3a.

Explain two possible consequences of a sustained current account deficit in a country’s balance
of payments. [10]

Answers should include:

 definition of current account in a country’s balance of payments
 explanation of a sustained current account deficit
 an explanation of any two consequences such as:

– a deficit will reduce AD

– the need to counterbalance the deficit with capital inflows, which may lead to future
outflows of profits, interest and dividends
– the need for higher interest rates to attract overseas funds
– a current account deficit may contribute to rising living standards as more goods and
services are being consumed
– a current account deficit being necessary to build future export potential in terms of vital
imports of raw materials and capital goods needed for export production
– may necessitate deflationary demand policies, with an adverse impact on employment and
output
– may necessitate borrowing from institutions such as the IMF, with unwanted strings
attached
– downward pressure on the currency which may bring inflation.
Examiners should be aware that candidates may take a different approach which if
appropriate, should be rewarded.

Introduction

 Current account deficit is when the net inflow of money from trade in goods and services and
income flows and current transfers is negative.

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Body: Explain two possible consequences (choose any of the top 4 points)

• A deficit will, among other things, exert downward pressure on an economy’s exchange rate,
which will result in cost-push inflation. A currency depreciation in a freely floating exchange
rate, increases the price of imports to domestic consumers hence makes imports more
expensive. If domestic producers are heavily dependent on imported factors of production
such as Europe is dependent on Russia’s imports of natural gas, their costs of production
increase, resulting in a leftward shift of the SRAS curve from SRAS1 to SRAS2 resulting in rising
General Price level from P1 to P2 while real output falls from Yp to Yrec (Figure 1). The more
price inelastic is the demand for the imported input (such as the demand for oil), the greater
is the cost-push inflation. Therefore, the central bank may need to respond by raising interest
rates aggressively which would slow down economic growth and increasing risk of a recession.
Exchange rate changes also affect aggregate demand by influencing net exports (X−M). A
currency depreciation decreases the price of exports to foreigners and imports more
expensive to domestic consumers thus increasing the quantity of exports and lower the
quantity of imports, thus raising net exports (X−M). Since the latter is a component of
aggregate demand, this leads to a rightward shift from AD1 to AD2 thus causing demand pull
inflation from P2 to P3 in Figure 1. Rising inflation will, in turn, have negative effects on export
competitiveness thus hurting economic growth eventually.

Figure 1: Cost Push Inflation

 Since a current account balance is matched by the sum of the financial and capital account
balances, therefore, a current account deficit is typically matched by a surplus in the financial
account. This means that the country is able to consume more than it produces through a
financial account surplus which may requires higher interest rates to attract foreign financial
investments or portfolio investments such as stocks, bonds and loans. However, higher
interest rates result in higher cost of borrowing that reduces borrowing by consumers and
firms. Lower investment spending (I) and lower consumer spending (C) weakens AG hence
resulting in falls in real GDP, weaker economic growth and possibly creating a recession in the
economy. Moreover, the interest payments on the loans incurs opportunity cost as it could be
used elsewhere in the economy such as provision of merit and public goods that promotes
economic development in the country.

 The need to finance a current account deficit with a surplus or inflow of funds in the Financial
Account may lead countries to sell domestic assets to foreigners such as stocks or shares which
will result in capital inflow into the portfolio investment account or sale of domestic fixed
assets such factories or real estate that would capital inflow into the foreign direct investment

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 account. For example, the Thailand government sold shares in Thai Danu Bank to Singapore’s
DBS Bank to help finance the current account deficit meaning that the Thai financial institution
is now owned by foreigners. Similarly, there could be sale of domestic assets like real estate
or factories to foreigners, all of which eventually lead to loss of control over the country’s
assets.

• If a country borrows over long periods of time to finance its current account deficit, there is
rising risk of accumulating so much debt that it may be unable to pay it back hence leading to
a default. Risks of default, along with actual default, causes a severe loss of investor
confidence leading to significant currency depreciation or collapse, difficulties of getting more
loans and risk of depleting a country’s foreign exchange reserve to support the falling currency
due to huge sale by foreigners. Recently, Sri Lanka incurred unsustainable foreign debt to
finance its current account deficit with total debt-to GDP ratio at 106% in 2021. The country
eventually defaulted on its loan repayments to foreign creditors like China and Japan in 2022
as it needed to save its reserves for food and fuel imports. The country is in bailout talks with
the IMF.

• Foreign exchange reserves may be used to increase the capital account to regain balance in
the current account. However, this cannot continue indefinitely as the reserves would
eventually run out.

• Effects on credit rating. A persistent current account deficit may lead to a credit rating
downgrade which will increase the country’s borrowing cost. For example, Turkey’s sovereign
credit rating was cut in 2013 which subsequently raised bond yields.

• May necessitate deflationary demand policies, with an adverse impact on employment and
output

Conclusion

A persistent current account deficit has negative economic consequences on an economy and can
cause inflation arising from downward pressure on the currency, rising interest rates that huts a
country’s economic growth and a possible debt default (these points must be explained in body
otherwise use the points that you chose to elaborate). However, these problems need not
necessarily arise if the current account deficit remains relatively small and does not get out of hand
by excessive borrowing while the borrowed funds are used to finance imports of capital goods and

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other inputs needed in production and geared towards export industries instead of consumer goods
imports).

3b. Using real world examples, evaluate the methods available to a government to reduce a current
account deficit. [15]

Introduction

 Define Current Account Deficit (refer to part a)

 Possible methods are expenditure-reducing policies (decreasing aggregate demand),
expenditure reducing policies and supply side policies.

Body

1. Expenditure reducing policies: expenditure-reducing policies try to influence the levels of

imports and exports by reducing domestic expenditures through lower aggregate demand.
This is achieved by implementing contractionary fiscal and monetary policies to reduce
aggregate demand and therefore output and incomes, in turn leading to lower demand for
imports.

Thesis: Expenditure reducing policies are Anti-Thesis: Not effective.

effective.

 A contractionary fiscal/monetary policy will  Undesirable consequences for

reduce AD, lower output, income and
imports hence reduce trade deficit. In turn,
this improves the CAD.
 For example, Pakistan’s current account
deficit (CAD) increased to 4.6% of GDP in
2022, up from 0.8% of GDP a year ago. In
response, the government implemented
an expenditure reducing policy by using
a contractionary monetary policy.
 Pakistan’s central bank reduced money
supply to raise interest rates to 15% by
mid-2022 leading to rising borrowings
costs which discouraged spending by
consumers (C) and firms. As such, C and I
fell resulting in leftward shift of AD curve
from AD1 to AD2 while GPL fell from Po
to P1 (Figure 1). Real GDP dropped from
Yp to Y1 resulting in income falls. In turn,
other macro-economic objectives
like economic growth as it triggers
a recession by slowing down the
economy and causing
unemployment to rise. The
resulting lower income means
reduced access to education and
healthcare as well as general
goods and service causing falling
standards of living. The recession
also lower tax revenue for the
government hence leading to less
provision of merit goods and
public goods including critical
infrastructure like good and
efficient transportation network.
This harms a country’s economic
development.

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 this lowered demand for imports and  Resulting currency appreciation
reduced demand-pull inflation which from contractionary monetary
increased Pakistan’s export policy from higher interest rates
competitiveness. The combination of would make exports more
lower imports and higher exports expensive to foreign consumers
reduces the size of the current account thus discouraging exports.
deficit. Meanwhile, it also makes imports
cheaper to domestic consumers
 The country can also use contractionary FP thus increasing imports. In turn,
involving lower government spending (G), this worsens the country’s current
raising income tax and or corporate tax. The account deficit assuming the
resulting fall in government spending, Marshall Lerner condition holds
consumption and investments respectively (PEDx+PEDm>1). Hence, this
will lower AD, real GDP and income. Hence M cancels out the beneficial effects
falls while X rises on lower DD pull inflation. of expenditure reducing policies
 However, lower G will help reduce foreign on the CAD.
debt as countries with huge current
account deficit will typically also incur high
debt such as Pakistan to finance its
current account deficit.
 Similarly, higher taxes and reduced
government expenditure will also help the
government reduce its budget deficit.
 But contractionary FP is also more
effective than MP as it does not lead to a
currency appreciation which will further
hurt X competitiveness and worsen the
current account if the Marshall-Lerner
condition (M-L condition) holds.

Figure 1: Contractionary Demand Side Policy

P0
P1

Y1

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 2. Expenditure switching policies: expenditure switching policies switch consumption away
from imported goods and towards domestically produced goods using trade protection and/or
currency devaluation.
Thesis: Expenditure switching policies are
effective.
Expenditure switching policies help improve
current account deficits by switching
consumption away from imports and towards
domestically produced goods through trade
protectionism and/or by depreciating the
currency hence reducing imports and increasing
exports.
 The different types of trade protection
measures are tariffs, quotas, production
subsidy, export subsidy and administrative
barriers. For example, US has a persistent 
current account deficit which jumped to
4.8% of GDP in first quarter of 2022 –
representing a record high since 2008. This
had prompted the US government to adopt
trade protectionism to help reverse its
widening current account deficit. Hence
the US government-imposed tariffs, which
is a tax on imports, on a wide range of
imports from China like semiconductors
and batteries.
 Assume the US imports solar panels from
China at world price Pw and US is a price
taker. The US produces quantity Q1 and
demands quantity Q4 and imports Q4-Q1
from China.
 Suppose a tariff is imposed on the
imported good; the world supply curve
shifts upwards raising the price of solar
panels in the US from Pw to Pw+t where
t is the tariff.
 At Pw+t, US domestic quantity supplied
increases from Q1 to Q2 thus benefiting
domestic US workers in the industry as
firms gain in terms of higher revenue.
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Anti-Thesis: Not effective.
 Higher domestic prices of protected
goods and services will
disproportionately hurt consumers
who pay a higher price (Pw+t) and
buy smaller quantity of Q3 instead of
Q4 making them worse off as
indicated by a fall in the consumer
surplus from areas abcdef to ab
(Figure 1).
Trade protection measures such as
tariffs cause an increase in
production by inefficient producers
which results in a waste of scarce
resources. A global misallocation of
resources results. The decrease in
consumption and the shift of
production away from efficient
foreign producers and towards more
inefficient domestic producers
translate into a misallocation of
resources both domestically and
globally. Hence there is a welfare or
deadweight loss equal to the area d+f
(Figure 1).
 Moreover, trade protection
measures like tariffs and quotas
worsen income distribution. Tariff is a
regressive tax which burdens people
on lower incomes proportionately
more than people on higher incomes.
This is because as income increases,
the proportion of income paid as
taxes falls.
 Domestic quantity demanded fell from 
Q4 to Q3 so the amount of China imports
dropped from Q4-Q1 to Q3-Q2 (Figure 2).
Hence, this helped to reduce US current
account deficit.
 Moreover, the US government also
benefits in terms of revenue as shown by
the shaded area (Figure 2). Hence the US
government has more funding that can
be used to benefit society if it is spend on
merit goods like education or to improve
the economy’s infrastructure.
Figure 2: tariffs
 The government may allow the currency to
depreciate, in which case it makes imports
more expensive to domestic consumers thus
increasing imports and encourages exports as
they become cheaper to foreigners. In turn,
this improves the country’s current account
deficit assuming the Marshall Lerner
condition holds (PEDx+PEDm>1). This is
another type of expenditure-switching policy,
because it, too, switches consumption away
from imports and towards domestically
produced goods.
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Trade protectionism also provokes
trade retaliation. For example, there
was trade retaliation by China in
response to US’s tariffs on imports of
solar panels from China while the UK
also retaliated to US’s tariffs on its
steel imports by imposing tariffs on
US imports like alcohol and Levi’s
jeans. Hence, under the protectionist
Trump administration, trade war
erupted between US and many of its
trading partners including Europe and
Japan.
 However, if imports comprise of
significant amounts of imported
capital goods and raw materials,
then COP rises and can lead to cost
pull inflation. Hence, firms
experience higher costs of
production, which may be passed on
to consumers in the form of higher
prices. This is a type of cost-push
inflation, and it has recessionary
effects.
 A currency devaluation or
depreciation reduces the size of a
trade deficit and therefore a
 current account deficit provided
the Marshall–Lerner condition
holds whereby the sum of the
price elasticity of demand for
imports (PEDm) and price
elasticity of demand for the
country’s exports (PEDx) are
greater than one.
 But in the short term, the trade
balance will deteriorate first and
then improve later as consumers
and producers need time to
adjust to the price changes,
which is known as the J curve
effect (Figure 3).

Figure3: J-curve effect

3. Supply side policies: policies that aims to increase long term economic growth by improving
productivity hence increasing export competitiveness.

Thesis: Expenditure switching policies are Anti-Thesis: Not effective.

effective.

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 The use of supply-side policies can help to  Supply side policies have long time
increase export competitiveness hence lags
reducing the current account deficit.  If government is in debt, then they
 Interventionist supply side policy, which will not be able to prudently finance
relies on government intervention to interventionist supply-side supply
increase an economy’s potential output or policies  otherwise, further in
government debt  other economic
long-term economic growth, can be
problems. Can lead to via crowding
adopted to help increase export out effect when government wants
competitiveness. Interventionist supply side to pursue expansionary FP due to
policy comprise 1) investment in human Deficit Financing which limits
capital (education and healthcare), 2) effectivness of the policy.
Investment in new technology; 3)  Governments require substantial
investment in Infrastucrure and 4) Industrial amounts of tax revenues to be able
to provide the support services,
policies.
which means high taxes and a large
 Government spending on infrastructure, government sector. High taxes act as
which is a type of physical capital that disincentives to work, and a large
results from investment, is an example of
government sector promotes
an interventionist supply side policy that
inefficiencies.
can also help increase productivity and
 For example, the average total debt-
lower cost of production, thus increasing
to GDP ratios of developed countries
a country’s economic growth.
are now close to 300% while that of
 Many types of infrastructure are merit
China is around 256% with the
goods or public goods with positive
government accounting for about
externalities of production. For example,
half of this increase after the Covid-
better transportation system allows more
19 pandemic crisis. This suggest that
Goods and Services (G/S) to be
such governments of countries like
transported efficiently thus lowering the
Europe, US and Japan have rising
COP. Hence the high-speed rail between
budget deficits thus less resources
Beijing and Shanghai has cut travelling
to fund interventionist supply side
time from six to four hours hence
measures such as the US’s US$4
increasing the productivity of firms and
trillion worth of infrastructure and
labour in China. In turn, this helps to
economic spending that was not
improve productivity thus lowering the
approved by Congress due partly to
cost of production in China that helps
its impact on US budget deficit.
boost the country’s export
competitiveness. In turn, China’s exports
rise. The policy also helps to increase the
country’s potential increases in real GDP
through higher quality and quality of
capital good and labour.

 The government can also use market-  The under-provision of merit goods
oriented supply-side policies which and public goods as market forces
emphasise the importance of well- alone will not be able to provide

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 functioning competitive markets in achieving
growth in potential output. The involve,
Incentive-related policies, Labour market
reforms and encouraging competition.
 Such policies also lower costs of
production for firms by increasing
productivity and raising the potential
output. This is reflected by shifting the
SRAS to the right due to falling cost of
production and LRAS curves to the right
resulting in non-inflationary long term
economic growth.
 Several policies, such as increasing
competition, reducing the power of labour
unions, reducing or eliminating the
minimum wage, cutting business taxes,
deregulation, and others, could have the
effect of making fi rms more competitive
in global markets. Over a long period of
time, higher productivity and lower COP
will help boost the country’s exports,
thereby addressing the current account
deficit. Hence, Indonesia implemented
labour market reforms with its Omnibus
Bill that made it easier for firms to fire
workers and the elimination of minimum
wage, all of which helped boost
Indonesia’s export competitiveness. This
policy has less impact on government
budget compared to an interventionist
supply side policy.
them sufficiently due to market
failure might hurt a country’s export
competitiveness due to rising
inefficiencies and cost of
production. For example, shortage
of public goods like good roads in
Africa and under production and
consumption of merit goods like
health services which has resulted
in higher HIV infection have hurt
the region’s export
competitiveness.
Market oriented policies may lead to
increased income inequality and rising
social tensions due to rising structural
unemployed as workers without the
relevant skills in demand will become
worse off from increased competition
arising from measures like increased
trade liberalisation, deregulation and
privatization.

Evaluation

 Expenditure reducing policies are effective as they help correct the country’s CAD by
reducing income but the policy has high economic costs as it causes a recession and higher
unemployment which are destabilising and lowers standard of living which is negative for
the government.
 Expenditure switching policies creates even bigger problems for a country as it relies on
trade protection measures that provoke trade war, create global misallocation of resources
and result in welfare loss. A currency devaluation also increases risk of a cost push inflation
and can trigger competitive devaluation which offsets the policy’s effectiveness to reduce a
country’s current account deficit. Hence, this policy is not recommended.
 Although supply side policies have limitations such as long-time lags, they represent the
most viable measure to help boost a country’s export competitiveness. An interventionist
supply side policy can be implemented by investing in human capital and infrastructure, for
example, but requires substantial government support and funding. A market-based supply
side policy, on the other hand, impacts less on the government budget but there must be

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 government interventions to help mitigate possible rising income inequality and structural
unemployment.
 Given that supply-side policies are long term in nature, in the meantime, the country could
also use expenditure reducing policies which are short term in nature but a contractionary
monetary policy might be better to help prevent a serious recession as interest rate hikes
can be incrementally adjusted.

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