Correcting Balance of Payment Deficits & Surpluses (AQA A Level Economics)

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Written by: Lorraine

Reviewed by: Steve Vorster

Significance of Persistent Current Account Deficits

A persistent current account deficit refers to a situation where a country consistently spends more on imports than it earns from exports

The Impact of a Persistent Current Account Deficits on the Economy

Impact	Explanation
Depreciating exchange rate	A persistent current account deficit can put downward pressure (depreciate) on a country's currency as the economy is constantly supplying its currency onto world markets
Interest rates	With falling demand for a country's currency, the Central Bank may raise interest rates in order to attract foreign investment The raised rates will encourage demand for the currency which will help it to stop [popover id="R_K9APg0X~Rh783K" label="depreciating"]
Domestic assets	A persistent current account deficit may result in increased foreign ownership of domestic assets It can be driven by the need to finance the deficit through foreign capital inflows, leading to a larger share of ownership from abroad
National debt	Government needs to borrow to finance a current account deficit, which can create a large national debt, especially if deficit is persistent
Credit ratings	If the deficit is persistent, international credit rating agencies may downgrade the country's creditworthiness, potentially raising borrowing costs Investors can lose confidence in a country's ability to repay any future borrowing
Conflict with macroeconomic objectives	The government may have to trade off with other macroeconomic policies objectives They may have to use monetary or fiscal policy to stimulate domestic consumption or stimulate exports to reduce the deficit and rebalance the economy
Economic growth	A large current account deficit can have implications for economic growth It may signal an imbalance in the economy, relying on external financing rather than domestic productivity and competitiveness

Impact

Explanation

Depreciating exchange rate

A persistent current account deficit can put downward pressure (depreciate) on a country's currency as the economy is constantly supplying its currency onto world markets

Interest rates

With falling demand for a country's currency, the Central Bank may raise interest rates in order to attract foreign investment
The raised rates will encourage demand for the currency which will help it to stop [popover id="R_K9APg0X~Rh783K" label="depreciating"]

Domestic assets

A persistent current account deficit may result in increased foreign ownership of domestic assets
It can be driven by the need to finance the deficit through foreign capital inflows, leading to a larger share of ownership from abroad

National debt

Government needs to borrow to finance a current account deficit, which can create a large national debt, especially if deficit is persistent

Credit ratings

If the deficit is persistent, international credit rating agencies may downgrade the country's creditworthiness, potentially raising borrowing costs
Investors can lose confidence in a country's ability to repay any future borrowing

Conflict with macroeconomic objectives

The government may have to trade off with other macroeconomic policies objectives
They may have to use monetary or fiscal policy to stimulate domestic consumption or stimulate exports to reduce the deficit and rebalance the economy

Economic growth

A large current account deficit can have implications for economic growth
It may signal an imbalance in the economy, relying on external financing rather than domestic productivity and competitiveness

Significance of a Persistent Current Account Surplus

A persistent current account surplus occurs when a country consistently exports more goods and services than it imports
The implications of this occurring can be summed up as follows:

1. Rising consumption and investment

Investment increases as exporting firms are making excellent profits
With a higher level of profits in the economy, domestic income rises leading to an increase in consumption

2. Appreciating exchange rates

With higher exports, foreigners demand more of the local currency to pay for their goods/services leading to currency appreciation
Appreciating exchange rates make the economy less desirable as a destination for foreign direct investment

3. Both an inflationary and deflationary effect on price levels

Diagram: Persistent Current Account Surplus

A surplus may cause price levels to rise or fall in an economy

The net effect on inflation will depend on the extent to which domestic firms rely on imported raw materials used in their production process

4. Employment

With rising demand for exports, unemployment usually falls as exporting industries require more workers
Rising profits usually result in increased investment which may mean that even more workers are required
Decreasing unemployment creates a higher average domestic income and much of this income is spent domestically
- Non exporting domestic industries may also require more workers to help meet the rising domestic demand

5. Export competitiveness

Appreciating exchange rates associated with a persistent surplus, will gradually erode the nation's export competitiveness over time
The extent to which this is eroded will depend on the price elasticity of demand for the country's exports
- if PED for their exports in [popover id="Bv1knULMbp3AEkrb" label="inelastic"], then currency appreciation will not impact the competitiveness as much as it does when the PED for exports is [popover id=Uz-HDkXw9P75ze9K" label="elastic"]

Policies to Correct Deficits & Surpluses

The Government has several options available to them in order to tackle persistent current account imbalances
- They could do nothing, leaving it to market forces in the foreign exchange market to self-correct the deficit
- They could use expenditure-switching policies
  - These aim to switch consumption from foreign goods to domestic goods and involve the use of protectionism (tariffs, quotas), or a devaluation of the currency under a fixed exchange rate mechanism
- They could use expenditure-reducing policies
  - These aim to reduce aggregate demand in an economy and include policies such as contractionary fiscal or monetary policy
- They could use supply-side policies
The choice of any policy, or any combination of policies, generates both costs and benefits

Costs & Benefits of Policies used to Tackle Current Account Deficits or Surpluses

Policy Option	Benefits	Costs
Do nothing	Floating exchange rates act as a self-correcting mechanism Over time, a higher level of imports will end up depreciating the currency, causing imports to decrease (they are now more expensive) and exports to increase (they are now cheaper) This improves the deficit	There may be other external factors that prevent the currency from depreciating It may take a long time for self-correction to happen and many domestic industries may go out of business in the interim The longer it takes to self-correct, the more firms will delay investment in the economy
Expenditure switching	This is often successful in changing the buying habits of consumers, switching consumption on imports to consumption on domestically produced goods/services This helps improve a deficit	Any protectionist policy often leads to retaliation by trading partners The retaliation may consist of reverse tariffs/quotas which will decrease the level of exports This may offset any improvement to the deficit caused by the policy
Expenditure reducing	Deflationary fiscal policy invariably reduces discretionary income, which leads to a fall in demand for imported goods and improves a deficit	Deflationary fiscal policy also dampens domestic demand, which can cause output to fall. When output falls, GDP growth slows and unemployment may increase
Supply-side policies	Improves the quality of products and lowers the costs of production Both of these factors help the level of exports to increase, thus reducing the deficit	These policies tend to be long term, so the benefits may not be seen for some time They usually involve government spending in the form of subsidies and this always carries an opportunity cost

The Implications for the Global Economy of Correcting Imbalances

If a small economy experiences a deficit or surplus on the current account, it is unlikely to have a major impact on another economy. However, if the economy is large, it will likely to have a large effect on other economies
- E.g. USA runs a large current account deficit, while China runs a a large current account surplus
Correcting these persistent deficits can be problematic as it means that finance from abroad (in the form of loans or foreign direct investment) is required in order to fund continued imports
- This may mean that a country is gradually selling its assets
- Owing money to a foreign entity creates vulnerabilities
  - The 2008 Global Financial Crisis demonstrated the impact of fast changing conditions in which creditors were insisting on being repaid quickly e.g. Greece owed creditors (including Germany) significant sums & was required to pay these back creating numerous problems in their economy

Last updated: 14 October 2024

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