Question

Some people recommend that the United States impose restrictions on imports in order to reduce its current account deficit. When is this approach likely to be effective? Explain your answer in terms of the national income identity CA = (Sp – I) + (T – G).

Answer 1

Current account balance (CA) = (Private saving - Investment) + (Tax revenue - Government spending), i.e.

CA = Private saving - Investment + Budget surplus

CA = National saving - Investment, where National saving = Private saving + Budget surplus (Public saving)

When import restrictions are imposed, CA surplus will increase (or CA deficit will decrease) (since CA balance includes trade balance which equals exports minus imports). From above relationships, it is seen that CA balance will improve if

(i) Private saving increases, and/or

(ii) Investment decreases, and/or

(iii) Tax revenue increases, and/or

(iv) Government spending decreases.

Conditions (i) and (ii) will be simultaneously satisfied if there is an increase in interest rate, for example, as result of contractionary monetary policy. Conditions (iii) and (iv) will be simultaneously satisfied if government adopts contractionary fiscal policy.