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高收入和低收入国家之间的经济比较
本研究分析是基于以1995 - 2008年期间由8个发达国家和8个发展中国家组成的16个国家样本的截面数据。它应该包括最高为的896个的观察值。世界银行将收入不高的国家分为不同的地区群组，我选定了欧洲和中亚地区。表1列出了被选择的国家。
然而，16个国家对某些变量在1995年和2008年期间相关的数据集是偶尔不连续的，特别是企业税率。这造成个问题的主要原因是，一些国家特别是发展中国家(例如塞尔维亚和波斯尼亚)经历了重要的事件，包括战争，分布在不同的国家和低效的政府机构。此外，数据集包括三个虚拟变量，国与国之间的距离，区域贸易协定和电话主线。然而,这个数据库提供了显著的完整评估模型。我选择的变量是关于UNCTAD和文献综述作为外国直接投资(FDI)现金流量的主要决定因素。
Economic comparison of high and lower income countries
The analysis in this study is based on a sample of cross sectional data for the 1995-2008 period on 16 countries which are comprise of 8 developed countries and 8 developing countries. It should include a maximum 896 observations. World bank classifies the non-high income countries as regional groups which I selected Europe and central Asia. Table 1 listed selected countries.
However, the data set associated with the 16 countries is occasionally discontinuous for some variables over the period of 1995 and 2008, particularly corporate tax rate. The main reason of this issue is that some countries especially developing countries (i.e. Serbia and Bosnia) experienced important events including battles, division in different countries and inefficient government agencies. Furthermore, the data set includes three dummy variables, which are distance between countries, regional trade agreements and telephone main lines. Nevertheless, this database significantly offers the complete estimation for the model. I selected variables as the main determinants of foreign direct investment (FDI) flows with respect to UNCTAD and literature review. Supposedly, other variables different than the main determinants suggested by the literature review, impact FDI, such as the values of export and imports and the consumer price index for countries. I used these variables to calculate the main determinants variables of FDI, which are:
Foreign Direct Investment (FDIIJ): it denotes net FDI outflows from developed countries into non-high-income countries. Besides, it is the dependent variable as a measure of foreign investment. Data Source: International Direct Investment Statistics, OECD (2011).
GDP per capita (GDPJ): The growth rate of GDP per capita as annual percentage is based on constant US dollar. Market size of country measured by GDP per capita or GDP. Data Source: World Development Indicators, World Bank (2011).
Distances (DISTIJ): it denotes distance between developed countries, which are investors, and non high-income countries that are investees, in kilometres. Distance basically affects transport costs and moreover, relates to efficiency of transport ways. Data Source: CEPII (2011).
Regional Trade Agreements (RTAIJ): It denotes trade agreement between developed countries and non high-income countries (=1 if there is an agreement). Data Source: World Trade Organisation (2011).
Telephone Mainlines (per 1,000 people) (TELJ): it indicates that telephone lines connect a customers’ tool to public switched telephone network. Data are showed per 1,000 people for the whole country, which is a proxy for infrastructure of country. Data Source: World Development Indicators, World Bank (2011).
Openness (OPENJ): this variable denotes a developing country’s level of openness to international finance, which calculates as the nominal import plus the nominal export divided by the nominal GDP.
Inflation, CPI deflator (INFJ): it indicates the rate of changes in consumer prices at a whole economy. Inflation is a proxy for economic stability, which is measured as follow:
Rate of Inflation = (CPIt – CPIt-1)/ CPIt-1 × 100
Real Exchange Rate (RERJ): it denotes the competiveness of country to international trade. In this paper, It calculated that it corrected value of the domestic currency against to US dollar with respect to consumer price index:
RERK : nominal exchange rateK * ( CPIUS / CPIK)*100
Question 2
The gravity model for international trade derived from the Newton’s law of gravity. Some academicians transferred the gravity equation to analyse the international trade flows between countries such as Tinbergen ‘s simple model (1962). Therefore, the gravity model examines the interactions of trade between countries by using the determinate variables. There are three types of panel estimators:
Pooled ordinary least squares (POLS): it puts the data set together which means that it doesn’t make any segregation between cross section and time series in used data.
According to the gravity model, I decided to run the following regression and the outcomes of which are presented in Appendix 1:
Ln fdiij = β0 + β1 ln gdpi + β2 ln gdpj + β3 ln gdppci + β4 ln gdppcj + β5 ln openj + β6 ln reri + β7 ln rerj + β8 ln telj + β9 ln distij + β10 rtaij
Fixed effects (FE): it is using F and likelihood linear tests and Quantitative Micro Software (2007, p. 498) states “The fixed effects portions of specifications are handled using orthogonal projections.” Furthermore, dummy variables exclude from model, so that the regression is;
Ln fdiij = β0 + β1 ln gdpi + β2 ln gdpj + β3 ln gdppci + β4 ln gdppcj + β5 ln openj + β6 ln reri + β7 ln rerj + β8 ln inf
Random effects (RE): it is interested in the realizations of independent variable with mean zero and limited variance. It has the similar regression with FE.
Ln fdiij = β0 + β1 ln gdpi + β2 ln gdpj + β3 ln gdppci + β4 ln gdppcj + β5 ln openj + β6 ln reri + β7 ln rerj + β8 ln inf
According to the results of POLS, The appropriate model seems to be high with an adjusted R2 of 0.76 and the independent variables in the regression explain the variation at the approximately 76% level in FDI outflow. Furthermore, FE estimator is the highest with adjusted R2 and the independent variables elucidate the model at about 87% level in dependent variable, whilst RE has the lowest explanation with adjusted R2 0.58. By excluding the dummy variables (rtaij, distij, telj), FE estimator is more significant with respect to other estimators.
It is generally accepted that depreciation in home country currency increases FDI flows into that country. For this reason, I expect that a deprecation in the real exchange rate (hereafter RER) of our non high-income countries or a rise in developed countries currency directs and increases FDI flows into these countries. In the other word, rerj has positive effect; whilst reri is inversely correlated with FDI flows. Because, an appreciation of the developing countries’ RER leads to depreciation their competiveness associated with attracting foreign investments. Goldberg and Kolstad (2000, p.21) rightly points out that “… a depreciation of the domestic currency does make foreign facilities more expensive, and probably leads to a reduction in demand for physical investment abroad.”
FE and RE estimators confirmed our expectations while POLS only rejected our expectation in related to RER of non high-income countries. In the other words, rerj have positive but not great impact on FDI flow into developing countries in the outcomes of FE, RE and POLS. However, reri has linear and insignificant correlated with FDI flow in the results of POLS, despite it affects negatively dependent variable in results of FE and RE.
The coefficients of GDP and per capita GDP showed significant impacts based on the results of each estimator. GDP and per capita GDP are a proxy for Market Size and increasing market size leads to efficiently utilize the resources and avoid exploitation of them. Therefore, market size has positive effects on FDI. When I use per capita GDP is a proxy for market size, gdppci affects positively and significantly FDI flows into developing countries, but surprisingly, a rise in per capita GDP of developing countries has negative impact on FDI in the outcomes of POLS and FE except RE. The different result occurs when GDP is used as a proxy for market size. In the POLS’s result, GDP positively and significantly affect FDI flow. However other estimators found that it has negative and great impacts on FDI. However, if I make a decision about selecting GDP or per capita GDP as an indicator of market size, my answer will be per capita GDP, because GDP reflects the bulk of GDP more so than income.
Surprisingly, the impact of inflation in developing countries on FDI is fairly small but positive in all estimators. It points out that when Inflation is used as a proxy for economic stability, increasing the ambient of stability leads to move FDI to unstable countries. However, the opposite of this situation should be valid. Moreover, the coefficient of telephone main lines as a proxy for infrastructure is significant and positive. It denotes better infrastructure attracts FDI to developing countries as a significant determinant.#p#分页标题#e#
An economy’s degree of openness denotes the readiness of a country to allow foreign investment. According to the outcomes of all estimators its coefficient is positive and significant. It presents that increasing openness raises FDI flow. Apart from this, regional trade agreements as a dummy variable positively and insignificantly affects FDI flow, since it normally appreciate the rate of foreign investment due to eliminating trade barriers between countries. In addition, rising distance between countries has negative effect on FDI with respect to the results of POLS. Because, distance associated with economic efficiency affects transportation cost. Long distance between investee and investors country inversely stimulates FDI flow.
Question 3
The LM and IS curves denote the combinations of the degree of income and interest rate. According to the IS schedule, leakages (savings and imports expenditure) is equal to injections (investments, exports and government expenditure). The LM schedule says that money demand is equal to money supply due to the presence of equilibrium in money market. Besides, the BP schedule indicates the equilibrium in the current account and the capital account with respect to income and interest rate.
Monetary expansion
Figure 1. An expansionary monetary policy under flexible rates (Pilbeam, 2006, p. 86)
First equilibrium is at point A with interest rate r1 and real output Y1. A rise in money supply shifts the LM schedule (LM1→ LM2) thanks to an expansionary monetary policy. Interest rate decreases and income increases. This situation causes to the balance of payments deficit. Therefore, the exchange rate depreciates and this causes to move the BP and the IS schedules to rightward (BP1→BP2, IS1→IS2) and to shift the LM to rightward (LM2→LM3). New equilibrium of internal and external is at point C with interest rate r2 and real output Y2 . Monetary expansion results as follows:
The exchange rate depreciates
Income increases
The interest rate decreases on the condition of semi mobile capital flow
The current account improves to offset effects.
Fiscal Expansion
Figure 2. Case 1: A fiscal expansion under floating rates (Pilbeam, 2006, p. 87)
There are two cases in a fiscal expansion with respect to the slope level of the BP schedule. First case is that BP is steeper than LM. This means BP is low sensitive to changes in the interest rate. First equilibrium is at point A with interest rate r1 and real output Y1. A rise in public expenditure moves the IS schedule to rightwards (IS1→IS2). This situation implies that increased real output leads to rise in imports of foreign goods whilst increased interest rate causes to heal the capital account. However, the exchange rate depreciates because of capital flows have limited mobility, thus BP shifts into deficit area (BP1→BP2). Furthermore, the LM schedule moves rightward (LM1→ML2) and the IS schedule shifts rightward (IS2→IS3). New equilibrium is at point C with interest rate r2 and real output Y2. It results in depreciation in the exchange rate and inflated income and interest rate.
Figure 3. Case 2: A fiscal expansion under flexible rates (Pilbeam, 2006, p. 88)
Second case is that the BP schedule is more flat than the LM schedule which means BP is more sensitive to the interest rate changes. Initial equilibrium is at point A with interest rate r1 and real output Y1. Increased public expenditure moves the IS schedule to right (IS1→IS2). It results in amount of the increased income is higher than the increased interest rate. This improves the current account and the BP schedule shifts into surplus area. In this case, the exchange rate appreciates so the LM schedule moves rightward (LM1→ML2) and the BP and the IS schedule moves leftward (BP1→BP2, IS2→IS3). New equilibrium is at point C with interest rate r2 and real output Y2. It results in appreciation in the exchange rate and higher interest rate and income.
An expansionary fiscal policy causes to increase or decrease the exchange rate according to the level of capital mobility.
Many academic people has been criticising the effectiveness of monetary and fiscal policies for years. They queries specific and important question: Which policy is more effective? According to Monetarists, monetary policy is more effective whilst Keynesians claims that fiscal policy is more significant than monetary policy. However, there is no final evidence prove their effectiveness. An expansionary fiscal policy leads budget deficit and to decrease the amount of investment by use of the interest rate and these mean depreciation in the growth of economic. The main reason of the ineffectiveness of fiscal policy is based on crowding out effect which means increasing interest rate preclude private investments. Apart from this, the expansion of monetary policy leads to decrease the interest rate and increase the real output. However, in monetary policy, there is the hazard of liquidity trap, which means a rise in the money supply supposes to depreciate the interest rate but it does not work because of believing that the interest rate is minimum level. However, the effectiveness of monetary and fiscal policy ought to determine with respect to the benefits of economic program and policy of country. For instance, Duzgun (2010) observes that countries, which try to get rid of economic crises, ought to embrace a contractionary fiscal policy instead of a contractionary monetary policy.
Section B
Question 4
The structure of international financial has shifted dramatically since the system of the Bretton Woods collapse in the 1970s. The term of persistence exchange rate has ceased and volatile exchange rate began by means of deregulation and liberalisation. The result of the breakdown of Bretton Woods System in Europe was that the European Community (EC) has planned a monetary union. However, the members of EC were not ready to apply the same monetary policy themselves. Firstly EC preferred to embrace monetary stability, external equilibrium, price stability and particularly national economic policy as their joint goals.
One of the most significant steps associated with monetary union is Smithsonian Agreement (1971). According to agreement, it cause to approximately 9% devaluation of US Dollar with respect to other currencies and the member currencies’ the margin of fluctuation around US dollar increased to %4,5 (±%2,25). However, EEC in 1972 made a decision that the fluctuation frontier of member currencies decreased at ±%1,125 because of the goals of monetary union. Thus, the member currencies varied by ±%1,125 against to each other (Snake) and floated at ±%2,25 vis-à-vis the US Dollar (the tunnel). This system called ‘ Snake in the Tunnel ‘.
In 1973, after the devaluation storms of US Dollar, EC began new exchange rate application. EC removed to the frontier against to the US Dollar so the member currencies could infinitely float against to the US Dollar but they still varied by ±%1,125 vis-a-vis each other. Authorises called that system as ‘ Snake Without The Tunnel’.
In 1979, new exchange rate regime arose with the establishment of the European Monetary System (EMS). This regime pledged the exchange rate stability for Europe. The exchange rate mechanism comprised 2 steps:
The application of mutual exchange rate bands between the member currencies came into force.
The application of an individual band (aka. central rate) for each of the members’ currencies vis-à-vis the European Currency Unit (ECU) came into force. ECU was a simulated currency or account currency derived from the technique of basket. ECU is weighting to the basket with respect to the members currencies.
After the establishment of EMS, the member countries assembled in Maastricht, in 1991 due to eliciting the European Monetary Union (EMU). Delors Report (1989) determined an outline of EMU and members embraced economic and monetary stability as an ultimate goal in Delors Report and they envisaged that these goals would apply gradually. These there stage plan stated by Delors (Braithwaite and Drahos, 2000),
‘If there is no stability there can be no monetary union. We as the anchor state need to solve our inflation first. Then dialogue is important and learning. That means you have to defend your case within the union. But against the shared objective of non-inflationary growth. They want union and the price is price stability policies (Bundesbank interview 1994).’
The tenets of EMU are clear: a low inflation rate, decreased government deficit, currency stability. After a bit, in 1991, EMU involved bank money named the Euro and it turned into real money on 1 January 2002, then the Euro became a single currency in the European Union (1 July 2002).
Question 5
(1) TL – Turkish Lira
In frame of economy, the real exchange rate has been expressed in a few ways, which are the modern and the traditional. According to conventional approach, Kirkpatrick and Diakosovvas (1990, p.14) defined the real exchange rate as “ the nominal exchange rate adjusted for changes in domestic and foreign prices.” Modern approach is defined, as the real exchange rate is corrected value of national currency vis-à-vis foreign currency with respect to purchasing power parity. Generally it is formulates as the following equation:#p#分页标题#e#
S? = S. (P/P*)
Where S? is the real exchange rate in indicator form, S is the index of nominal exchange rate, P is the indicator of national price level and P* is the index of foreign price level. For instance, the nominal exchange rate is at 2TL/1$ and its index of TL is at 100, whilst the Turkish and US index prices is at 100 as the beginning position. We assume that Turkish price index rises from 100 to 110 whilst the US index remains at the same level. According to this, the Turkish real exchange index of TL is at 110. It indicates that in second case, the real value of TL appreciates against to US dollar with respect to the beginning position (Table 1). Then, in third case, US price index rises at the same level with Turkish prices. But, the Turkish Lira depreciates, because of this; Turkey does not obtain the competitive advantage against to USA.
One of theories associated with the approach of foreign exchange rate is the purchasing power parity (hereafter PPP). According to this theory, two currencies exchanges at the current rate and these currencies could equate the two relevant domestic prices levels in the context of a common currency. Thus, These currencies have the same purchasing power in both economics. This rule is also known as the law of one price (LOP), which underlines the PPP. The LOP’s equation in the domestic economy is displayed as;
P = P* (1)
Where P and P*is the price of good in terms of the national currency and the foreign currency, respectively. And the LOP in the open economy (aka absolute version) is formulated as:
P = S . P* (2)
Where P indicates the price of good measured in terms of the national currency, P* is the price of traded good in terms of the foreign countries and S symbolises the nominal exchange rate stated as the domestic price of foreign currency. Furthermore, transactions cost can be included in equation (1) and (2).
Purchasing power parity as two different forms, which are absolute and relative, is derived from differently interpreted the LOP. Absolute PPP is based on a severe interpretation of the LOP theory. Basically, the price of good in a country compares the price of identical good sold in foreign country and foreign currency transformed by a common currency in order to compensating the prices. The its formula written as:
S = P / P*
Where S represents the exchange rate that defines as the national currency units per unit of foreign currency, P is the price of good expressed in the national currency and P* states the price of good expressed in the foreign country currency.
The relative PPP discusses that the exchange rate regulates by the countries’ inflation rate because of absolute PPP disregards the transaction cost, the trade tariff barriers and flawed information. The national prices levels are P and P. if we take logs, they will be p and p. That is states as:
s= p – p* (3)
From equation (3), we can see the real exchange rate, which is in case of logarithmic form:
q = s – p + p*
It exemplifies as if the price of bundle of goods is 200 TL in Turkey, the price of identical bundle of goods is 100$ in USA. And the exchange rate indicates as Turkish liras per dollar will be 200TL/100$ (2TL/1$). A fall in the value of Turkish bundle relative to foreign bundle will cause to increase the value of Turkish currency across Dollar. The price of Turkish bundle increase to 150TL whilst UK bundle stays the same price at 100$. According to absolute PPP the price of Turkish currency appreciates against dollar and the exchange rate will be 250TL/100$ (1.5TL/1$).
(2)
The best benchmark for testing the exchange rate movements is purchasing power parity. Real exchange rate shows the competitiveness of domestic goods and services against foreign goods and services. If PPP holds, the real exchange rate should be one that means a constant. It is formulated as follows:
??=?? × ,???-.
If PPP holds, then the value of Q should be one in principle. However changing the base of year for index leads the opportunity of arbitrage. For instance if the value of Q falls under one which means depreciated the real exchange rate, this situation leads to incentive the imported products for home country. A rise in the value of Q below one leads the adverse results. However, PPP completely holds and the external competitiveness of home country is steady in case of the value of Q equals to one (i.e., the constant real exchange rate).
(3)
One of the major problems is that it is not easy to decide and make a choice among both tradable and non-tradable goods to apply them theory. Although tradable goods seem to apply more easily to PPP theory, researchers suggest that applying non-tradable goods to PPP theory is unlikely or blurred. For instance, house rents differ in value from UK compared to USA (Pilbeam, 2006).
Another problem is related to the use of general prices index which is consist of both tradable and un tradable goods. For example, some un tradable goods which are included in GDP is not priced by authorises.
There is a problem about the weights of goods in basket. Since, while consumer prices in undeveloped countries have a low weighting for some goods (washing machine, computer and so on), the identical goods have a higher weighting in developed countries in terms of consumer prices.
Statistical problems for measuring PPP theory are the base country and the base period. If there are 3 and more countries to compare them, it is not easy to select the base country between them. Because selecting the base country affects other countries’ levels of development. Apart from the base country, PPP doesn’t measure every single year and price indices used for the estimations the base period vary by countries.
Question 6
(1)
The spot exchange rate is that the exchange rate is used for immediate currency procedures buyers or sellers. For example, if a person requires foreign currency, he/she can immediately find it by using currency exchange offices or financial institutions. The forward market is that buyers and sellers make a deal to exchange currencies in the certain future date. For example, a trader decides to buy foreign currency to make a payment for his foreign trader. The payment date is in the future. Trader may agree today to buy foreign currency at specific time in the future. The reasons of using forward exchange markets are:
Hedging from the fluctuations of spot exchange rate
Arbitrage opportunity
Firstly, hedgers use the forward exchange market to defend themselves against the fluctuations that are arising from exchange rate risk. An UK trader must to pay 10,000 € to French firm for three months later. The Spot rate is at €1=￡0.90, and the three month forward exchange rate is at €1=￡0.89. The UK trader should use the forward exchange rate instead of buying Euro currency at the spot rate. Since, if UK firm does not enter the forward exchange market and the spot rate will be at €1=￡0.95 at the end of three month, UK trader will pay 9,500 ￡ for 10,000 € at the spot rate instead of paying 8,900 ￡ at the forward exchange rate. The UK trader will make loss. Therefore, traders or firms might use the forward exchange rate to protect the spot exchange rate movements.
Secondly, the differences in the interest rates of the risk free assets with respect to countries lead arbitrage opportunity. Nevertheless, the main rule of arbitrage is that investments are made as risk free. This is also known as Forward premium or discount. Forward premium raises the interest rate differentials in the national currency of a country that has lower interest rate against to the national currency of another country that has higher interest rate. The higher level of interest rate in a country’s currency sells as a forward discount in the forward exchange rate market due to the interest rate differentials. In addition, if there are arbitrageurs in the market, the covered interest parity (CIP) condition holds and it calculates the forward exchange rate as following equation:
??= ,,??? ???.??-
Where
?? is forward exchange rate
?? is the spot exchange rate
?? is one year domestic interest rate
??? is one year foreign interest rate
If I apply data in the question to above-mentioned equation, forward exchange rate is at
??= ,(,0,02?0,03.0,9)/4-7 ￡
If the CIP associates with forward premium and discount, the equation of interest parity could be as follows:
r – r* = F-S / S
If apply data in question to this equation, forward exchange rate is at#p#分页标题#e#
0,03 - 0,02= F – 0,9 / 0,9
F = 0,91 ￡
At the same time, 0,91 ￡ is interest parity.
(2)
As Seyidoglu (2003) If the interest rate differences in main country is higher than the forward discount rate of its currency, this case directs capital flow to main country. Because investment in main country more profitable than foreign country. That is to say,
r(UK) – r*(euro) > F-S / S
According to above-mentioned case, arbitrageurs flow capital form euro zone to UK. If the forward rate is at €1=￡0.95 instead of 0,91 ￡ in our example, the equation is that,
r(UK) – r*(euro) > F-S / S
0,03 - 0,02 <> 0,95 – 0,9 / 0,9
0,01 < 0,05
In this case, the arbitrageurs direct the capital flow to the region of Euro zone. Because, whilst UK has the higher interest rate, investment in euro zone area is more profitable than UK. Similarly , if forward rate is lower than interest parity (0,91 ￡ ), arbitrageurs flow the capital to UK.
Question 7
Figure 1. Short run effects Figure 2. Long run adjustment
Note: Graphs took from the book of Krugman and Obstfeld (2003, p.458, 459)
Short run Effects of a permanent rise in the money supply
Initial equilibrium point is at 1 in Figure 1. A temporary increase in the money supply leads the AA schedule to shift rightward from AA1 to AA2. However money growth will become a permanent increase. Because, a permanent money growth influences the expected exchange rate for the future. To be more precise, a permanent increase in the money supply causes to comparatively escalate the expected future exchange rate. Thus, a temporary increase in the money supply becomes a permanent money growth thanks to the expected exchange rate. The new equilibrium point is in short run is point is at 2. Furthermore, if increasing in the money supply might end up as temporary instead of as permanent in spite of the expected future exchange rate, new equilibrium might be at point 3 in figure 1.
Long run adjustment to a permanent money growth
Short run equilibrium is at point 2. This permanent increase in the money supply boosts the level of output above its full-employment (Yf→Y2). Furthermore, the working hours of labour and machines increases at point 2. This situation creates upward pressure on the price level. Since, worker demands high earnings and overdoing machines lead to a rise cost of manufacture. Therefore, in an economic sense, manufacturers try to cover their costs by rising prices of products. Therefore, a rise in price level leads to lose the competiveness of domestic products against to foreign products. It denotes that imports increases and export decreases. For this reason, DD moves to leftward DD1 to DD2 in figure 2. Then, an increased price level causes to narrow the money supply because of this AA2 moves to leftward (AA2→AA3). The long run equilibrium takes place at point 3 in figure2. Exchange rate increases at the level of E3 with respect to beginning and output returns to its full-employment.
Moreover, first the domestic currency appreciated (E1 to E2), then exchange rate depreciated at a point that is between E1 and E2. This situation is a case of overshooting, which means changes in the short run exchange rate, is larger than long run reaction. To conclude, a permanent increase in the money supply leads to a rise the exchange rate while output is constant at its full employment.
Question 8
Figure 1. Macroeconomic policies and the Current Account
Note: Graphs took from the book of Krugman and Obstfeld ( 2003, p. 463)
As we known, increasing imbalance in the current account (it also indicates budget deficit and surplus) affects the macroeconomic parameters of country such as welfare, and inflation. An intensive imbalance in the current account augments to government limitations on trade. Because of this, that is very significant to know how monetary and fiscal policies affect the current account.
Figure 1 illustrates the impacts of these policies on the AA/DD schedule. However, apart from AA and DD curves, there is a XX schedule in figure. It illustrates the fusion of exchange rate and output. Moreover, the current account balance equals at intended level on XX schedule. It has upward slopes because of the expenditure of imports leads to worsen the current account due to a growth in output level. Besides, XX schedule is more leaning compared with DD. Because Krugman and Obstfeld (2003, p. 462) explains that “... net foreign demand—the current account—must rise sufficiently along DD as output rises to take up the slack left by domestic saving. Thus to the right of point 1, DD is above the XX curve, where CA > X; similar reasoning shows that to the left of point 1 DD lies below the XX curve (where CA < X) “.
In figure, the point 1 is the initial equilibrium point where every curves intercept. An increase in country’s money supply causes interest rates to fall and output level to rise. In parallel with decreasing interest rate, the rates of return on the domestic currency deposits decrease and the domestic currency depreciates. Therefore, AA schedule shifts up at point 2. This point is on the right hand side of XX schedule. This position indicates to improve the state of current account.
Lower taxes as a temporary fiscal expansion (it also results the widened government’s budget deficit) generally increase consumption expenditure, aggregate demand and output in equilibrium for every exchange rate. Therefore, DD schedule shifts rightward at point 3. This position of point 3 is situated on the left hand side of XX schedule. This case denotes the current account to deteriorate. A permanent fiscal expansion shifts the AA to leftward at point 4. Once again, this point is under the XX schedule. This case leads the current account balance to more worsen.
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