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Balance of Payments » Current Account Deficits: Causes and Effects

What you'll learn this session

Study time: 30 minutes

Edexcel spec: 2.1.1 (d)

How the current account is linked to exchange rates
The reasons for current account deficits and surpluses
The impact of a current account deficit on the economy
How a country can pay for a deficit

This topic is examined on Paper 2 (Macroeconomics and the Global Economy). In the last lesson you saw how to spot a deficit or a surplus. Now we ask two harder questions: why do they happen, and why might a deficit be a problem?

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Exchange rates and the current account

Countries use different money. To buy goods from abroad, a firm must swap its own money for the seller's money. The price at which one currency swaps for another is the exchange rate.

Some real-world examples: a UK shopper can swap pounds for euros, US dollars or Japanese yen. A statement like "one pound buys a certain number of dollars" is an exchange rate. These rates change from day to day, so exam questions give you the numbers you need. You never have to remember them.

Key terms:

Exchange rate: the price of one country's currency in terms of another country's currency.
Leakage: money that flows out of a country's economy, for example money spent on imports.
Imported inflation: a rise in the general price level caused by higher prices of goods and materials brought in from abroad.
Foreign reserves: a country's stock of foreign currency, held by its central bank, that can be used to pay other countries.

The link to the current account is simple. The exchange rate changes how expensive a country's goods look to foreign buyers, and how cheap foreign goods look to its own buyers. That changes how many exports and imports there are, so it changes the balance on the current account. (How exchange rates are set is covered in a later lesson, Exchange Rates and How They Are Set.)

Reasons for deficits and surpluses

If foreign goods are cheaper or better, a country imports more and its current account can slip into deficit

A country's current account balance depends on how attractive its goods are compared with foreign goods. There are five main reasons in the spec.

🏆 Quality of goods

If foreign goods are better made than domestic goods, buyers choose imports. Imports rise and a deficit is more likely. If the country's own goods are high quality, foreigners buy more exports and a surplus is more likely.

💲 Price of goods

If foreign goods are cheaper than domestic goods, imports rise. If domestic goods are cheaper than foreign goods, exports rise. Lower prices help the current account.

Exchange rates between countries

Suppose a country's currency becomes worth more in other currencies. Its exports cost foreign buyers more, so they buy fewer. Its imports cost its own buyers less, so they buy more. This pushes the current account towards deficit. If its currency becomes worth less, the opposite happens: exports look cheaper abroad, imports look more expensive at home, and the current account moves towards surplus.

So in total the five reasons are: quality of domestic goods, quality of foreign goods, price of domestic goods, price of foreign goods, and exchange rates between countries.

Worked example: a stronger currency

Worked example

A firm in Country Ralda sells bicycles abroad for 400 Ralda units each. At first, 1 Ralda unit swaps for 2 foreign dollars, so a foreign buyer pays 800 dollars. Later the Ralda unit is worth 3 foreign dollars. The same bicycle now costs the foreign buyer 400 × 3 = 1,200 dollars. The bicycle has not changed, but it looks 50% more expensive abroad. Fewer are sold, exports fall, and the current account moves towards deficit.

The impact of a current account deficit

A deficit means money leaks out of the economy to pay for imports

A deficit means more money flows out for imports than flows in from exports. The spec lists four effects.

Leakage from the economy: money spent on imports leaves the country and becomes income for foreign firms and workers. There is less spending on home-produced goods, so less income for home firms.
Can be inflationary if prices rise abroad: if the country buys a lot of imports and the foreign sellers raise their prices, the cost of imports goes up. Firms that use imported materials face higher costs and pass them on. Shoppers pay more for imported goods. The result is imported inflation, which works like the cost-push inflation you met earlier.
Low demand for our exports: a deficit often goes with weak demand for the country's goods abroad, for example because they are expensive or poor quality. Firms that sell less may cut output and jobs.
Problems finding foreign reserves to fund the deficit: to pay for imports, a country needs foreign money. It can use its foreign reserves. But reserves are limited. If the deficit carries on year after year, the reserves can run low, and the country may struggle to pay for the things it needs to import.

Not always a disaster

A small deficit for a short time is not usually a big problem, especially if the country has plenty of reserves. The danger is a large deficit that goes on for years, because reserves cannot last for ever.

Common mistakes

1. Saying a deficit means the government is overspending. That is a different idea (a fiscal deficit, covered later). A current account deficit is about trade with other countries. 2. Mixing up the effect of exchange rates: a currency worth more makes exports more expensive, not cheaper. 3. Forgetting to say why something happens. "Exports fall" gets less credit than "exports fall because they cost foreign buyers more".

Exam-style question

Country Bellow has a current account deficit. Its car makers say that foreign cars are cheaper and better made. The value of its currency has also risen against other currencies.

(a) State two reasons for Bellow's current account deficit. [2 marks]

(b) Explain one way a current account deficit could harm Bellow's economy. [3 marks]

(c) Which one of these is a foreign reserve? [1 mark]
A. A tax paid by foreign firms B. A stock of foreign currency held by the central bank C. Exports of services D. Money spent on imports

Model answer

(a) Foreign cars are cheaper than Bellow's cars (1). Foreign cars are better quality (1). (The higher value of the currency is also accepted.)
(b) A deficit means money is leaking out of the economy on imports (1). Bellow's firms sell fewer goods, because buyers choose imports (1), so firms may cut output and jobs (1).
(c) B (1)

Exam tip

In part (b), name the effect, then add "because" and a reason. Each link in the chain earns a mark.

Recap

The exchange rate is the price of one currency in terms of another, and it affects exports and imports.
Deficits and surpluses depend on the quality and price of domestic and foreign goods, and on exchange rates.
A deficit means leakage, can bring imported inflation, can go with low demand for exports and uses up foreign reserves.

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