How can a current account which is in deficit be restored to-00641
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vu cs403 Database Management Systems.
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vu cs403 Mid Term Solved Past Paper No. 4.
There is solution for how can a current account which is in deficit be restored to balance under fixed exchange rate regimes. The answer is "Economic Deflation"
Economic Deflation says When a country's national income rises, it spends more; part of that spending falls on imported goods; higher imports cause the current account to worsen.
The reverse is also true for this lower income must reduce import spending and therefore improve the current account spending.
However, economic contraction is not a good idea to restore current account equilibrium the other alternative solution presented by economist is to devaluate or "devaluation".
Devaluation is the phenomena related to exchange rate where exchange rate faces depreciation but in the context of fixed exchange rates. The complement of devaluation is revaluation.
A concept of devaluation is to bring the exchange rate in line with its long-run equilibrium level, i.e. a level consistent with international competitiveness.
Competitiveness is simply defined as the real exchange rate RER, where RER = (Pf/Pd)*NER. Where
NER Nominal Exchange rate
Pf is the price level prevailing in the foreign country (US)
Pdis the price level prevailing in the home country (Pakistan).
The formula implies that, for a fixed NET if inflation is higher in Pakistan (relative to the US), Pakistani exports will become less attractive in the international market. As a result, our exports will fall, and current account will go into deficit.
To fix this problem, the NER can be devalued so as to make our goods cheaper and competitive and it is to bring competitiveness back to its original higher level. However, there are many provisos attached to the devaluation policy prescription.
Devaluation only works if the country's exports and imports are elastic, otherwise the price effect of the devaluation will dominate the volume effect and the current account will worsen. Secondly, the country must have excess productive capacity in order to meet the higher demand for exports that is created as a result of the devaluation.
