RDP 9003: The Balance of Payments in the 1980s II. Analytical Framework

A rise in domestic expenditure (such as a rise in government spending or private investment) in a Mundell-Fleming world[9] would create an excess demand in the domestic goods market (domestic absorption exceeds domestic production and domestic investment exceeds domestic saving) and put upward pressure on domestic interest rates and prices. With flexible exchange rates, capital mobility and static exchange rate expectations both the nominal and real exchange rate will appreciate. The appreciation will continue until the excess demand is offset by a rise in the current account deficit. Over the longer run, the exchange rate will depreciate and domestic expenditure fall (due to the wealth effects of higher net foreign liabilities) until the current account deficit is in equilibrium and the stock of net foreign liabilities is not growing relative to GDP. Models in this tradition therefore imply that initially a rise in government (or private) spending will be reflected one-for-one in a rise in the current account deficit. As a result, it has been suggested that the current account and fiscal deficits are “twins”.[10]

These results do not neccessarily hold in more recent models that emphasise the intertemporal nature of consumption, investment and production decisions.[11] Generally, shocks which are perceived to be permanent have no effect on the current account in these models. For example, a permanent bond-financed rise in government spending may be offset by a rise in private saving (a permanent fall in private expenditure) because consumers take account of the implied higher future taxes. The current account may therefore be unaffected by a permanent rise in government spending. Temporary shocks can, however, influence the current account.

It is also important to distinguish between temporary and permanent terms of trade disturbances. Where the change in the terms of trade is seen to be permanent, individuals immediately and fully adjust their expenditure to their new permanent income, which may leave the current account unchanged as a proportion of GDP. A temporary rise in the terms of trade (such as a rise in export prices) will temporarily boost income which, because of consumption smoothing, will increase saving and reduce the current account deficit. Also, the rise in export prices shifts demand towards non tradables putting upward pressure on domestic prices and the real exchange rate. If consumption is not completely smoothed then this response will be reinforced.[12]

Greater access to foreign financing generally means that the types of disturbances discussed above will have larger effects on the current account. In the absence of capital flows, a rise in expenditure will push-up domestic real interest rates until the domestic goods market is in balance and domestic saving equals investment. With perfect capital mobility, such a shock will be equilibrated by increased capital inflows that appreciate the real exchange rate resulting in a trade deficit. Part of the increased demand is met by foreign producers (or to put it another way, the reduction in net domestic saving is met by foreign borrowing). In this sense, greater access to foreign funds merely facilitates the adjustment to shocks through allowing larger current account imbalances. However, it also introduces another influence on the current account, namely autonomous shifts in the portfolio preferences of international investors.

The resource shifts associated with the types of shocks discussed above have been an important issue in Australia. In Swan-Salter models, an increase in demand (through government or private spending) will create an excess demand for traded and non-traded goods. The price of non-traded goods will rise until that market clears. With the price of traded goods exogenous, the real exchange rate will appreciate. Resources will be diverted to the non-traded goods sector with the excess demand for traded goods being met by higher net imports, A rise in export prices will induce a real appreciation and resources will be shifted from the production of import-competing goods towards non-traded goods. See Dornbusch(1980) and Dornbusch and Fischer(1984).


See Mundell(1968) and Frenkel and Razin(1987a,b). Sachs(1980), Turner(1986) and Frenkel and Razin(1987b) discuss some of the problems of the Mundell-Fleming approach. [9]

For a discussion of the twin deficits hypothesis see Genberg(1988) and Nguyen(1990). [10]

Open economy models in this tradition have been used by Obstfeld(1980. 1981, 1982), Sachs(1981a,b), Dornbusch(1983), and Svensson and Razin(1983). Other references can be found in the bibliography. A detailed exposition can be found in Frenkel and Razin(1987a). [11]

There is an extensive literature on the effect of transitory terms of trade shocks on the current account. See Obstfeld(1980, 1982), Dornbusch(1983), Svensson and Razin(1983), Persson and Svensson(1985), Frenkel and Razin(1987a) and Ostry(1988) for examples. This literature shows that real interest rates may also change in response to the terms of trade. Real interest rates may rise or fall depending on the nature of the shock, if they fall then the income effect may be offset by the intertemporal substitution effect leaving the current account unchanged. [12]