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Current Account and Foreign Liabilities

Economics (Year 12) - Foreign Investment

Christian Bien

What is the Relationship Between the Current Account and Foreign Liabilities?

There is an indirect relationship between the current account and foreign liabilities. An increase the foreign liabilities will decrease the current account balance. An increase in foreign liabilities will increase the servicing cost of foreign investment, i.e. increase the current account deficit, mainly in the form of income debits as the foreign investment will require the repayment of interest and dividends to overseas residents.

Effect on the Current Account on the Trade Balance

Short-Run Effect

An initial increase in foreign investment is mainly used to finance capital expenditure. As most capital is imported, imports will increase positioning the trade balance towards a deficit. In addition, the increased foreign investment will increase demand for the currency, appreciating the currency and positioning the trade balance further towards a deficit.

Long-Run Effect

Once expenditure on capital imports have matured, the output of exports will increase. An increase in the quantity of exports will increase export values positioning the trade balance towards a surplus.

J-Curve Model

A J-Curve model can be used to show the effect of increased foreign liabilities on the trade balance, as described in the above section on the short and long-term effects. The J-Curve model is shown above. The J-Curve model shows the initially the trade balance will be below 0, positioned in a deficit in the short run as increased foreign liabilities will increase expenditure on imported capital and appreciate the currency. However, in the long run, the trade balance will be positive, positioned towards a trade surplus as export quantities increase.

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