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

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

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

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