2.5 The Balance Of Payments

Question 1

What are the consequences of a CA deficit? Pt1

Answer 1

1) downward pressure on the exchange rate - caused by a fall in demand for the domestic currency as well as an increase in the demand for foreign currency, since imports are greater than exports
2) reduced foreign exchange reserves - this is a problem since central bank hold foreign reserves to maintain the exchange rate
3) increased foreign ownership of domestic assets - CA deficit needs to be offset by a financial account surplus, this means in the future, further outflows of income from the domestic assets, this may increase the CA deficit in the future

Question 2

What are the consequences of a CA deficit? Pt2

Answer 2

4) loss of domestic sovereignty, if there is increasing foreign influence on decisions in the domestic economy, e.g China in west Africa
5) possible increase in foreign indebtedness - due to increased foreign borrowing. This could lead to increasing costs of external debt servicing
6) negative impact on international credit rating, due to a possible increase in perceived risks and uncertainty for creditors

Question 3

What does the significance of the CA (deficit or surplus) depend on ? Pt1

Answer 3

• the size of the CA deficit or surplus: the larger the deficit, the larger the outflow of income from the domestic economy, which could have been spent on G/S produced in the domestic economy, additionally the larger the deficit the more international borrowing may be required to finance the deficit
• duration - how long the CA imbalance persists for: in the short term, a CA deficit may be a sign of rising living standards, however in the long run it may reflect a lack of international competitiveness
• the cause of the CA imbalance: structural weakness and a lack of price-competitiveness possibly due to low productivity growth are likely to be far more damaging to an economy since there will be a decrease in SRAS causing inflationary pressure, however if the deficit is due to importing capital goods this can increase productive capacity in the long run, possibly increase competitiveness and correct the CA deficit over time.