RDP 9001: Is Pitchford Right? Current Account Adjustment, Exchange Rate Dynamics and Macroeconomic Policy 5. Conclusions

This paper has used a simple model of current account and exchange rate determination to ask two questions:

1. Following a permanent adverse shock, will a current account deficit eventually correct itself, even when the real exchange rate is slow to adjust ?
2. In the event of this slow adjustment, can macroeconomic policy improve allocative efficiency and hence social welfare ?

The answer to both of these questions is an unequivocal yes. The results of this paper should not, however, be interpreted as offering precise predictions on either how long the process of current account adjustment will take, or the costs of inefficient adjustment. Rather, the paper offers qualitative results that seem to be both realistic and robust to changes in both behaviourial and institutional assumptions.

Of course, more research needs to be done on this important subject, and the analysis of this paper can be usefully extended in a number of ways. One way would be to add a monetary sector to the model, and to examine how any inefficiencies in the determination of nominal exchange rates affect the adjustment path for the real exchange rate, and hence the current account. This could be of major consequence, since there is ample evidence to suggest that these inefficiencies have played a significant part in hindering the adjustment mechanism (Krugman 1989).

A current account deficit is fundamentally a consequence of aggregate demand exceeding aggregate supply. This paper has highlighted the means by which demand can be reduced to meet a given supply, but this is only half the story. One might just as well examine the means by which supply can be increased to meet a given demand. The introduction of a supply side would enable an analysis of the effects on the current account of different kinds of price rigidities e.g. in the product and labour markets.

A third extension worthy of consideration would be to introduce a non-traded good into the model. The ease with which resources can be transferred between sectors of an economy may well turn out to be the most important factor of all in determining the pace and cost of the current account adjustment process.