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This chapter addresses the nonlinear models of current account adjustment for the G7 countries. For most of the G7 countries, significant evidence of threshold effects in current account adjustment is observed. Statistically significant increases in exchange rate volatility during current account deficit adjustment regimes for the United States, Japan, and Germany are found. Additionally, it shows that compared to other G7 countries, the United States over the sample exhibited relatively wide thresholds within which current account adjustment is absent and relatively slow speeds of adjustment once these thresholds, especially the deficit threshold, are crossed. The U.S. current account deficit is in part an endogenous, general equilibrium outcome of global financial and macroeconomic integration. Moreover, it identifies a tendency toward G7 exchange rate depreciation during current account deficit regimes and exchange rate appreciation during current account surplus regimes.

This chapter investigates the episodes of current account adjustment in industrial countries. The data support the claims that the size of the current account deficit and the extent to which it is financing consumption matter for adjustment. Larger deficits take longer to resolve and are linked with relatively slower income growth during recovery. There is no evidence that the growth in the fiscal balance influences gross domestic product (GDP) growth relative to long-run average. There is a strong inverse correlation between the extent of exchange rate adjustment and the slowdown in GDP growth. Financing does not significantly matter for the adjustment process, indicating that markets are efficient at intermediating funds. The status of the dollar as the reserve currency has crucial implications for adjustment. Deficits driven by investment growth are more benign in terms of exchange rate adjustment than deficits driven by consumption or fiscal spending.

This chapter reveals that when one takes into account the global equilibrium ramifications of an unwinding of the U.S. current account deficit, currently running at nearly 6 percent of gross domestic product (GDP), the potential adjustment of the dollar becomes considerably larger than estimates from previous papers. U.S. current account adjustment entails a larger potential decline in the dollar. It is assumed that labor and capital cannot move freely across sectors in the short run. The model indicates that the U.S. nontraded-goods productivity boom could help explain the widening of the U.S. current account deficit. The exchange rate effects may be massive when U.S. current account adjustment comes. Moreover, further deepening of global capital markets may postpone the day of reckoning.

This chapter employs a sophisticated new open economy multicountry simulation model to examine different scenarios for global current account adjustment. The analysis indicates that competition-friendly structural policies could play a prominent role in reducing current account imbalances on a sustainable basis if they were linked with a sustained increase in growth and a permanent downward shift in the net foreign asset positions of Europe and Japan. Japan and the euro area are relatively stable in terms of adjustment. US fiscal consolidation would not be obtained without some short-run costs for output growth. Europe and Japan could meaningfully add to the multilateral adjustment process through stronger pursuit of growth-enhancing structural reforms that align with their own national interests. Labor market reforms alone might not significantly contribute to rebalancing.

Chapter 4 reviews how Japanese authorities managed the flexible exchange rate for the yen in response to external and domestic developments. In particular, the chapter discusses policy actions taken during the currency crises of 1971 and 1973, the oil crises of 1973–4 and 1979–80, and the international policy coordination attempts of 1978 and 1985–7, explaining how authorities used capital controls, market intervention, monetary and fiscal policies, and other measures to manage the yen–dollar exchange rate. The concluding section reviews the academic debate that has since ensued about the impact of exchange rate changes on current account and price adjustments and assesses the economic consequences of Japan’s policy stance that, in retrospect, subordinated domestic objectives to external considerations

Euro area countries have witnessed significant differences in developments in international price-cost competitiveness since the launch of the euro. Also as a result of it, external accounts have differed to a large extent, creating country heterogeneities in the run-up to the 2008 financial crisis. This chapter investigates the sources of external imbalances in the euro area countries and studies with the help of a GVAR model the implications of competitiveness adjustment. The degree of improvement in price-cost competitiveness is assessed under three different types of shocks: a decrease in nominal wages, a negative shock to prices and an increase in labour productivity. Overall, the results show that a decrease in wages leads to some short-term improvement in the external accounts. The positive supply shock decreasing price levels also leads to some medium-term improvement in the trade balance. Finally, the productivity shock is less powerful on net exports as the resulting improvement in GDP creates income effects that imply higher imports. Although the impact of these shocks tends to have the expected sign on external balances, their size is small, implying that to get large, significant effects, these shocks would have to be relatively large.