Causes and Consequences of a Current Account Deficit

Question 1

What are the main demand-side causes of a current account deficit?

Answer 1

1️⃣ Strong domestic economic growth → higher incomes → more spending on imports → money leaves the country.
2️⃣ Overseas recession → foreign incomes fall → demand for exports decreases → export revenue falls.
3️⃣ Strong exchange rate → makes exports more expensive, imports cheaper → worsens trade balance.

Question 2

How does a strong exchange rate cause a current account deficit?

Answer 2

Exports become expensive for foreigners → export volumes and revenue drop.
Imports become cheaper → import volumes and spending rise.
Net effect: money outflow rises, worsening current account position.

Question 3

What are key supply-side causes of a current account deficit?

Answer 3

• Low investment → less capacity & innovation.
• Low productivity → less competitive.
• High relative inflation → exports less price competitive.
• High unit labour costs → increases export prices.
• Poor quality or outdated products.
• Depletion of natural resources → less export revenue.

Question 4

Why are supply-side causes often more problematic than demand-side?

Answer 4

Supply-side problems are often structural and long-term, meaning the deficit may persist without fundamental reforms.
Demand shocks can be temporary and reversible.

Question 5

What are possible economic consequences of a current account deficit?

Answer 5

• Need to finance deficit through borrowing → rising foreign debt.
• Depreciation pressure on currency → inflation risk.
• Loss of investor confidence if deficit is large or persistent.
• Potential reduction in economic growth if deficit reflects competitiveness problems.
• Vulnerability to external shocks.

Question 6

When might a current account deficit not be problematic?

Answer 6

• If deficit finances investment that boosts future productive capacity.
• If funded by stable FDI rather than volatile portfolio flows.
• If deficit size relative to GDP is manageable and temporary.
• If offset by surplus in capital and financial accounts.

Question 7

How can a country improve its current account position?

Answer 7

• Depreciate exchange rate to boost exports and reduce imports.
• Improve productivity and competitiveness.
• Diversify exports.
• Implement fiscal or monetary policies to reduce import demand.
• Supply-side reforms (education, infrastructure, innovation).

Question 8

What is the formula for Aggregate Demand (AD)?

Answer 8

AD = C + I + G + (X – M)
(Consumption + Investment + Government spending + Net exports)

Question 9

What happens when AD falls (shifts left)?

Answer 9

A decrease in economic growth, lower price levels, increased unemployment, and reduced output (lower real GDP).

Question 10

How does a fall in AD affect the labour market?

Answer 10

Lower demand for goods → less production → lower demand for labour → higher unemployment.

Question 11

How can a current account deficit (CAD) affect AD?

Answer 11

A rising CAD (i.e. more imports than exports) reduces net exports (X - M), which reduces AD.

Question 12

What are the possible consequences of a CAD on the macroeconomy?

Answer 12

Negative economic growth

Higher unemployment

Weaker currency (in the long run)

Reduced national income

Question 13

Can a current account deficit be a sign of strength?

Answer 13

Yes – if it’s caused by high consumer spending or investment, it may reflect strong domestic growth.

Question 14

What does the effect of a CAD on AD depend on?

Answer 14

The size and persistence of the deficit

Whether it’s financed sustainably

Whether it’s driven by imports of capital goods or excessive consumption

The openness of the economy

Question 15

Why might a current account deficit not matter much?

Answer 15

If the deficit is small or temporary, or if it’s due to imports of investment goods that raise future growth potential.