Current account deficits – Chains of Reasoning

Here are three examples of chains of reasoning explaining some possible causes of an external deficit on the current account.

Explain how an economic boom can cause an external deficit

An economic boom occurs when demand, real incomes and national output (real GDP) are all rising at above trend rates.

One effect of this is often a strong rise in consumer spending for goods and services which have high income elasticity of demand.

A large percentage of consumer durables such as new cars and household appliances tend to be imported.

Thus a rise in consumer spending (and a reduction in household saving) can cause the volume of imports to rise at a fast pace.

If the domestic economy is booming, there might be limited spare capacity in general and in export industries.

Thus, higher imports and a slowdown in exports might lead to a widening of a country’s trade deficit on the current account.

Explain how a strong currency can cause an external deficit

When a currency appreciates, the foreign price of a country’s exports increases.

This can lead to exports becoming less price competitive overseas causing a substitution effect leading to weaker demand.

A fall in the value of exports can then lead to a higher trade deficit since net trade = X-M.

A stronger currency also leads to cheaper prices for imported products such as finished manufactured products

This might cause domestic consumers to switch demand and spending towards goods and services produced overseas.

A rise in spending on imports (ceteris paribus) will lead to a higher trade deficit especially if demand for imports has a high coefficient of PED

Explain how low productivity can cause an external deficit

Labour productivity measures output per person hour worked or the value of output per person employed.

Relatively low productivity means that efficiency in the UK is below that of other major trading competitor nations.

If labour productivity is low, then – for a given level of wages – the unit labour cost of production will be higher.

As a result, exporting firms with low productivity may find themselves at a price and cost disadvantage in overseas markets.

This might cause a slowdown in exports as foreign consumers look for relatively cheaper substitutes.

And it might also cause a rise in import penetration into a domestic economy as consumers prefer to buy cheaper goods/services.