Global imbalances, current account rebalancing and exchange rate adjustments

Abstract

Global imbalances pose a serious question for academia and policy makers related to its formation, sustainability and correction. In this paper we analyze the required adjustments of exchange rates for rebalancing in current accounts. We set up a two-country two-sector model for the US-China with two asymmetries. First, we assume that the size of China initially is one third of the US but its size becomes half in the next 10 years. Second, we assume that China initially runs a net export surplus. Then we quantitatively study two adjustment scenarios. First scenario, called Slow Adjustment, assumes that in the process of growth, Chinese demand composition moves more towards domestic non-tradable sector. In this case, Chinese real exchange rate appreciates gradually and net export surplus decreases slowly. Second scenario, called Quick Adjustment, assumes that net export surplus against US goes to zero quickly in five years. In this case, net export adjustment happens quickly and real exchange rates in China appreciate at a higher rate. Even though, global imbalances are eliminated faster in the Quick Adjustment case, high real appreciation in China hurts importers in the US. A comparison in terms of output shows that Slow Adjustments is preferred for both countries.