• Some examples of the double-entry bookkeeping system can be helpful.

Case 1: Mr. A. Phile pays $65,000 in cash to Jaguar of U.K. for a new XJ8 convertible.

Jaguar deposits the dollars into its U.S. bank account. Current Account = -$65,000 [Imports

(debit)] Capital Account: = $65,000 [Jaguar has increased holdings of U.S. currency (credit)].

Case 2: Dell buys $15,000,000 worth of hard-disk drives from a South Korean company and

sells $25,000,000 worth of computers to another Korean company. Dell now has $10 million

that it lends to Daewoo, which is struggling to build cars. Current Account: $10,000,000

[Exports $25,000,000 (credit), Imports $15,000,000(debit)] Capital Account: - $10,000,000

[Increased loans to foreigners $10,000,000(debit)]

Case 3: I buy $10,000 worth of shares of MushyPeas-R-Us by borrowing money from a British

broker. Capital Account $0 [U.S. Purchase of Foreign Asset $10,000 (debit), Foreign loan to

U.S. resident $10,000 (credit)]

The Solutions for improving current account deficit

1. Slowdown Consumer Spending.

The best way to reduce imports is to reduce consumer spending and boost the savings ratio. The Government could increase taxes and reduce government spending (deflationary fiscal policy). This will reduce consumer spending. This will be effective in reducing the current account deficit because the UK has a high propensity to import. (about 40% goes on imports)

However, to reduce consumer spending will cause a fall in economic growth and higher unemployment. So it is rather a drastic policy.

The government may not need to reduce consumer spending as the economy is predicted to slowdown in 2008. This slowdown should reduce the current account deficit.

2. Boost Productivity.

In the Long term the government could try and increase the productivity of industry. This will enable UK exports to become more competitive helping to increase exports and reduce the attractiveness of imports. To increase productivity the government can implement supply side policies such as:

1.      Better education and training

2.      Privatisation

3.      Investment in transport / infrastructure

Of course supply side policies are easier to say than do. Every government will say they are trying to increase productivity. But, in reality there is only so much government policy can do to increase productivity of industry. Even successful supply side policies will take a long time to have any effect.

3. Devaluation.

The obvious solution for a current account deficit is to devalue the currency. This makes UK exports cheaper and imports more expensive. This should improve the current account deficit.

However,

How exactly does the government devalue the exchange rate? The exchange rate is determined by market forces not the government. True the government could sell pound reserves, but, this is only a fraction of the market these day. Lower interest rates would weaken the currency. But, interest rates are set by the MPC and their target is inflation not the current account deficit.

Furthermore demand for UK exports has become more inelastic therefore the boost in export value may be quite limited.

Present the mechanisms of the Covered Interest Arbitrage when interest rate differential does not equal the forward premium or discount?

                                                              i.      This is the movement of short-term funds between countries to take advantage of interest differentials with exchange risk covered by forward contracts.

                                                            ii.      These activities lead to equilibrium, i.e. interest rate parity. 

                                                          iii.      This arbitrage leads to four tendencies:

1.      The spot rate of currency one against currency two will tend to appreciate as investors buy currency one against currency two.

2.      The forward rate of currency one against currency two will tend to depreciate as investors sell currency one against currency two.

3.      Interest rates will tend to rise in country two as investors borrow currency two.

4.      Interest rates will tend to fall in country one as investors borrow currency one.