Current Account Deficit Consequences Flashcards
(16 cards)
What is a current account deficit (CAD)?
When a country imports more goods, services, and income than it exports (X < M), leading to a negative balance on the current account.
How does a CAD affect Aggregate Demand (AD)?
A CAD reduces net exports (X - M), which decreases AD. This can lower GDP, increase unemployment, and reduce inflationary pressure.
What are the macroeconomic consequences of a CAD through AD?
Lower economic growth
Higher unemployment
Lower inflation (or even deflation)
Possible recession (if severe)
How do countries finance a current account deficit?
Through a financial account surplus – by borrowing or attracting investment from abroad.
What are the long-term risks of financing a CAD with foreign borrowing?
Increasing national debt burden
Loss of investor confidence
Capital flight (investors pulling money out)
How can a CAD affect the exchange rate?
A persistent CAD increases the supply of the domestic currency (to pay for imports), putting downward pressure on the currency.
What happens when a currency depreciates due to a CAD?
Imports become more expensive
Exports become cheaper (can help reduce CAD)
Imported inflation may rise
Foreign debt becomes more expensive to repay
What is capital flight?
When investors move money out of a country due to fears of instability or currency devaluation, often worsening the CAD and causing further economic damage.
Can a falling currency help correct a CAD?
Yes – by making exports cheaper and imports more expensive. But only if Marshall-Lerner Condition is met (elasticity of demand for X and M is sufficient).
Why might a weaker exchange rate not fix a current account deficit?
If the demand for imports is inelastic (e.g. oil, raw materials), a falling currency increases import costs without reducing quantity, worsening the deficit.
What is stagflation and how can it be linked to a weak currency?
Stagflation is the combination of low growth and high inflation. A weaker pound can cause this by raising import prices, especially for raw materials, while demand stays low.
Why is the size of a current account deficit important?
A small or manageable CAD may not be a concern, especially if financed sustainably. A large, persistent CAD (as a high % of GDP) poses bigger risks, such as loss of investor confidence.
What could make the UK’s CAD harder to fix than in other countries?
Heavy reliance on imports (inelastic)
Deindustrialisation (weak export base)
Dependence on foreign capital inflows
Weak productivity and competitiveness
What does the effectiveness of exchange rate adjustment depend on?
Price elasticity of exports and imports
Time lags (J-curve effect)
Global demand conditions
Ability to switch to domestic suppliers
What is the J-curve effect?
After a currency devaluation, the current account may worsen before it improves due to contracts, inelastic demand, and time lags.
What policies might be needed alongside currency depreciation?
Supply-side policies to boost productivity
Investment in exports
Import substitution
Trade deals or incentives
