I noticed that this has become the subject of discussion so it thought it would be worth explaining what this entails.
In an open economy (ie one that has some degree of trade with the outside world), we can summarise the desirable economic goals as being the attainment of internal and external balance. Internal balance means a steady growth of the domestic economy consistent with a low unemployment rate. External balance is the achievement of a desired trade balance or desired international capital flows.
We assume that macroeconomic equilibrium requires equilibrium in three major sectors of the economy:
• Goods market equilibrium. The quantity of goods and services supplied is equal to the quantity demanded.
• Money market equilibrium. The quantity of money supplied is equal to the quantity demanded.
• Balance of payments equilibrium. The current account deficit is equal to the capital account surplus, so that the official settlements definition of the balance of payments equals zero.
These are all at the aggregate level. Production, Prices and the Balance of Payments are the three variables. Any fundamental imbalances will eventually be visible in these. If we witness volatility in exchange rates, inflation, interest rates or widespread shortages of goods these are all usually indicative of imbalances.
Keynes’s contribution to economic theory has been the central role he assigned to fiscal policy in stabilising output. Within the Keynesian framework, the fiscal deficit or a surplus is the most important balancing factor in the economy. This determines the levels of aggregate demand, income, prices, and eventually, in an open economy, of the balance of payments.
The means by which a budget deficit is financed, whether by borrowing, taxes or money printing (Central Bank credit) will determine the way in which this impacts the economy.
Fiscal deficits can cause fluctuations in inflation, interest rates (through increased levels of government borrowing) and exchange rates (thorough the current account deficit). Higher public debt which accumulates due to persistent deficits may create uncertainty around future tax policy. In addition to crowding out, fluctuations in these key macroeconomic variables increases economic uncertainty causing businesses and individuals to defer investment decisions.
The connection between fiscal and current accounts deficits is sometimes obscure. The Keynesian view is that a rise in the budget deficit will increase domestic absorption via import expansion, causing a current account deficit. This view seems supported by empirical evidence for Sri Lanka; for example Saleh, Nair & Agalewatte (2005), Chowdhury and Saleh (2008). Perera and Liyanage (2011) find empirical evidence for long run relationships between twin deficits in Sri Lanka1.
To explain the connection between the budget deficit and the balance of payments in simple terms see the figures below. Between 2019-2022 the government recruited an additional 250,000 people. Payments increased as follows:
What would these people have done with their salaries? They would have spent a proportion (the marginal propensity to consume or MPC) and saved some. Of what was spent, some would be on local goods, some of it on imported goods. Even some of the local goods (for example local biscuits) would include imported inputs - from the board/plastic used in the packaging to the wheat and sugar in the ingredients. The marginal propensity to import is as important a determinant of the results of a fiscal expansion as the MPC. This is how the budget deficit connects to the current account deficit. This phenomenon is sometimes termed the twin deficit hypothesis. Pay more salaries = larger deficit, cut taxes = larger deficit; do both and deficit becomes very large. Current account deficit follows suite.
Sri Lanka's ongoing crisis bears all the hallmarks of a serious disequilibrium, addressing this means revisiting the causes; closing the deficit and controlling the money supply. This causes a sharp contraction in the economy and hardship on the population which needs to be managed as far as possible, foreign grants and assistance in the form of food and humanitarian supplies would be one option for example.
The alternative to painful stabilisation is to continue to proceed on this path until it ends in a meltdown.
1Staff StudieS Central Bank of Sri lanka (2011) [online] Available at: https://www.cbsl.gov.lk/sites/default/files/cbslweb_documents/statistics/otherpub/StaffStudies_Vol_41_2011-min.pdf [Accessed 14 Jan. 2022].
No comments:
Post a Comment