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Comparing High Inflation and Current Account Deficit

Discuss whether a high rate of inflation or a deficit on the current account of the balance of payments is the more serious problem for an economy. [12]

Category:

Macroeconomic Factors and Policies

[CIE AS May 2018]

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Answer

Tip : Do not go out of subject, for example, by explaining the causes of inflation or by being overly descriptive. Careful reading of the question is essential to ensure that full reward is gained for the analysis


Step ➊ : Define ‘inflation’ and ‘a current account deficit’ in the introduction.


A high rate of inflation and a current account deficit can both have major impacts on the economy. Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. A current deficit is when a country imports more goods, services, and capital than it exports. Several factors should be considered before concluding which is a more serious problem to the economy.


Step ➋ : Discuss whether a high rate of inflation is a serious problem for an economy. Discuss the ways inflation can be harmful and why it is not always harmful.


➤ 2.1 Inflation may be harmful to an economy in several ways

⫸ 2.1.1 A relatively high inflation may reduce the international competitiveness of a country’s products and so increase import expenditure and lower export revenue. This may result in a deficit on the current account of the balance of payments.


⫸ 2.1.2 Inflation will typically make borrowers better off and lenders worse off.

For instance, if the rate of interest does not rise in line with inflation, borrowers will gain and lenders (savers) will lose. This is because borrowers will pay back less in real terms and lenders will receive less.


⫸ 2.1.3 Inflation may cause menu costs.

This is the cost of changing price lists. When inflation is high, prices need frequently changing which incurs a cost. For example, catalogues, price tags, bar codes and advertisements have to be changed. This involves staff time and is unpopular with customers.


⫸ 2.1.4 There may be shoe leather costs.

These are the costs involved in moving money from one financial institution to another in search of the highest rate of interest.


⫸ 2.1.5 Inflation may discourage investment.

Unanticipated inflation can create uncertainty and so make it more difficult for firms to plan ahead. This may dissuade firms from investing, which will have an adverse effect on economic growth.


⫸ 2.1.6 A high rate of inflation is likely to cause more damage than a low rate especially if the high rate develops into hyperinflation.

Indeed, hyperinflation can lead to households and firms losing faith in the currency and may bring down a government.


➤ 2.2 It can also be argued that a high rate of inflation or a current account deficit is not always harmful


⫸ 2.2.1 Inflation may not always be a serious problem, for example, when inflation is caused by increases in aggregate demand.

Demand-pull inflation is likely to be less harmful than cost-push inflation. This is because demand-pull inflation is associated with rising output whereas cost-push inflation is associated with falling output.


⫸ 2.2.2 Anticipated inflation is less harmful than unanticipated inflation.

Unanticipated inflation, which occurs when the inflation rate was different from that expected, can also create uncertainty and so can discourage some consumer expenditure and investment. In contrast, if households, firms and the government have correctly anticipated inflation, they can take measures to adapt to it and so avoid some of its potentially harmful effects. For instance, firms may have adjusted their prices, nominal interest rates may have been changed to maintain real interest rates and the government may have adjusted tax brackets, raised pensions and public sector wages in line with inflation.

⫸ 2.2.3 The inflation rate may be below that of rival countries.

It is possible for a country to have a relatively high rate of inflation but if it is below that of rival trading partners, its products may become more internationally competitive


Step ➌ : Discuss whether a current account deficit is a serious problem for an economy. Discuss the ways it can be harmful and why it is not always harmful.


➤ 3.1 A current account can be harmful to the economy in several ways.

⫸ 3.1.1 If a current account deficit is financed through borrowing it is said to be more unsustainable.

This is because borrowing is unsustainable in the long term and countries will be burdened with high-interest payments. Other developing countries such as Brazil, African countries have experienced similar repayment problems.


⫸ 3.1.2 There is the risk of capital flight.

A very high balance of payments deficit may, at some point, cause a loss of confidence by foreign investors.

Therefore, there is always a risk, that investors will remove their investments causing a big fall in the value of the currency (devaluation). This can lead to a decline in living standards and lower confidence for investment.


⫸ 3.1.3 A current account deficit is also an indication of an uncompetitive economy.

A current account deficit may imply the economy is becoming uncompetitive and the exchange rate relatively overvalued.



⫸ 3.1.4 There is a risk of depreciation.

A country running large current account deficit is always at risk of seeing the value of the currency fall.

If there are insufficient capital flows to finance the deficit, the exchange rate will fall to reflect the imbalance of foreign flows of funds. A depreciation in the exchange rate will cause imported inflation for consumers and firms who rely on imports of raw materials



➤ 3.4 A current account deficit is not always a source of concern.

For example, when the trade deficit is the consequence of rapid growth, which causes higher consumer spending.

When the trade deficit is financed by long term capital flows helps the economy with financing inward investment. If the trade deficit is too large, it will cause a depreciation in the exchange rate to restore competitiveness and improve trade deficit.


Step ➍ : Conclude whether a high rate of inflation or a deficit on the current account of the balance of payments is the more serious problem for an economy.


To conclude, a high rate of unanticipated inflation and cost-push inflation may be a more serious in the long term problem than a current account deficit. Unanticipated inflation can also create uncertainty and so can discourage some consumer expenditure and investment whereas the trade deficit may be the consequence of rapid growth, which causes higher consumer spending. Inflation would also be a concern if it’s rate is higher than in major counties. Hyperinflation can also be a danger to the economy and should be a source of concern. Furthermore, it should be considered that a large trade deficit is self-correcting. If the trade deficit is too large, it will cause a depreciation in the exchange rate to restore competitiveness and improve trade deficit.


♕ Examiner’s report


Some strong answers were provided here and many candidates were awarded a high mark. Unfortunately, some candidates who seemed to have the required knowledge and understanding of the consequences of both a high rate of inflation and a deficit on the current account did not use this to provide sound analysis of each effect. Many answers were overly descriptive and there was again a great deal of time wasted in explaining the causes of inflation. This meant that essential and relevant analysis was omitted. Clearly, this undermined the attempts to provide some evaluative judgement and reach a reasoned conclusion. Careful reading of the question is essential to ensure that full reward is gained for the analysis provided.

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