Exchange Rates: Impact of a current account deficit

In this short revision topic video, we look at how to structure an exam answer to a question on how an increasing current account deficit might cause a change in a country’s exchange rate.

Question:

Examine how an increase in a country’s current account deficit might cause a change in the external value of their currency.

The current account of the balance of payments comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers. A deficit is usually the result of an increasing net trade deficit where the value of imports exceeds the value of exports i.e. M>X.

As a result, there will be a net outflow of money from a country’s circular flow. Households and businesses pay for imports in their own currency, but this is eventually converted into the currency of the exporting nation. Hence, a rising current account deficit leads to an increased supply of a nation’s currency in the foreign exchange markets.

Therefore, in the currency market there will be an outward shift of supply. This – ceteris paribus – might lead to the external value of the currency falling. In a free-floating system, this is called a depreciation.

The rising net trade deficit might have also been caused by a drop in the value of exports which will cause an inward shift in the demand for a currency - this will also lead to a depreciation.

"Examine" requires some evaluation points:

1. Many factors influence the exchange rate – not just the trade and current account balance
2. There might have been capital inflows coming into a country which increases currency demand and therefore causes the exchange rate to appreciate
3. The central bank may opt for a managed floating system and intervene if they want to slow down a currency depreciation