(15 points) When countries have severe balance of payments difficulties caused b
ID: 1147195 • Letter: #
Question
(15 points) When countries have severe balance of payments difficulties caused by unsustainable current account deficits, they can approach the International Monetary Fund (IMF) for assistance. In providing financial assistance, the IMF generally insists that the country implement a series of policy changes designed to reduce the deficit. These programs are controversial as they tend to focus on demand reduction. Explain why demand reduction would solve a current account deficit problem. Would a program designed to increase the nation's GDP growth rate be a method of reducing a current account deficit? Why or why not?Explanation / Answer
Demand reduction solves the problem of Current account deficit, because as evident from the massive deficit in the Country's current account, it is the excessive demand of foreign goods and not the demand of domestic goods is the major component of domestic consumption. Thus, a control on consumption of foreign goods in the domestic market will certainly helping in improving the current account situation in the domestic economy.
A program designed to increase nation's GDP will aim at reducing current account deficit because increasing GDP would require increase in aggregate investment, which could only be possible if there is increase in savings in the economy. For savings to increase, there has to be reduced consumption, which in this case will be possible through reduced consumption of foreign goods. Reduced consumption of foreign goods will ultimately lead to reduced current account deficit.
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