Is Pitchford Right? Current Account Adjustment, Exchange Rate Dynamics and Macroeconomic Policy

The recent debate on Australia’s current account imbalance has focused on two issue: whether the dynamics of current account deficits and debt accumulation are leading to a “debt trap”, and what role (if any) should public policy play in altering the current account outcome. In this paper, I develop a simple theoretical model of current account and exchange rate determination to examine these issues. I find that a debt trap, meaning a situation where the income available for repayment of the debt is lower than the interest on the debt, can exist in only the most implausible of circumstances. Therefore, a current account deficit can be expected to eventually correct itself without policy intervention. However, the conclusion that non-intervention is the optimal policy depends on the assumption that the real exchange rate adjusts continuously to equate actual and desired savings. When the real exchange rate is slow to adjust to its equilibrium value, social welfare will be increased by a fiscal policy that alters the dynamic path of the current account.