5.3 Consequences of a Current Account Surplus

Question 1

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

Answer 1

A country with a current account surplus is likely to have a trade surplus, as export revenue from goods and services exceeds import expenditure. This increases the value of (X-M) in the aggregate demand (AD) equation, causing AD to increase from AD1 to AD2. The increase in AD leads to an increase in actual growth from Y1 to Y2. With greater demand in the economy, firms respond by increasing output, utilizing spare capacity. As a result, real GDP increases, indicating an increase in economic growth.

Question 2

2. How does a current account surplus impact unemployment?

Answer 2

A current account surplus can lead to a decrease in unemployment. Labor is a derived demand, dependent on the demand for goods and services. When there is high demand for goods and services, firms require more workers to produce the additional output, leading to a reduction in unemployment rates.

Question 3

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

Answer 3

A current account surplus can contribute to an increase in demand-pull inflation. The surplus creates more pressure on existing factors of production, such as labor and resources, increasing their prices. This, in turn, translates into higher prices for goods and services in the economy, leading to an upward pressure on demand-pull inflation from P1 to P2.

Question 4

4. How does a current account surplus impact the exchange rate?

Answer 4

Current account surpluses put upward pressure on the exchange rate. As demand for the country’s currency exceeds supply, the exchange rate strengthens. A stronger exchange rate can be beneficial for a net importer, as it makes imports cheaper when purchased in foreign currency. For firms that import raw materials, lower production costs can lead to a decrease in cost-push inflationary pressures. However, for net exporters, a stronger exchange rate makes exports more expensive and imports cheaper. This can lead to a decrease in the demand for exports and a decrease in export revenue, potentially worsening the trade balance and canceling out the current account surplus.