Do High Interest Rates Improve or Worsen the Current Account?

Abstract

BackgroundConventional wisdom in Australia has been that high interest rates, through their impact on domestic demand, will reduce the current account deficit. However, a s interest rates were increased through 1988 and 1989, the current account deficit worsened rather than improved.Throughout this period the lack of success of the high interest rate policy in reducing the current account deficit has been blamed on extended lags between the tightening of monetary policy and the slowing of domestic demand. Blame has also been placed on the way in which monetary policy was tightened, by stealth rather than overt action. It is intriguing that the current account has only shown signs of improving after interest rates were eased.The view that higher interest rates were needed to stem an expanding current account deficit was held by most market economists and financial commentators. A June 1990 survey indicated that 55% of respondents believed that raising interest rates reduced the current account deficit. Only 27% of respondents thought that higher interest rates increased the current account deficit (see following chart).The following quotes from the Peasurer make clear the relationship he and many others expected to see between interest rates and the current account as interest rates were raised through 1988189:

External Debt and Liabilities: Evidence from a Cross Section of Countries*

“…&he opposite relationship is similar to that found by Bewley and White (1990) who showed a negative correlation between high real interest rates and current account performance. 7See for example Keamey and Monadjemi (1990).…”

“…The evidence with regard to fiscal policy is ambiguous. Pitchford (1992) and Bewley and White (1990) are clearly correct: monetary policy does not have any empirical effect upon the current account in our sample of OECD countries. This suggests that there is no basis for the use of restrictive monetary policy to target Australia's net external position.…”

“…we've had to reduce economic activity to hold down the current account and inflation . (1990) Quoted in Bewley and White (1990). of debt financing and against lending. He argues that these effects are magnified with higher rates of inflation.…”

Was Demand Growth Unsustainable in 1988/89?

“…The strength of the links between monetary policy, international capital movements and the exchange rate have grown with the world-wide trend toward financial deregulation and market innovation. Consistent with such an interpretation is the conclusion drawn by Bewley and White (1990) that high interest rates are more likely to increase rather than reduce the current account deficit. In other words the raising of interest rates is likely to have increased rather than reduced GNE relative to GDP during 1988/89.…”

International Linkages in Monetary Policy

“…However, the risk premium cannot be ignored because it is likely that it plays a significant role. Erb, Harvey and Viskanta (1994) consider the relationship between a country's credit rating and the interest rate paid on its bonds. Australia has the lowest credit rating and the highest average return on bonds amongst the countries in their sample, suggesting that there is a risk premium component in Australian interest rates.…”