💲 A high exchange rate
When a currency appreciates, exports become more expensive for foreign buyers and imports become cheaper for home buyers. Export sales fall and import purchases rise, so the balance moves towards deficit.
Current Account of the Balance of Payments » Current Account Deficits and Surpluses
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 6.4.2, 6.4.3
- The main reasons a country has a current account deficit or surplus
- How a deficit and a surplus affect GDP, employment and inflation
- How a deficit and a surplus affect the foreign exchange rate
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Unlock This CourseWhy do deficits and surpluses happen?
Remember from The Current Account that a deficit means more money flows out of a country than flows in, and a surplus means more flows in than out. Trade in goods and services is a major part of the balance. So the reasons for a deficit or surplus are mostly reasons why a country sells more or fewer exports, or buys more or fewer imports.
The main reasons are set out below. For each one, a change in the opposite direction pushes the account towards a surplus.
Key terms:
- Competitiveness: how attractive a country's goods and services are to buyers compared with those of other countries, in terms of price and quality.
- Relative inflation: a country's inflation rate compared with the inflation rates of the countries it trades with.
Reasons for a deficit
📈 Higher inflation than trading partners
If prices at home rise faster than prices abroad, home goods become dearer in comparison. Foreign buyers turn to cheaper rivals, and home buyers switch to cheaper imports.
🏆 Poor quality or competitiveness
If a country's goods are lower quality, less modern or less well known than goods made abroad, buyers choose foreign goods. Exports are low and imports are high.
🏭 Low productivity
If workers produce little output each, costs per unit are high. Prices have to be higher, so the country's goods are less competitive on price.
🚀 Fast growth at home
When incomes at home rise quickly, people spend more, including on imports. If exports do not grow as fast, imports overtake exports.
🌍 Slow growth abroad
When incomes fall or grow slowly in the countries that buy a country's exports, they buy less of them. Export earnings fall.
Reasons for a surplus
A surplus comes from the opposite of each reason above:
- A low exchange rate: exports are cheap for foreign buyers and imports are dear at home.
- Lower inflation than trading partners: home goods stay good value, so exports are strong and imports are weak.
- High quality and competitiveness: foreign buyers want the country's products.
- High productivity: low costs per unit allow low prices.
- Strong growth abroad and slow growth at home: foreign incomes lift export sales while home spending on imports stays modest.
Worked example
Tessara makes tractors. Over two years, its inflation is 8% a year while its trading partners have 2%. Its tractors rise in price much faster than rival tractors. Foreign farmers switch to other makers, so exports of tractors fall. At the same time, farmers in Tessara start buying cheaper imported tractors. Exports go down and imports go up, so the current account moves towards a deficit. Relative inflation is the cause.
Consequences of a deficit
Exports and imports are part of total demand. Net exports are exports minus imports, so a deficit on trade means net exports are negative. A deficit has these effects, all else being equal:
📉 GDP and employment
Net exports are negative, so total demand is lower and GDP is lower than it would have been. Firms that lose sales to imports may cut output and jobs.
💲 Foreign exchange rate
People abroad want less of the home currency to buy exports, while home buyers supply more of it to buy imports. This puts downward pressure on the exchange rate, which can lead to depreciation.
🏷️ Inflation
Cheap imports can hold prices down. But if the currency depreciates, imported goods and materials cost more, which pushes inflation up.
💰 Lower incomes
Lower sales mean lower incomes for workers and owners in the industries that lose out to imports, so they spend less on other goods too.
Consequences of a surplus
📈 GDP and employment
Net exports are positive, which adds to total demand. GDP is higher and export firms hire more workers.
💲 Foreign exchange rate
Foreign buyers need more of the home currency to pay for exports, so demand for it rises. This puts upward pressure on the exchange rate and can lead to appreciation.
🏷️ Inflation
Strong export demand adds to total demand. If the economy is already close to full capacity, prices may rise, which is demand-pull inflation. Imports are cheaper if the currency appreciates, which can hold prices down.
💰 Higher incomes
More sales abroad mean higher incomes for workers and owners in export industries, so they spend more on other goods too.
Common mistakes
Students often say a deficit is always bad and a surplus is always good. Neither is true. A deficit caused by a country buying machinery to make future exports may be helpful, while a surplus caused by weak spending at home may mean people are missing out on goods. Another mistake is to mix up the cause and the effect: a high exchange rate is a reason for a deficit, while a falling exchange rate is a consequence of a deficit. Always say which way the effect goes.
Exam-style question
Tessara is a country that sells tractors, coffee and tourism services. Its government has noticed that imports have risen faster than exports for three years, while its currency has risen in value against the currencies of its main trading partners. Tessara's inflation is higher than in the countries it trades with.
(a) Identify two reasons for the current account deficit in Tessara. [2 marks]
(b) Explain how a current account deficit may affect the foreign exchange rate of Tessara. [4 marks]
(c) Discuss whether a current account deficit is bad for Tessara's GDP and employment. [6 marks]
Model answer
(a) The currency has risen in value, which makes exports dearer and imports cheaper (1). Inflation is higher than in trading partners, so Tessara's goods are less competitive (1).
(b) In a deficit, Tessara is buying more imports than it sells exports, so home buyers supply more of their currency to buy foreign currency (1). Foreign demand for Tessara's currency is relatively low because exports are low (1). Supply of the currency is greater than demand, which puts downward pressure on its value (1). This may lead to depreciation of the exchange rate (1).
(c) A deficit means net exports are negative, so total demand and GDP are lower than they would have been (1). Tessara's tractor and coffee firms may lose sales to imports and cut jobs, so employment falls (1). Lower incomes in those industries mean less spending on other goods (1). However, a deficit may not be bad if the imports are machinery that makes firms more productive in future (1), or if cheaper imports hold down prices for consumers (1). Overall, a deficit is likely to harm GDP and jobs in the short run, but it depends on what is being imported and how long the deficit lasts (1).
Exam tip
In part (c), a "Discuss" question needs both sides. Give the harm to GDP and employment first, then one reason a deficit may not be harmful, then a short conclusion.