Annex 2B


capital imports, foreign credits, other foreign capital transfers). If the value of imports
exceeds the exports, we have a current account deficit, and the demand for foreign currency
(to pay for imports) exceeds its supply (export earnings in foreign currencies exchanged .by
the exporters into local currency). In this situation, the price for foreign currency, hence the
exchange rate tends to rise (if it is allowed to do so), meaning a depreciation of the local
currency in relation to foreign currencies. As result of the increased exchange rate, the
domestic prices of importables as well as exportables will increase. In response to these price
changes, the demand for imported goods and overall imports are likely to go down, while the
production of exportables and the volume of exports are likely to increase. Both effects,
diminished imports and increased exports, tend to bring about a new equilibrium in the
market for foreign currencies and a balanced current account.

The condition for a halanpd current account, expressed in local currency, is given by the
following formula:

3) XQ.*P..= XQ.*P

where Qx/m stands for the quantity of export/import items, and Px/m,lc for the domestic prices
of tradables (determined by the world market price, local currency equivalents at current
exchange rate applied).

Using formula 1) above, the condition for a balanced current account can also be expressed in
foreign currency equivalents:

3a) Q *(P ER)= Q. *(P, ER)
 x.l -I

If both sides of the equation are not equal, we have a current account surplus (Left>Right), or
a current account deficit (L<R), and the market forces of supply of and demand for foreign
currency induce a change of the exchange rate which, in turn, leads to a change of the
domestic prices of tradables (world market prices unch ed). n.the case of a current
account surplus (L>R), the exchange rate would fall (appecia ii ot domestic currency),
and the domestic prices of tradables would fall accordingly. In response to these internal price
changes, the domestic production of tradables is likely to go down (see Box A-1 in Annex 1),
hence experts are likely to go down as well, while the imports will increase'(lower production
of importables is substituted by increased imports, and the effect on the production side is
compounded by increased demand due to lower prices, see Box A-2 in Annex 1). These
movements work towards re-establishing a balanced current account.

The same mechanism works, as already described, in the other direction in the case of a
current account deficit (L<R). If the exchange rate is free, the domestic prices of tradables
tends to rise, inducing increased production, increased exports and decreased imports. These
effects are expected from a currency devaluation, which plays a prominent role in many
adjustment programmes.

Formula 3a) points to a third important factor,(other than a fixed exchange rate and
insufficient domestic production of tradables), being responsible for an unbalanced supply


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