Macroeconomic Policies and the Current Account

Macroeconomic Policies and the Current Account
Policy makers are often concerned about the level of the current account. As we will discuss
more fully in Chapter 19, an excessive imbalance in the current account—either a
surplus or a deficit—may have undesirable long-run effects on national welfare. Large
external imbalances may also generate political pressures for governments to impose
restrictions on trade. It is therefore important to know how monetary and fiscal policies
aimed at domestic objectives affect the current account.
Figure 17-17 shows how the DD-AA model can be extended to illustrate the effects of
macroeconomic policies on the current account. In addition to the DD and AA curves, the
figure contains a new curve, labeled XX, which shows combinations of the exchange rate
and output at which the current account balance would be equal to some desired level,
say . The curve slopes upward because, other things equal, a rise
in output encourages spending on imports and thus worsens the current account if it is not
accompanied by a currency depreciation. Since the actual level of CA can differ from ,
the economy’s short-run equilibrium does not have to be on the XX curve.
The central feature of Figure 17-17 is that XX is flatter than DD. The reason is seen by
asking how the current account changes as we move up along the DD curve from point 1,
where all three curves intersect (so that, initially, ). As we increase in moving up
along DD, the domestic demand for domestic output rises by less than the rise in output
itself (since some income is saved and some spending falls on imports). Along DD, however,
total aggregate demand has to equal supply. To prevent an excess supply of home
output, therefore must rise sharply enough along DD to make export demand rise faster
than import demand. In other words, net foreign demand—the current account—must rise
sufficiently along DD as output rises to take up the slack left by domestic saving. Thus to
the right of point 1, DD is above the XX curve, where ; similar reasoning shows
that to the left of point 1, DD lies below the XX curve (where ).
The current account effects of macroeconomic policies can now be examined. As shown
earlier, an increase in the money supply, for example, shifts the economy to a position like
point 2, expanding output and depreciating the currency. Since point 2 lies above XX, the
CA 6 X
CA 7 X
E
CA = X Y
X
CA(EP*/P, Y - T) = X
Ms/P = L(R*, Y f)
R R* Yf
G
Yf
CHAPTER 17 Output and the Exchange Rate in the Short Run 447
current account has improved as a result of the policy action. Monetary expansion causes
the current account balance to increase in the short run.
Consider next a temporary fiscal expansion. This action shifts DD to the right and
moves the economy to point 3 in the figure. Because the currency appreciates and income
rises, there is a deterioration in the current account. A permanent fiscal expansion has the
additional effect of shifting AA leftward, producing an equilibrium at point 4. Like point 3,
point 4 is below XX, so once again the current account worsens, and by more than in the
temporary case. Expansionary fiscal policy reduces the current account balance.