Subject: Economics
Level: A Level
Exam Boards: All


THE GLOBAL ECONOMY

Structural and cyclical causes of a current account deficit*

Structural

  • Under-investment
  • Relatively low productivity
  • Persistently high relative inflation
  • Inadequate R&D, innovation
  • Emergence of lower cost competition

Cyclical

  • Over-valued exchange rate
  • Boom in domestic demand
  • Recession in key export markets
  • Slump in global prices of exports
  • Increased demand for imported technology

What does a current account deficit mean? Does it matter?

Running a deficit on the current account means that an economy is not paying its way in the global economy. A deficit means a country is drawing in money from elsewhere and, as a consequence, building up corresponding liabilities – i.e. an increase in external debt.

  • A deficit is a net outflow of AD from circular flow – this is a drag on real GDP growth
  • Loss of jobs in export sectors & industries affected by rising imports – negative multiplier effects e.g. consider steel, coal etc.
  • Fall in foreign exchange reserves - can be problematic for smaller developing nations who struggle to attract financial capital
  • Can lead to exchange rate weakness - reducing real living standards and increasing investor risk – higher yields on government debt

There are a number of policies that can be introduced to achieve an improvement in a country’s trade balance – some of them focus on changing the growth of demand, others look to improve the supply-side competitiveness of an economy. As with any macroeconomic ‘problem’ effective policies are those that target the underlying causes. Improving Trade Performance in the Short and Long Run

  • Expenditure-reducing policies - designed to control demand and limit spending on imports - squeeze on demand, encouraging rising private sector saving
  • Expenditure-switching policies - designed to change the relative prices of exports and imports - this causes changes in spending away from imports and towards domestic/export production
  • Improving the supply-side performance of the economy - to boost competitiveness - economic reform is a long-run strategy
  • Improving macroeconomic stability to make a country more attractive to inward investment - investment can raise productivity and increase a country’s capacity for exporting

Demand management: Reductions in government spending, higher interest rates and higher taxes could all have the effect of dampening consumer demand reducing the demand for imports. This leads to an increase in spare productive capacity which can then be allocated towards exporting.

Natural effects of the economic cycle: One would expect to see a trade deficit fall during a recession – so some of the deficit is partially self-correcting – but this does little to address the problems of a structural balance of payments problem.

A lower exchange rate:

  • The central bank of a country might decide that a lower exchange rate provides a suitable way of improving competitiveness, reducing the overseas price of exports and making imports more expensive
  • For those countries operating with a managed exchange rate, the government may decide to authorise intervention in the currency markets to manipulate the value of the currency Supply-side improvements:
  • Policies to raise productivity, measures to bring about more innovation and incentives to increase investment in industries with export potential are supply-side measures designed to boost exports performance and compete more effectively with imports. The time-lags for supply-side policies to have an impact are long.
  • Policies to encourage business start-ups – successful small businesses with export potential
  • Investment in education and health-care to boost human capital and increase competitiveness in fast-growing and high value industries such as bio-technology, engineering, finance, medicine
  • Investment in modern critical infrastructure to support businesses and industries involved in international markets Protectionist measures such as import quotas and tariffs are rarely used because of our commitments to the World Trade Organisation and our membership of the European Union.

Japan has the largest current account surplus in the world. Although a surplus sounds better then a deficit, both can be bad. Japan’s surplus forces other countries in the world to have deficits. In fact, while Japan’s surplus is the biggest in the world, the USA’s deficit is the biggest in the world. This is not a coincidence! The UK tends to be in deficit, although the current account was in surplus a couple of years ago, mainly due to our strength in the service sector.

Questions

  1. ‘George Osborne talks about boosting exports and rebalancing the economy, but the Chancellor is not nearly as worried about the trade deficit as he is about the budget deficit.’ Source: The Guardian: Economics Blog, 30 June 2015

Explain the factors which are likely to cause a large budget deficit. [15 marks]

In 2013, two key aims of the UK Government were: to move the budget deficit towards a surplus over the course of the Parliament and to ensure that the main burden of deficit reduction would be through reduced government spending, rather than increased taxation.

  1. Explain the possible demand-side consequences of an increase in taxation in the UK. [15 marks]
  2. Evaluate the view that the UK Government’s policy of deficit reduction through lower government spending is unnecessary and undesirable. [25 marks]

Select an option from the dropdown.

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