Consequences of Imbalances
Definition
Current account deficit: outflows on the current account exceed inflows, so the balance is negative.
Current account surplus: inflows exceed outflows, so the balance is positive.
- An imbalance has effects both at home and abroad, so answers should address the domestic and the external dimension.
- The domestic economy feels effects on growth, employment, inflation and living standards.
- The external economy feels effects on external debt, asset ownership and the exchange rate.
Key Idea
- A deficit must be matched by net inflows recorded elsewhere in the balance of payments.
- Whether an imbalance is harmful depends on its size, cause and sustainability.
Effects of a Deficit
- A trade deficit makes net exports (X − M) negative, which subtracts from aggregate demand, so growth can slow and jobs in export and import-competing sectors are lost.
- Financing a deficit by borrowing or selling assets builds up external liabilities, so more interest and profit flow abroad as primary income later, worsening the account further.
- A large deficit can put downward pressure on the £, and if inflows dry up the £ may fall sharply, raising import prices and inflation.
Example
- An economy running persistent deficits relies on foreign investors keeping faith in its £ assets.
- A sudden stop in those inflows can force a sharp fall in the £, so import prices jump.
Effects of a Surplus
- A surplus makes net exports (X − M) positive, which adds to aggregate demand and can support growth and employment.
- A large surplus may mean domestic consumption and living standards are lower than they could be, since output is sent abroad rather than consumed at home.
- Persistent surpluses build up foreign assets but can provoke trade tensions and protectionism abroad.
Note
- Large surpluses in some economies mirror deficits in others.
- So imbalances across countries are linked and can be a source of global instability.
The External Dimension
- A deficit is financed by net inflows recorded elsewhere in the balance of payments, so foreign claims on the economy rise.
- A surplus is matched by net outflows, so the country lends to or invests in the rest of the world.
- Growing external debt raises the interest and profit payments that flow abroad in future.
Judging Significance
- For concern: a large, rising deficit driven by weak competitiveness is worrying.
- Against concern: a deficit financed by stable long-term inflows may be sustainable.
- The cause matters as much as the size: a deficit driven by importing capital and investment goods during fast growth is relatively benign, since it can raise future output, whereas one driven by eroding competitiveness or an unsustainable consumption boom is far more worrying.
- The size relative to GDP, the cause and the way it is financed all matter.
- On balance, an imbalance should be judged by its size, cause and sustainability rather than treated as automatically harmful.
Example
- Suppose a country runs a current account deficit of £75bn with GDP of £2,500bn.
- The deficit is 3% of GDP; a figure below roughly 4-5% is usually seen as sustainable, so it depends on how the deficit is financed.
Exam technique
- Separate the consequences of an imbalance from its causes.
- Cover both the domestic economy and the external economy.
- Judge a deficit or surplus by its size, cause and sustainability.
Common Mistake
- Do not assume every deficit is harmful and must be corrected at once.
- Do not assume a surplus is always good, because it too carries costs.
Self review
- Give two domestic consequences of a current account deficit.
- Give one external consequence of a persistent deficit.
- Give one cost of running a large surplus.
- How should the significance of an imbalance be judged?
