JC Economics Essay Series #97 – Capital Account Deficit & Exchange-Rate Centred Monetary Policy

JC Econs Essay Capital Account Deficit & Exchange-Rate Centred Monetary Policy Model Answers 

In Singapore, her balance of payments is split into Current Account Balance, Capital and Financial Account Balance (aka Capital Account) and (Foreign) Reserve Assets Account.
Source: Department of Statistics of Singapore

USA remains the main source of inflow of investments into S’pore, in particular, Foreign Direct Investments, or FDI (aka long term capital flows).


(a) Explain the causes of a persistent and large balance of payments deficit. [10]
(b) Assess the view that the government of a country should always adopt an exchange rate centred monetary policy to focus primarily at reducing the BOP deficit. [15]


Balance of Payments Deficit – Current Account & Capital & Financial Account Deficits

Part (a)
Explain – Detailed economic analysis showing clear causal links

Key words:
BOP – includes both current and capital accounts

Causes reasons, both and Internal and external, why a BOP deficit might arise and why the end result is a persistent and large deficit

BOP: causes of a large and persistent deficit

Current Account
Cyclical factors: recession / GDP of trading partners; Inflation rate exceeds that of trading partners / competitors

Structural factors: loss of CA, overvalued ER

Capital account
Expected rate of return on Investments;
Relative Interest rate

Full Length Model Answer:

A persistent deficit in the BOP can be caused by problems in the current account &/or capital account and can be due to the following factors:

Loss of Comparative Advantage: a country loses comparative advantage with respect to other competitors due to Improved efficiency of competitors or a decrease of internal efficiency. As a result, exports are likely to fall leading to trade deficit (current) account) E.g. due to higher labour cost, many developed countries lost their comparative advantage in labour-intensive manufactured goods (such as textile and toys) to the low-cost developing countries (e.g. China and Vietnam). Thus, these developed countries experienced a fall in export earnings and rise in import expenditure on these goods resulting in a current account deficit.


An over-valued exchange rate: it can be argued that trade problems stem from the exchange rate being set at too high a level. They argue that the persistent deficit in the US BOP is caused by an overvaluation of the US dollars against the Asian currencies such as China and Japan. The strength of the US dollar in recent years has made life difficult for US exporters in overseas markets, while encouraging imports. With the current weakening of the US dollar, US exports have been doing better.


Rising domestic national Income: A rising income may lead to higher demand for imports. The extent of the rise in imports due to a rise in the level of domestic income depends on the marginal propensity to Import. At the same time, a rising domestic Income may lead to higher aggregate demand and hence higher demand pull inflation.


Relative rates of Inflation between trading partners: consumers in a country with a higher domestic inflation relative to its trading partners will find its domestic goods relatively more expensive compared to imported goods. Thus, consumers will switch from domestic goods to imported goods. At the same time, its exported goods will be more expensive than its trading rivals and hence there will be a fall in quantity demanded for its exports. Assuming that the demand for its exports is price elastic, quantity demanded will fall more than proportionate to the price rise, thus causing its export revenue to fall. With a rise in imports and fall in exports, the country’s current account may be in deficit.


Falling Income of trading partners: a slowdown in the national income of trading partners may reduce the demand for the country’s exports, E.g. the recent economic downturn of the global economy caused Singapore’s exports to fall.


Level of Interest rate: if a country’s interest rate is relatively lower then foreign countries Interest rate, this will lead to a capital outflow as foreigners will withdraw their funds from the domestic banks and park it in foreign banks with a relatively higher interest rate to earn a higher interest return. This will cause the capital account to go into deficit and ,ceteris paribus, the overall BOP will deteriorate.


Fall In expected returns on Investment: with a fall in expected returns on investment due to factors such as rising cost of capital. fall in national income and political Instability, there will be a fall in foreign direct investment into a country and hence its capital account may worsen to a deficit. E.g. due to political instability in Indonesia triggered by the Asian currency crisis, many Indonesian firms left Indonesia and invested in Singapore and other countries.


Expected fall in external value of money: a country’s capital account may be in deficit due to hot money outflow caused by an expected fall in external value of money. E.g. during the Asian currency crisis in 1997, speculators expect the Aslan currencies to depreciate hence leading to outflow of hot money from Asia. This caused the capital account and BOP of many Asian countries such as Thailand and Indonesia to fall into deficit.


A persistent deficit is a concern as it reflects structural problems of the economy. For example, a country which has chronic inflation (which may be caused by rigid labour markets due to powerful labour unions) may lose international competitiveness in its exported goods resulting in a persistent bop deficit which is a permanent and serious problem. In addition, it is a concern when countries (e.g. Greece and USA) experiences persistent BOP deficit due to excessive spending by both the government (deficit spending) and by the private sector (low private savings rate). Should these problems be allowed to continue and macroeconomic policies are not appropriately applied. consequences on the economy are dire following the Inevitable depletion of a country’s reserves.



Exchange-Rate Centred Monetary Policy & BOP Deficit

Part (b)
(Recommended to be done as a Written Exercise)

1. Command word: Assess examine the validity of the reasoning that underlies a particular point of view. Stress relative importance of the different arguments and their relevance to the basic issue under

2. Key words:
Should always adopt ER policy…focus primarily reducing BOP deficit – reasons to use ER policy as a primary tool to
reduce a BOP deficit.


Thesis: The government should always adopt an exchange rate centred monetary policy to focus primarily at reducing the BOP deficit.

(Benefits of having healthy BOR & consequences of BOP deficit)
BOP equilibrium is desirable because…

It also ensures a more stable exchange rate of the country’s currency which is necessary to promote…


(Explain how devaluation works to correct BOP deficit)
Devaluation involves… 

The success of this policy in removing a deficit therefore depends on the elasticities of demand for exports and imports…

When a currency is devalued…, rise in export revenue, …, a fall in import expenditure, …lessen the BOP deficit…

Assuming that the demand from exports and imports are both price elastic, this results in a rise in export earnings and…



Antithesis: The government should NOT always adopt an exchange rate policy to focus primarily at reducing the BOP deficit.

Limitations of ER and circumstances where ER may not be appropriate…
Eg: Hence the effectiveness of this exchange rate policy depends on the importance of these elasticities of demand which is generalized in the Marshall-Lerner condition. This condition states that devaluation will lead…

Eg: However, elasticity conditions are unlikely to be favorable in the short run: It takes time for people…
The result is that devaluation Initially leads to an Increased BOP deficit. (J-Curve effect)…
However, over time, demand for exports and Imports is much more elastic as patterns of consumption and investment flows change in response to the price changes brought about by the devaluation…

Also this policy may be only suitable for economies whose cause of the deficit is that of an overvalued currency. Furthermore, devaluation may lead competitive devaluation (retaliation) rendering the intended results of the policy unsustainable

ER should be focused on other macro aims…

Conflicts with other objectives…


If the cause of the BOP deficit is, … contrationary FP and/or MP (aka Expenditure – Reducing Policies) which are more suitable and this should be tailored according to the needs of the economy.

If the cause of the deficit is dd pull Inflation, then deflating the level of aggregate demand works in two ways…

If the cause of the BOP deficit is, … SSP, … it is effective In lowering costs, Increasing the quality of goods and making exports more competitive abroad.

The government can also boost exports by providing Information on trade possibilities abroad to the export Industries. However, this is a long term solution.

Depending on state of economy,
Depending on the root cause of deficit,
Depending on economic priority,


While the BOP macro alm is an important macro aim especially for countries which are highly trade reliant, there are other macro aims which may be competing for the use of the exchange rate policy. Hence the primary target of an exchange rate policy, if it is used at all, should not just be the BOP aim. A case in point is the Singapore economy.


ER should not always be adopted to focus primarily on BOP deficit.
Other policies may be more appropriate in addressing the root cause of the BOP deficit.
If deficit is not persistent and large, the government might wish to utilize ER policy to achieve other macro aims instead of focusing it on BOP.

Eg: In summary, the government should not always adopt exchange rate policy to deal with a BOP deficit and even if such a policy is adopted, its primary focus may change depending on the state of the economy and the relative severity of concurrent macroeconomic problems like inflation vs BOP deficit.