Question

Until recently, China actively purchased US Treasury securities in order to limit the appreciation of its currency. (Currently it is losing foreign reserves). Explain what are the possible effects of this strategy on US interest arte and value of its own currency (i.e., appreciation or depreciation). Should the USA be worried about China suddenly deciding to sell its holdings of US treasury bonds? Why or why not? Do you agree? Why or why not? How do you explain the fact that since the financial crisis the US government budget deficit has exploded, yet at the same time the US Current Account deficit has actually decreased. What happened to the ‘twin deficits’ hypothesis?

Answer 1

According to Krugman, the USA should not be worried about China suddenly deciding to sell its holding of the US treasury bonds. While this move might depress the U.S dollar, the move is good for America as the value of U.S exports to China would grow steadily. With a low value of the dollar, the U.S exports will make their way to China which will improve the balance of payment. Yes, I agree, the effect on America would be small. As for China then Yuan would improve but the later will shift spending towards imports and America will spend more on the exports. China will, therefore, more of the U.S products which will boost the U.S exports.

Speaking of the U.S deficit, Krugman maintains that the budget doesn’t have to be balanced to put the country on a fiscally sustainable path. The deficit should be small enough that debt grows more slowly than the economy at any time. Krugman argues that the act of borrowing in US own currency and printing more money is unlikely to generate difficulties at the face of the high national debt. For this reason, the crisis of US government budget deficit explosion will not affect the economic growth.
While the US current account deficit has actually decreased, the US government deficit has exploded because of US government’s inability to raise as much money as it spends. Additionally, there is the issue of wealth and power inequality which has seen some members of the society become wealthy and some are still poor.
Speaking of the twin deficits hypothesis, there should a strong link between a national economy’s current account balance and the government budget balance. The twin deficit hypothesis has been reversed in the US because of a large federal deficit and equally a formidable trade deficit. Essentially, the deficit is good as it facilitates a rapid economic growth. The link between the national economy’s current account balance and the government budget balance is pretty wide because the increased government spending have reduced unemployment which has, in turn, boosted productivity resulting into an increased GDP
The increased GDP have led to an reduced current account deficit, but the government deficit haven’t reduced because of the increased government spending to boost the economic growth