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    relationship between the current account and budget deficits

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    Your hometown newspaper needs someone to write an informative article on large scale economic issues. The reporter who spoke with you before thinks of you, welcomes you home, and requests another article. Click here to view a summary of disaggregated data drawn from information provided on the 2000 U.S. balance of payments which is in the 2002 federal document, Economic Report of the President, available on the web.

    In addition to the balance of payments data presented above, the Bureau of Economic Analysis' document entitled, International Investment Position of the United States (http://www.bea.gov/bea/newsrel/intinvnewsrelease.htm) offers the following information.

    "At year-end 2002, the value of foreign investments in the United States exceeded the value of U.S. investments abroad by $2,387.2 billion (preliminary) with direct investment valued at current cost. At year-end 2001, foreign investments in the United States exceeded U.S. investments abroad by $1,979.9 billion (revised)."

    Write a 2-3 page article on the United States's current account deficit. The reporter will edit your material down to a usable length but asked for plenty of material with which to start. She requests that you answer the following questions:

    What has caused the U.S. run a merchandise trade deficit year after year since the early 1980s?
    Is the current account a deficit problem? Explain.
    Is the trend of the international investment position of the U.S. problematic? Why or why not?
    How is the current account related to a country's business cycle?
    What is the relationship between a country's net financial inflow and its current account?
    How does the U.S make adjustments for the balance of payment issues?
    Please submit your assignment.

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    Solution Preview

    Before you begin your paper, make sure you understand the background information presented. The balance of payments (or BOP) is a measure of the payments that flow into and out from a particular country from and to other countries. It is determined by a country's exports and imports of goods, services, and financial capital, as well as financial transfers. The current account of the balance of payments is the sum of the balance of trade (exports less imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). The current account balance is the difference between a country's savings and its investment. If the current account balance is positive, it measures the portion of a country's saving invested abroad; if negative, the portion of domestic investment financed by foreigners' savings. A current account surplus will increase a country's net foreign assets by the corresponding amount, and vice versa. A country's international investment position (IIP) is a financial statement setting out the value and composition of that country's external financial assets and liabilities. The IIP is one component of the country's balance of payments.

    Include in the first part of your paper such things as the adjustment process and the trend in the current account. In the later parts you can talk about the causes and whether it is a problem, and these are contentious issues and will require you to take a position.

    What happens when the US imports more than it exports? We could obtain the needed amount from the government. However, recall that under a truly flexible exchange rate regime, the central bank does not attempt to influence the exchange rate. The value of the currency is determined according to the supply and demand that prevails in the currency market. As a
    result, we can think of the central bank as not holding any foreign currency reserves under a flexible exchange rate regime. So, instead, individuals and firms will turn to the foreign exchange market to get their hands on foreign currency. As a result we would expect movement in the foreign exchange market: the demand for foreign currency would rise, and the dollar would depreciate.

    In the first table mentioned, data on trade in goods in current dollars are presented on a balance-of-payments (BOP) basis that reflects adjustments for timing, coverage, and valuation. The main point you should take away is that the United States consistently shows a positive current account balance imbalance, which over time amount to a ...

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