account deficit. 600 to 700 words to words excluding bibliography.
Part 2: Critically evaluate the effectiveness (i.e. consider and explain the pros and cons) of two policies that the USA could use to reduce its current account trade deficit. 1,050 to 1,400 words excluding bibliography.
Economics Assignment Part 1:
The current account of a nation in economics, records the value of the exports and the value of the imports of both the commodities and services as well as the international transfers of capital. The current account is one of the three major elements in the balance of payments (BOP), along with financial account and capital account. According to Ivanova (2019), current account deficit refers to the measurement of the trade of a nation where the value of the commodities and services it imports is more than the value of the commodities and services it exports.
Current Account Deficit: USA
The United States of America is one of the most economically advanced and developed nations of the world. However, the nation has been experiencing current account deficits for decades. There are various reasons due to which the USA is facing this deficit in its current account for the last two decades. The main reason behind this current account deficit is that the USA is incurring expenditures which clearly exceeds its income (Kerremans, 2022). This has been escalating the federal budget deficits. This current account deficit also leads to trade deficits, further resulting in anemic rate of national savings.
As per Stockhammer and Kohler (2020), the overvalued exchange rate could be a reason behind the current account deficit. In case of overvalued currency, the import rises as it becomes cheaper. However, the export is hampered as the prices grow uncompetitive. This disrupts international trade, resulting in imports exceeding the exports. When the economic growth is high and the people of the nation have more money in hand. This raises the demand for consumer goods, which if not met through domestic production leads to higher imports. This in turn aggravates the current account deficit. As opined by Iacoviello and Navarro (2019), the deficit in balance of trade and subsequent deficit in current account is caused when the exports reduce due to lack of competitiveness at the global market, which has developing nations as players besides a developed nation like the USA. Inflation in USA makes the export prices high and less competitive in the global market. This raises the proportion of imports to exports. The recession in the nations which are main buyers of USA’s products, also leads to lesser exports. The USA also borrows money to invest in the underdeveloped nations, which deteriorates the position of the current accounts (Belabed, Theobald and Van Treeck, 2018).
Consequences of Current Account Deficit
The USA has been running a huge deficit in its current account since last two decades. There are various reasons of this deficit creation which raises the imports while reducing the exports. The nation faces several consequences due to this current account deficit. If the deficit is due to higher investments, the consequence of higher deficit could be higher productive investments, resulting in higher economic growth. The deficit in current account means the nation is creating liabilities which are to be repaid. However, if the deficit is due to investment in unproductive ventures, the ability of the nation to pay back becomes weak (Post, 2018).
In case of a deficit in the current account, there would be a surplus on the financial account for compensating for the net withdrawals. The currency of the USA might fall due to this persistent current account deficit (Morrison, 2019). Moreover, the nation needs adequate capital inflows so that the deficit could be financed. In case of absence of this capital, the exchange rate would fall. This would lead to an imbalance e in the flow of foreign funds. Therefore, the main problem or consequence of current account deficit to the USA is the risk of depreciation.
To cope up with the current account deficit, the USA needs to attract adequate capital flows. This would facilitate financing the current account deficit. In case of absence of sufficient financial flows, the currency of the USA would depreciate. The currency in fact, would continue depreciating until the equilibrium is reached.
Economics Assignment Part 2:
As stated by Gizem and Mehmet (2020), the current account deficit of the USA occurred due to the value of the import of commodities and services exceeding the value of the export of commodities and services. There are various policies which the USA can adopt to reduce their current account deficit. The two policies which could be implemented include:
- Devaluation of the currency’s exchange rate
- Reduction in the nation’s domestic consumption and expenditure on imports.
Policies to Reduce Current Account Deficit: Pros and Cons
Devaluation of Exchange Rate
The devaluation of the currency’s exchange rate would help in making the exports cheaper and the imports would then become relatively expensive. This would balance the international trade and reduce the current account deficit. The devaluation of the exchange rate can be implemented as a solution to the issue of high current account deficit. In order to do this, the USA has to reduce the value of its currency, i.e., US dollars against the currency of the other nations. This would be possible when the USA while selling its US dollars would cause the value of the currency to fall (Pali?, Bani? and Mati?, 2018).
The devaluation would be effective in addressing the issue of current account deficit because the falling value of the currency would make the imports more expensive. The price of the imported commodities would rise. Therefore, the demand for imports would reduce. The exports would become cheaper. The quantity demanded for the export commodities would increase. The demand if assumed to be relatively price elastic, the devaluation of the currency would result in improvement of net exports (X-M). This would make the export value relatively higher than that of the value of imports, balancing the current account position (Purwono, Mucha and Mubin, 2018).
The problem with devaluation is that though the low value of the currency would boost the exports and reduce the imports, the elasticity of demand for the commodities being exported and imported have an important role to play here. The imports, if price inelastic would still be high irrespective of the devaluation. This would hinder the reduction of the current account deficit (Saadaoui, 2018).
Another huge problem with the policy of devaluation is that it leads to inflation. Due to the devaluation, the imports will become relatively expensive (Mumtaz and Ali, 2020). The imported commodities and raw materials increase in price. The aggregate demand also increases. This results in the demand-pull inflation. The major concern is regarding the effect of long-term devaluation. This might result in drop in the productivity due to the declining incentives.
Reduction of Domestic Consumption & Expenditure
According to Behringer and Van Treeck (2018), the reduction in the domestic expenditure and consumption through tight fiscal policies like higher taxes, would reduce the current account deficit. The deflationary monetary and fiscal policies would help in addressing the issue of current account deficit. These policies would mainly target reducing the inflation and the growth of the aggregate demand. The tightening of the monetary and fiscal policies could be an effective policy for USA.
Deflationary Monetary Policy:
The deflationary monetary policy would imply increasing the interest rates. The higher interest rates would increase the cost of the mortgage repayments and the cost of debts. The people of the USA would be left with lesser money for spending. This would lead to reduction in the consumption of the imported commodities. Thus, the current account deficit can be improved. The higher interest rates also imply that the aggregate demand would fall. Therefore, the economic growth would also be reduced. The lowering or controlling of inflation would help in making the exports of the USA more competitive. The deflationary monetary policies create a pressure on the manufacturers which force them to reduce the costs (Gizem and Mehmet, 2020). This eventually results in competitive exports. Therefore, in the long run the exports might increase.
As per Iacoviello and Navarro (2019), the monetary policies can reduce the current account deficit for the USA. However, the policy has its cons too. The use of the monetary policies in reducing the current account deficit would lead to a rise in the interest rates. This rise in the interest rates would result in hot money flows. Thus, the appreciation of the exchange rate would be caused. The outcome of this appreciation would eventually reduce the competitiveness of the exports. This would in turn make the imports more attractive. The demand is assumed to be relatively elastic. Therefore, this appreciation would lead to worsening of the current account position.
The use of monetary policies could have conflicting effects on the current account. The higher rate of interest would reduce the expenditure on imports, which would reduce the current account deficit. On the other hand, this high rate of interest would cause exchange rate to appreciate. This will in turn worsen the issue of current account deficit. The overall impact of using monetary policies is uncertain because it depends on which of the above effects is stronger. However, in case of the USA, the marginal propensity to import is high. Thus, the high rate of interest will result in reduction of the aggregate demand. This would significantly improve the current account position (Liu and Woo, 2018). Therefore, the effect of the monetary policies depends on various factors. For instance, if a nation has a highly growing economy, the increase in the interest rates might not result in reduction of the consumer spending. This is because the income growth would be high along with the confidence.
Deflationary Fiscal Policy:
In place of the monetary policies, the fiscal policies could be used. For instance, the government of the USA could raise the income tax. This increase in income tax would result in reduction of the consumers’ discretionary income (Bonga-Bonga, 2019). This would further reduce the expenditure on the imports.
The advantage of using the fiscal policies for reducing the current account deficit of the USA is that it would have no impact on exchange rate of the nation’s currency. Moreover, the higher income tax would further improve the finances of the government of the USA (Lahiani, A., Mtibaa and Gabsi, 2022).
The problem with using the deflationary fiscal policy for reducing the current account deficit is that it is conflicting with the other macroeconomic goals of the economy of the USA. This implies that higher income tax would result in lower aggregate demand. This would yield lower economic growth. This drop in the growth would cause higher unemployment for the nation. The government of the USA should therefore, think before implementing the deflationary fiscal policy (Soylu, 2020). The government should not take the risk of creating higher unemployment just for the purpose of reducing its current account deficit.
The current account deficit of the USA can be reduced through the devaluation, deflationary fiscal and monetary policies. However, each of these policies or measures have their own pros and cons. In reducing the current account deficit, the nation should not compromise with its other macroeconomic objectives.
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