5.2 Consequences of a Current Account Deficit

Question 1

1. What happens when a country has a current account deficit?

Answer 1

A country with a current account deficit is likely to have a trade deficit, as import expenditure on goods and services exceeds export revenue. This reduces the value of (X-M) in the AD equation, causing a decrease in aggregate demand (AD) from AD1 to AD2. The fall in AD leads to a decrease in real GDP and a reduction in economic growth.

Question 2

2. What is the impact of a current account deficit on unemployment?

Answer 2

A current account deficit can lead to an increase in unemployment. Labour demand is derived from the demand for goods and services produced by firms. When a country has a current account deficit, firms may lay off workers to reduce costs and remain profitable, resulting in higher unemployment rates.

Question 3

3. How does a current account deficit affect demand-pull inflation?

Answer 3

A current account deficit can decrease demand-pull inflation. With a deficit, there is less pressure and competition for existing factors of production, reducing their prices or the rate of price growth. This feeds through to lower prices or a lower rate of price increases in the economy, causing a decrease in demand-pull inflation from P1 to P2.

Question 4

4. What is one way countries can balance a current account deficit?

Answer 4

Countries with a current account deficit can balance it by running an equal value financial account surplus. One way to achieve this is by borrowing from international investors. However, relying on external debt in the long term can lead to a loss of investor confidence. If investors stop buying debt and move their investments to safer countries, the supply of the currency increases, weakening the exchange rate. This can trigger a currency crisis and widespread economic crisis, known as a consequence of a large, persistent, and borrowing-financed current account deficit.

Question 5

5. How does a current account deficit affect the exchange rate?

Answer 5

A current account deficit puts downward pressure on the exchange rate. The increased supply of the currency exceeds the demand, resulting in a weaker exchange rate. For a net exporter, this weaker exchange rate can be beneficial, as exports become cheaper and imports become dearer. The demand for imports and expenditure on imports are expected to decrease, while the demand for exports and export revenue increase, improving the trade balance and rectifying the current account deficit. However, for a net importer, a weak exchange rate due to a current account deficit can be dangerous. It makes imports dearer when bought in foreign currency, increasing production costs and potentially leading to higher cost-push inflation, lower economic growth, and the risk of recession or stagflation (reducing growth with higher-than-target inflation).

Question 6

1. Evaluation: What are the considerations regarding the cause of a current account deficit?

Answer 6

The cause of a current account deficit plays a crucial role in evaluating its impact on an economy. If the deficit is caused by excessive consumption and the “sucking in of imports” effect, it may indicate a healthy growing economy where imports contribute to higher living standards. In such cases, financing the deficit may not be a major concern. Additionally, as economic cycles naturally reduce income levels, the expenditure on imports tends to decrease. However, if the deficit arises from underlying structural weaknesses (e.g., low productivity, poor investment, high relative inflation), it becomes long-term, persistent, and dangerous. In such cases, the economy must keep borrowing to finance the deficit, which is unsustainable and can lead to a currency crisis over time. Addressing structural causes of a deficit requires supply-side policies, which are costly, time-consuming, and offer no guarantee of success. Therefore, structural causes are a greater concern and more difficult to solve.

Question 7

2. Evaluation: How does the size of a current account deficit impact its sustainability?

Answer 7

The size of a current account deficit is a crucial factor in assessing its sustainability. A small deficit is unlikely to be challenging to finance, especially if the GDP growth rates outpace the deficit. This suggests that the country can afford the borrowing needed to finance the deficit without facing the risk of a long-term currency crisis. Additionally, the negative impacts on aggregate demand (AD) are unlikely to be significant in the case of a small deficit. However, if the deficit grows rapidly, surpassing the growth rate of real GDP, it becomes unsustainable and indicates a debt dependency. In such cases, the negative consequences of running a current account deficit become much more significant and raise concerns about long-term stability.

Question 8

Draw the Diagram too

Why does a current account deficit lead to changes in the exchange rates?

Answer 8

• The current account of the balance of payments comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers. A deficit is usually the result of an increasing net trade deficit where the value of imports exceeds the value of exports i.e. M>X.
• As a result, there will be a net outflow of money from a country’s circular flow. Households and businesses pay for imports in their own currency, but this is eventually converted into the currency of the exporting nation.
• Hence, a rising current account deficit leads to an increased supply of a nation’s currency in the foreign exchange markets.
  Therefore, in the currency market there will be an outward shift of supply. This - ceteris paribus - might lead to the external value of the currency falling. In a free-floating system, this is called a
  depreciation.

Question 9

Evaluation points for a current account deficit causing a depreciaiton in the value of the currency?

Answer 9

• Many factors influence the exchange rate - not just the trade and current account balance
• There might have been capital inflows coming into a country which increases currency demand and therefore causes the exchange rate to appreciate
• The central bank may opt for a managed floating system and intervene if they want to slow down a currency depreciation