SPYKE_JOE said:
What would your response consist of?
1. Explain the relationship between net income in the currenct account & the capital financial account. (3 marks)
2. Explain 2 ways through which a sustained increase in the current account deficit could affect an economy. (4 marks)
for question 2 would it be write to say:
Positive effect: increased CAD leads to increased investment leading to reduced supply/capacity constraint leading to increasedAD leading to increased eco growth.
Negative effect: contiuned borrowing leading to increased KAS leading to a further cad, due to debt cycle?
1. CAD is initially caused by a trade deficit, the economy borrows to cover the deficit through the form of finance and investment (we're basically borrowing money or selling our own assets). Finance and investment has to be repaid with interest which forms under net income. If the trade deficit contines, there will be more finance and investment, resulting in more negatives in net income. The cycle repeats, it is called a vicious debt trap.
2. I don't think there are any benefits of having a CAD.
Way 1. We put ourselves in a debt cycle, thus more and more income is diverted from the circular flow of income to other economies. Which basically means a reduction in GDP growth, I am sure you can list all the effects of that
. Sub-Saharan economies experience this a lot.
Way 2. A really high CAD would mean you're sitting on dynamite, with foreign investors waving a flaming torch all over the place. The moment these investors sees negative signs, they pull out all theirs assets, since 60% of Australia is owned by foreigners, its like a economic nuclear bomb going off. There is an effect caued the 'golden straight jacket' (one of the journals from UNSW eco department), it means that investors would only channel funds in to the economy on if the government agrees on certain conditions (e.g. fiscal balance or surplus). THis basically removes some sovereignty from the government and places it in the hands of the investors.
These are from my eco notes:
Over time, when trade deficit increase and net payments overseas increase, the Australian dollar would fall as more $A are flooded into the international market. Under law of supply, as more goods on the market, price drops. This is due to the loss of confidence amongst investors from investing into a heavily indebted economy, capital inflow will only stay the same if they are compensated for greater risks by holding financial assets in return for CAD, so unless domestic interest rate rise, they will not be willing to purchase Australian interest bearing assets as same quantities before.
There's a few points in there, just take your pick.
