Working Paper: NBER ID: w2424
Authors: Paul Krugman
Abstract: There is a widespread view that world payments imbalances can be remedied through increased demand in surplus countries and reduced demand in deficit countries, without any need for real exchange rate changes. In fact shifts in demand and real exchange rate adjustment are necessary couplets, not substitutes. The essential reason for this complementarity is that a much higher fraction of a marginal dollar of US than of foreign spending falls on US output. As a result, a redistribution of world spending away from the US leads to an excess supply of US goods unless accompanied by a decline in their relative price. Although some economists believe that the integration of world capital markets somehow eliminates this problem, this is a fallacy that confuses accounting identities with behavior. The paper also addresses a number of relates issues, such as the role of budget deficits in determining domestic demand and the effectiveness of nominal exchange rates changes in producing real depreciation.
Keywords: current account; fiscal policy; real exchange rate; nominal exchange rate
JEL Codes: F32; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal policy (E62) | Current account balance (F32) |
| Budget deficit (H62) | National savings (E21) |
| National savings (E21) | Real interest rates (E43) |
| Real interest rates (E43) | Real appreciation of the dollar (F31) |
| Real appreciation of the dollar (F31) | Trade deficit (F14) |
| Real exchange rate changes (F31) | Balance of payments adjustment (F32) |
| Decline in U.S. demand for goods (F61) | Excess supply (J20) |
| Excess supply (J20) | Need for real depreciation (D25) |