Applying

Monetary Policy
Nadine, Kaitlin, Alula, Ilhan, Christo
Summary of the USA’s problems
- The current account deficit is declining at a rapid rate

And now during pandemic, the U.S. current account deficit dipped to a near two-year low in
the first quarter as the COVID-19 pandemic restricted the flow of goods and services, while
companies continued to repatriate profits back home.
Summary of the USA’s problems
- It is currently the lowest level of all time since the third quarter in 2017

(120 billion current account deficit)

Exports plunged to a 10-year low in April, which economists said set up the current account
deficit to widen to as much as $120 billion in the second quarter.
In the first quarter, exports of goods and services and income received from foreign
residents fell $47.5 billion, the biggest drop in 11 years, to $902.2 billion. That was the
lowest level since the third quarter of 2017.
Summary of USA’s problems
- Investment income decreases

- This had lead to Balance of Payments deficit.

The Problems Caused By A BoP Deficit
- A deficit in the balance of payments leads to a higher demand for
foreign currency to the detriment of national currency which would
depreciate in this situation. However, an exceeding account balance
involves a high amount of foreign currency for which the national
currency would be exchanged.

- A country running large current account deficit is always at risk of

seeing the value of the currency fall. If there is insufficient capital
flows to finance the deficit, the exchange rate will fall to reflect the
imbalance of foreign flows of funds.
Possible Solution 1: Reduction In Interest Rates
- With lower interest rates foreigners will be less likely to save and more likely to borrow
- Eventually demand for currency will go down and exchange rates will be lower
- Then exports become cheaper and imports become more expensive
- This will lead to there being more exports and less imports
- This will allow current accounts to improve and help improve Balance of payments

Drawbacks: Reduction In Interest Rates

- The foreigners borrowing the money could also lead to a higher demand for the
currency and the exchange rates will increase thus the current account deficit may
continue
-
- A decrease in interest rates can lead to problems such as inflation and liquidity traps
Possible Solution 2: Devaluation Of The Exchange Rate
- Devaluation of USA’s currency, in theory, may reduce a trade deficit

- Current account deficit = demand for US exports < US consumers' demand for foreign

currency to buy imports

- Theoretically, when the US dollar falls in value, it would make exports relatively cheaper

and imports relatively more expensive

- US consumers will switch their purchases from imports to domestic goods, and foreign

consumers will switch from their home produced goods to US exports (assuming

demand is price elastic)

Drawbacks: Devaluation Of The Exchange Rate
- Purely based on economic theory, devaluation of the exchange rate makes sense as a

solution to a current account deficit

- It is not that simple to carry out in real life

- It is very difficult for a government to actually implement a policy of devaluation;

Occasional, gentle realignments may occur, but one-off drops in the value of the

currency do not really happen

- Risk of inflation: The resulting higher import prices lead to higher inflation, then exports

may not become more competitive

What’s The Best Solution?
To conclude, the final result of our group’s discussion would be the use of a reduction in
interest rates in solving the current account deficit issue provided in the case study.

Reasoning:

1) A reduction in interest rates are tightly linked to the devaluation of the exchange
rate anyway, so we feel it would be more effective to decrease the interest rates,
since in turn, both aims can be achieved theoretically.
2) Policies of devaluation are less reliable. It is nearly impossible to immediately
make significant changes in the exchange rate right away - would be simpler to
devalue the currency indirectly through the method of interest rates.
Thank You!