NYJC_H2_ECONS_Q6

The United States has run a large deficit on the current account of its balance of payments for several years. Explain what might cause a persistent and large def icit on the current account of a country’s balance of payments. [10] Discuss the view that policies to deal with such a deficit can be ineffective and potentially damaging. [15] (a) Synopsis: The answer would look into the different causes of current account deficit which include both price and non-price factors . Introduction: • Define Current Account: Records receipts from the export of goods and services as well as payments for the import of goods and services during the current period. • Explain that Current Account consists of visible trade, invisible trade, unilateral transfers and income flows. • Explain that Current Account deficit implies export earnings of goods & services < import expenditure on goods & services Body: Explain 3 factors (at least 1 price and 1 non-price factor) that can cause a Current Account deficit : (i) Higher price of domestic goods relative to imports – could be due to: • Loss of price competitiveness of goods produced as a result of higher cost of production compared to other producers in countries like China or India (due to loss of comparative advantage leading to the shift of ma ny manufacturing industries to other countries/slower growth in productivity compared to trading partners). ⇒ Impact on the US’s exports and imports: -With a loss in export competitiveness, US might find that their trading partners who used to import from them would switch to buying relatively cheaper China or India made goods. Furthermore, Americans might also stop buying relat ively more expensive domestic goods and switch to buying the cheaper imports instead. W ith the drop in export revenue and increase in import expenditure, the visible balance in the current account will worsen. • Undervalued Yuan ⇒ Loss of price competitiveness of US exports and a fall in domestic price of imports from China. ⇒ US consumers may thus substitute domestic goods wi th cheaper China goods. If the demand for imports is price elastic, US’s import expenditure will rise significantly. ⇒ China consumers may also reduce their quantity dem anded of US’s goods as it seems relatively more expensive in Yuan. If the China’s c onsumers’ demand for exports is price elastic, US’s export revenue will fall significantly.

⇒ Thus, with the fall in export revenue and the rise in import expenditure, US may face a Current Account deficit, ceteris paribus. • Higher rate of inflation in the U.S. ⇒ US’s exports become more expensive. Hence, the qua ntity demanded of US’s exports will fall and export revenue fall significantly if the demand is price elastic. US consumers may then substitute domestic goods with cheaper imports. This will raise import expenditure and it will rise significantly a s well if demand is price elastic. The