2010 OEM Chapter 5

2010 OEM Chapter 5 - Chapter 5: Theories of current account...

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Chapter 5: Theories of current account balance behavior 5.1 Introduction Why do some countries have current account deficits while others have surpluses? If a country has a deficit, will this condition self-correct or must policy makers take actions to change the situation? If actions must be taken, what policies are available, and, if they exist, how would they work? Over the years, economists have developed several theories of current account behavior to answer questions such as these. We turn now to consider two examples. As it turns out, the two theories that we consider look at the issue from alternative points of view and emphasis. As such, they provide somewhat, though not entirely, different answers to many of the questions raised earlier. To understand better, consider again the basic categories of the balance of payments table: Goods trade Services trade Income flows Unilateral transfers 9 the line (drawn here for the current account) Capital account Financial account The line shown above indicates how the current account is calculated. Above the line, credits and debits items are netted out to arrive at a value for the CAB. Items netted out below the line represent how the current account balance is financed. In other words, it spells out the net international trade in financial assets and liabilities required in order to pay for the trade activities that occurred above the line. The first of the two current account models that we will consider focuses on international trade in goods and services, the activities above the line. This theory is known as the elasticities model. The second model focuses on international flows of financial assets and liabilities, the activities below the line. This model is known as the intertemporal model.
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5.2 The Elasticities Model The elasticities model has been part of the international finance literature for decades. The focus of the model, originally, was on the role of exchange rate changes in correcting balance of payments imbalances. As such, the primary emphasis of the model was on the size of the price elasticity of import demand (at home and abroad). As we have already seen, when exchange rates change, prices change. When traded goods prices change, demand for imports and exports will change (the price elasticities tell us how much). If trade levels change in the appropriate fashion, the current account should move from a deficit toward surplus. This response and thus the size of traded goods price elasticities is still a primary concern today. More recently, researchers have also looked at the role of income elasticities and their influence on the current account. As countries grow so do their national incomes. Growing incomes lead to rising expenditures including spending on imports (the income elasticity tells us how much). Differences in growth rates and income elasticities could also explain persistent current account imbalances. In what follows, I will spell out a specific framework to study the role of price elasticities. Then, I will present a briefer discussion
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This note was uploaded on 04/17/2011 for the course ECON 1510 taught by Professor Stevenhusted during the Spring '11 term at Pittsburgh.

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2010 OEM Chapter 5 - Chapter 5: Theories of current account...

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