Impact of a Current Account Deficit | A-Level Economics Model Paragraph (AQA, Edexcel, OCR)

• Summary
• AD left shift
• Evaluation
  • sign of high incomes - luxury goods being imported
  • pound will fall and current account deficit will automatically correct

A current account deficit occurs when the total value of imports is greater than the total value of exports. Net exports (X-M) is one of the determinants of aggregate demand, which is the total planned spending in the economy. If the UK experiences a current account deficit, there would be a decrease in the value of (X-M) and therefore a left shift in the AD curve.

AD LEFT SHIFT DIAGRAM

The diagram shows that the outcome is a decrease in output from y1 to y2. This suggests there would be a fall in real GDP (negative economic growth) and also an increase in unemployment - since the demand for labour is derived from the demand for goods and services - which is now lower due to a fall in demand for UK exports and also a fall in consumer spending (as some people are buying less goods and services domestically and instead spending money on imports). An increase in unemployment is bad because it means that more people have low or no disposable income and this can lead to an increase in inequality and a fall in living standards.

However, in the UK, consumer spending (C) is the largest determinant of aggregate demand (around 60%) so a fall in net exports would not have a significant impact on aggregate demand as long as consumer spending remains high. It could be that the UK economy is experiencing economic growth which suggests there are low levels of umemployment and high levels of disposable income among consumers. This means that, as well as real GDP being high in the UK, consumers also spend money on holidays abroad or on luxury goods and services from abroad, which would not be so bad. However, if the high imports and lack of exports is a sign that our goods and services are not competitive (poor quality or over-priced), then this would be dangerous as it would mean that aggregate demand would be more likely to shift to the left, which would cause unemployment.

One more evaluation point is that a current account deficit can often increase temporarily before automatically correcting itself. This means it is not something to worry about. For example, if imports increase, then the supply of the pound would increase - and, if exports decrease, that means that the demand for pouund would fall. Then, the value of the pound would fall. which would make our exports more attractive again and it would make imports less attractive. As a result, the balance of payments on the current account would improve shortly.