What this lesson teaches
I can explain how a current account deficit or surplus affects GDP, jobs, inflation and the exchange rate.
Syllabus K343, 6.4.3. Consequences of current account deficit and surplus: impact on GDP, employment, inflation and foreign exchange rate
Make a guess
A country runs a large current account surplus. What tends to happen to its currency?
- It appreciates as foreigners buy it.
- Nothing, because trade does not move exchange rates.
- It depreciates, because the country exports so much.
Show the answer
It appreciates as foreigners buy it.
More demand for the currency raises its value. That makes exports dearer, which can shrink the surplus over time.
Deficits can lower GDP and jobs and weaken the currency; surpluses can raise GDP and jobs but may add to inflation.
A deficit caused by falling exports or rising imports means less spending on the country's own output. GDP grows more slowly and employment may fall, especially in export and import-competing industries.
A deficit means more of the currency is sold than bought, so it tends to depreciate. A large, lasting deficit may need financing by borrowing or selling assets to foreigners. However, imports can reduce inflation by bringing cheaper goods.
A surplus means more spending on the country's output, so GDP and employment can rise. But if the economy is near full capacity, extra demand can push up inflation.
A surplus means more demand for the currency, so it tends to appreciate. That makes exports dearer and can reduce the surplus over time.
- Deficit
- Lower GDP growth and jobs; currency tends to depreciate; cheaper imports may lower inflation.
- Surplus
- Higher GDP and jobs; possible inflation; currency tends to appreciate.
Worked example: Tracing a surplus through the economy
Suppose a country's exports rise strongly, increasing its current account surplus.
- GDP: exporters produce more, so output rises.
- Employment: firms hire more workers.
- Inflation: if the economy is near full capacity, prices may rise.
- Exchange rate: foreigners buy more of the currency, so it appreciates, making exports dearer later.
Watch out for this
A current account surplus is always good for living standards.
A surplus can raise output and jobs, but it may mean people consume less than they produce, and it can cause inflation or currency appreciation.
Check your understanding
A country's current account deficit grows because imports rise sharply. What is the likely effect on its exchange rate?
- It depreciates, as more of the currency is sold to buy imports.
- It is unaffected, because exchange rates are set by the central bank.
- It appreciates, as foreigners buy more of it.
Show the answer
It depreciates, as more of the currency is sold to buy imports.
Right. Supply of the currency rises.
Check your understanding
A country pays for a deficit year after year by borrowing from abroad. What problem is this most likely to build up?
- Rising foreign reserves, as loans pile up at home
- Falling unemployment, as imports create many new jobs at home
- Faster inflation, as foreigners buy more of its exports
- Rising foreign debt, with interest to pay overseas later
Show the answer
Rising foreign debt, with interest to pay overseas later
Right. Each year's borrowing adds to what the country owes, and the interest becomes a future outflow.