Wednesday, October 17, 2007

The current account and the exchange rate...

"What is the effect of the current account balance on the exchange rate?" - Vincent

To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.

Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.

Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?

The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.

To put this another way, the current account balance may be defined as

CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)

The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.

We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.


Anonymous said...

Thank you, that was very well explained. I have had a lot of trouble understanding this concept in the past, but your post has made it very easy for me.

Anonymous said...

How would a change in an autonomous variable, say autonomous investment, affect the current account? (Assuming price level is constant)

If autonomous investment decreases, this should shift the IS curve to the left, decreasing interest rates below the world level. This decrease causes capital outflows, and reduces the demand for pounds. The exchange rate depreciates, and there is an increase in competitiveness. Exports increase, and there is a trade surplus. The increase in exports offsets the decrease in Y due to decrease in investment. There is a permanent decrease in the exchange rate.

However, the decrease in investment should decrease national income, causing a decrease in imports. This reduces the supply of pounds and the exchange rate appreciates.

But if demand for pounds decreases and supply of pounds decreases simultaneously, then exchange rate doesn’t change, and the IS curve does not shift back to it’s original position. This means there is a permanent decrease in output.

So what is the overall effect?

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