Chapter 35
1a.The balance on capital account for Longland is zero.
Under the international convention adopted by the Australian Bureau of Statistics the capital account now includes only capital transfers such as capital brought into or taken out of the country by migrants or debt forgiveness by governments.
1b.The two balance of payments accounts are shown in table 1.
Table 1 Problem 1Longland’s Balance of Payments
Current Account(billions of stretches)
Goods and Services
Debits (imports) / -350
Credits (exports) / 500
150
Income / -200
Current account balance / -50
Capital and Financial Account(billions of stretches)
Investment
Abroad / -200
in Australia / 260
Reserve assets / -10
Financial account balance / 50
1c.The Longland central bank intervenes in the foreign exchange market.
We know that the central bank intervenes in the foreign exchange market because its official reserves changed. The exchange rate could be fixed but is more likely a managed float.
3a.Net exports are –$10 million.
Use the fact that
Y = C + I + G + NX
and solve for NX as
NX = Y – C – I – G,
which equals
NX = 60 – 36 – 20 – 14 = –10.
3b.Saving is $12 million.
Use the fact that
Y = C + S + NT
and solve for S as
S = Y – C – NT,
which equals
S = 60 – 36 – 12 = 12.
3c.National saving and foreign borrowing finance investment.
I = S + NT – G – NX,
which equals
I = 12 + 12 – 14 – (– 10) = 20.
5a.Imports of goods and services are 26 billion turkies.
Use the fact that
Y = C + I + G + X – M
and solve for M as
M = – Y + C + I + G + X,
which is
M = – 100 + 60 + 22 + 24 + 20
M = 26.
5b.The current account balance is – 6 billion turkies (assuming that net interest income plus net transfers is zero).
Use the fact that
CAB = X – M
CAB = 20 – 26= – 6.
5c.The capital and financial account balance is 6 billion turkies.
The sum of the current account, capital account, and financial account is zero. The capital account balance cannot be calculated unless information is given about the financial account.
5d.Net taxes are 20 billion turkies.
Use the fact that
Gov. budget deficit = G – NT,
so
NT = G – Gov. budget deficit,
which is
NT = 24 – 4= 20.
5e.The private sector balance is –2 billion turkies (a deficit).
Use the fact that
Private sector surplus = S – I,
with
S = Y – C – NT,
or
Private sector surplus = Y – C – NT – I,
which is
Private sector surplus = 100 – 60 – 20– 22
Private sector surplus = – 2.
7.As these are the last two problems in the text it would be worthwhile to extend the scope of the questions so that students have an opportunity to use most of the components of the model that has been built up over the past fifteen chapters and apply the various theories that have been covered. The questions set relate to the long run equilibrium positions. The answers use national accounting identities, the twin deficit hypothesis, that states that if the government sector takes a larger share of potential real GDP this leaves less for the private and overseas sectors. It would be useful for the students at this stage of the course to consider the various possibilities that could apply to the situation outlined in the question and discuss possible intermediate short run equilibriums on the path to the new long run equilibrium position. There is of course no definitive answer; that depends on the assumptions made by the student, but it does give the opportunity to discuss why there can be disagreement amongst economists, even when there is a strong consensus regarding theory. In the answer below the approach is more significant than the answer.
The model in figure 1 assumes the strong economic growth was demand driven, the result of the expansionary fiscal policy and fall in saving. It further assumes the expansionary policy was unexpected and permanent. During the expansionary phase of the business cycle automatic stabilisers are expected to increase the budget surplus unless there is a change in the fiscal stance. (If it were an election year this could be different). And so we can assume the increased government spending/tax cut was unexpected. The higher than expected aggregate demand has pushed the economy from point a to point b instead of point a/.
Assuming the change is permanent the long run equilibrium will be point c. A general believe that the new fiscal stance is permanent could change inflationary expectations, particularly if the central bank lacks credibility. The economy moves to point c on the long run Phillips curve in figure 1.
You might expect that not all students will assume the changes permanent or unexpected. This should provide good fuel for lively discussion.
Figure 1
7a.The fall in both private sector and public sector saving during a period of strong growth will, in the long run, ‘crowd-out’ net exports and reduce the current account balance.
The current account is in deficit or surplus depending on whether the accounts of the private sector and the government sector are in deficit or surplus. If one sector is in deficit but the other is in surplus, then the deficit sector can borrow from the surplus sector. But if both sectors are in deficit, or if the deficit sector’s deficit is larger than the surplus sector’s surplus, then, in sum, the sectors must borrow from abroad. In this case both private and public sector balances have been reduced and so the current account balance must be reduced.
Australian total income is the sum of income generated by domestic production (GDP) plus income from foreign sources. The total use for this income includes total expenditure on goods and services plus what we pay in income to foreigners, or give away.
That is:
Y + INCcr+ TRcr= C + S + T + INCdb+ TRdb.
Y= C + S + T NINC NTR.
C + I + G + EX IM= C + S + T NINC NTR.
EX IM + NINC + NTR = (S I) + (TG).
CAB = (S I) + (TG).
Whenever there is deterioration in either the balance of the government sector or the balance of the private sector, other things remaining the same, the current account deteriorates.
7b.The currency will depreciate.
The worsening current account balance means the value of imports and income payable overseas are growing faster than the value of exports and income received from overseas. The demand for foreign exchange is growing faster than the supply foreign exchange and the currency depreciates.
7c.If the country is a debtor country then its net foreign debt will increase and increase at a faster pace. If the country is a creditor country the growth of its overseas assets will slow or even decrease.
7d.The interest rate of the hypothetical country will increase relative to interest rates in other countries as its currency weakens. To maintain equal returns interest paid on loans in the hypothetical country will need to include an allowance for the expected depreciation of its currency.