Relationship between current account deficit and interest rates

relationship between current account deficit and interest rates

In equilibrium, there is likely to be a strong correlation between fiscal balances and the current account balance. Econometric analysis is. The current account balance seems to be an abstruse economic concept. the current account balance because there is no obvious connection between than the interest rate (or rate of return) the country has to pay on its foreign liabilities. Explanation of how changes in interest rates affect the current account Bof P. 2 different effects on consumer spending and exchange rate effect.

There are a few different implications. It is not possible to say definitely whether the current account will improve or worsen.

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An increase in interest rates on macroeconomy Reduces consumer spending — higher interest rates make it more attractive to save, and less incentive to borrow; therefore, this leads to lower disposable income after paying increased mortgage costs.

Lower consumers spending will lead to lower import spending and therefore improve the current account Reduce inflation. Higher interest rates help reduce inflation making exports more competitive — improving current account Exchange rate effect Higher interest rates lead to hot money flows and an appreciation of the exchange rate.

This makes exports more expensive and imports cheaper.

relationship between current account deficit and interest rates

This tends to worsen the current account assuming demand is relatively pricing elastic Which effect will be strongest? In turn, public savings are the difference between the government revenue taxes and budget expenditures, which include government purchases G and government transfers Rwhich can be written according to the formula: Therefore, in one hand, there is the Keynesian twin deficits hypothesis which claims, in situation when the economy is in a state of full employment, an increase in budget deficit leads to current account deficit as a result of an increase in aggregate demand for both domestic and imported goods and services.

Alternatively, the Ricardian Equivalence Hypothesis REH asserts that there is no relationship between budget and current account deficits. The proponents of the REH explained that if there is no constant relationship between saving and investments, then the change in the fiscal balance is fully offset by changes in the size of savings.

This situation results from the fact that the increase in budget deficit leads to an increase in national savings due to the expected increase in taxes in the future to reduce the public deficit. Current Account Deficit and Government Budget Deficit in Ethiopian context Current account deficit The current account consists of the goods balance, the service balance, net income receipts, and net international transfers.

A current account can be positive or negative. This means that Ethiopian imports exceed its exports or unable to cover its import bills.

Interest Rates and Balance of Payments

The reasons to such a deficit current account might be the level of development, policies and strategies of the country. The deficit becomes widened between and and basically reflecting a faster growth in imports of goods and services into the country relative to exports.

The imports have been largely in machinery and transport equipment, manufactured goods and oil products for industrial purposes. These are essential goods whose demand is not responsive to price changes. Growth in exports has been slow moving with little diversification away from the traditional exports of coffee, tea and horticulture.

International trade in services, which form part of the current account balance, has been in a surplus over the years, mainly due to improved earnings in export of transportation services, tourism services, among others. Net current transfers also increased, supported largely by rising emigrant remittances. However, the growth in the services account and net current transfers was not sufficient to offset the deficit in the merchandise or goods account Figure 1.

relationship between current account deficit and interest rates

Trend of Current account deficit in Ethiopian in millions of Birr. Government budget deficit Like that of the current account, Ethiopia is known for its consistent government budget deficit. The country underwent a deficit in its government budget in the study period. Two main reasons can be identified for the consistent government budget deficit in the country. The first is related with the huge government expenditure in the country.

The Effect of the Current Account Balance on Interest Rates

More than ever, since the last two decades, the Ethiopian government has exposed to a sky-scraping disbursement on road construction, health and education sectors. The government gives a great deal of attention and allocated an enormous budget to satisfy the continuing infrastructural demand of the nation.

The second reason is rather associated with extremely low government revenue from taxes. The government tax collection performance is too low compared to its spending.

This is partly due to the so-called tax evasion and lack of awareness among the citizens that income from taxes is finally used up for public development and partly owing to the low level of development of the nation which in turn influences the tax revenue negatively. The long lasting government budget deficit of the country can be illustrated in the following Figure 2. Government budget deficit in Ethiopian in millions of Birr.

Methodology of the Study In this study, annual data for the period were employed. The country underwent both current account and government budget deficits during the study period. After the author have changed the data for current account and budget deficit into positive, current account CAbudget deficit BDreal gross domestic product RGDP and real effective exchange rate index REERI have been transformed into natural logarithms, just for the purpose of removing possible heteroscedasticity and capturing non-linear properties.

The advanced economies, such as the United States see chartrun current account deficits, whereas developing countries and emerging market economies often run surpluses or near surpluses. Very poor countries typically run large current account deficits, in proportion to their gross domestic product GDPthat are financed by official grants and loans. One point that the savings-investment balance approach underscores is that protectionist policies are unlikely to be of much use in improving the current account balance because there is no obvious connection between protectionism and savings or investment.

Another way to look at the current account is in terms of the timing of trade. We are used to intratemporal trade—exchanging cloth for wine today. But we can also think of intertemporal trade—importing goods today running a current account deficit and, in return, exporting goods in the future running a current account surplus then. Just as a country may import one good and export another under intratemporal trade, there is no reason why a country should not import goods of today and export goods of tomorrow.

Current Account Deficits: Is There a Problem? - Back to Basics: Finance & Development

Intertemporal theories of the current account also stress the consumption-smoothing role that current account deficits and surpluses can play. For instance, if a country is struck by a shock—perhaps a natural disaster—that temporarily depresses its ability to access productive capacity, rather than take the full brunt of the shock immediately, the country can spread out the pain over time by running a current account deficit.

Conversely, research also suggests that countries that are subject to large shocks should, on average, run current account surpluses as a form of precautionary saving. When persistent is too persistent Does it matter how long a country runs a current account deficit? When a country runs a current account deficit, it is building up liabilities to the rest of the world that are financed by flows in the financial account.