Answer to Question #298151 in Macroeconomics for tegegne

Question

Consider a country with a flexible exchange rate, and which initially has a current account surplus of zero. Then, suppose there is anticipated increase in future total factor productivity. (a) Determine the equilibrium effects on the domestic economy in the case where there are no capital controls. In particular, show that there will be a current account deficit when firms and consumers anticipate the increase in future total factor productivity. (b) Now, suppose that the government dislikes current account deficits, and that it imposes capital controls in an attempt to reduce the current account deficit. With the anticipated increase in future total factor productivity, what will be the equilibrium effects on the economy? Do the capital controls have the desired effect on the current account deficit? Do capital controls dampen the effects of the shock to the economy on output and the exchange rate? Are capital controls sound macroeconomic policy in this context? Why or why not

Answer 1

A) When forms are anticipating an increase in the cost of production in the future and consumers are expecting that the prices of the commodities will also increase due to the increase in the cost of production, producers will tend to produce more in the moment and hence using more and more factors of production while consumers will tend to buy and hold the products so that they can use it when the prices increases. This will eventually cause a deficit in the current account.

B) Capital controls will stabilize the current account deficit though they are associated with other worse effects in the economy like inflation. Therefore capital controls are a sound macroeconomic policy for this case as they are most suitable for countries with lower income.