top of page

A level and O level ECONOMICS 

Access 400+ Economics Essays With the Economics Study Pack 
(Free previews below!)

What if you could score the highest grades possible on your economics essays? Subscribe and get access to a collection of high-quality A+ economics essays.

  • Well structured

  • Simple and clear english

  • Diagrams included where relevant

  • For A level, AS level, GCSEs and O level.

 

www.toolazytostudy.com.png

High Inflation and Exchange Rate Impact on Current Account

Explain how a high rate of inflation and a rise in an economy’s exchange rate can each cause a deficit in an economy’s current account of the balance of payments. [8]

Category:

International Trade and Exchange Rates

[CIE A level May 2018]

tgu9i.PNG

Answer

Tip: Consider all aspects of the question. Don't go out of subject, for example, by describing the causes of inflation or categorising inflation as cost-push or demand-pull. .


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


A current account deficit occurs where the value of the goods and services a country imports exceeds the value of the products it exports. This can be caused by either inflation or a rise in an economy’s exchange rate. Inflation is a sustained increase in an economy’s price level. An appreciation or revaluation is a rise in the exchange rate that will make exports more expensive in terms of foreign currencies, and imports cheaper in terms of the domestic currency.


Step ➋ : Explain how a high rate of inflation can cause a deficit in an economy’s current account of the balance of payments.


A current account deficit can be caused by a high rate. This is because inflation will raise the price of exports and reduce the relative price of imports. As a result inflation can cause a current account deficit.

If a country suffers from relatively high inflation, its exports will be more expensive and become less competitive in world markets. At the same time, imports will become relatively cheaper than home-produced goods. Thus exports will fall and imports will rise. As a result, the balance of trade will deteriorate and the exchange rate will fall. Both of these effects can cause a deficit in the current account.

It should however be noted that the effect of inflation on the current account position will depend on the price elasticity of demand (PED) of imports and exports. The greater the PED the greater will be the impact of inflation on the current account.

Furthermore, the impact of a high rate of inflation depends upon that economy’s inflation rate compared to that in other countries.


Step ➌ : Explain how a rise in the exchange rate can cause a deficit in an economy’s current account of the balance of payments.


A rise in an economy’s exchange rate can each cause a deficit in an economy’s current account of the balance of payments. An appreciation will make exports more expensive in terms of foreign currencies, and imports cheaper in terms of the domestic currency. Such a change is likely to result in a fall in demand for domestic products.

A higher exchange rate may increase a current account deficit but the outcome will depend mainly on the price elasticities of demand for exports and imports.

The Marshall-Lerner condition and the J-curve work in reverse. A current account deficit will occur if the sum of the price elasticities of demand for exports and imports is greater than 1. A rise in the exchange rate may reduce a current account deficit in the short run before increasing it in the long run as shown in the figure below also known as the J curve.

rurtrrutu.PNG


Step ➍ : Conclude.


To conclude, a current account deficit can be caused by a high rate of inflation or an appreciation of the currency. This is because both inflation and a rise in an economy’s exchange rate will raise the price of exports and reduce the relative price of imports. As a result both can cause a current account deficit. There will be an increase in imports and a fall in exports causing a current account deficit. The outcome will depend mainly on the price elasticities of demand for exports and imports.

───────────
♕ Mark scheme
───────────
Up to 4 marks for knowledge and understanding and application to show how inflation can cause a deficit.

• For a recognition of the impact of a high rate of inflation upon the relative price of exports and the price of imports (1 mark)
• and the total expenditures on exports and imports (1 mark)
• given the price elasticity of demand for exports (1 mark)
• For understanding that it is the relative rate of inflation that is relevant (1 mark)

Up to 4 marks for knowledge and understanding and application to show how a rise in the exchange rate can cause a deficit.

• For a recognition of the impact of a rise in the exchange rate on the relative price of exports and the price of imports (1 mark)
• and the total expenditures on exports and imports (1 mark)
• given the combined price elasticity of demand for exports and imports greater than one (Marshall-Lerner) (1 mark)
• Reference to the J-curve or long/short run distinction (1 mark)

Both inflation and a rise in an economy’s exchange rate will raise the price of exports and reduce the relative price of imports. As a result, both can cause a current account deficit.

────────────
♕ Examiner’s report
─────────────

This was the most popular question and some very good answers were provided. Those candidates who did less well often provided incomplete answers that neglected to consider all aspects of the question. Many appear to need to be reminded that the current account measures revenues and expenditures and this should be considered when assessing the impact of changes in the prices of imports and exports. A rise in the price of exports due to inflation or an appreciation of the currency will certainly reduce the volume of exports, but this does not necessarily mean a decrease in revenue. It depends upon the price elasticity of demand for exports and this needed to be included for a full answer to this question. Similarly, many candidates did not consider that the impact of a high rate of inflation depends upon that economy’s inflation rate compared to that in other countries. It is the relative rate that matters rather than the absolute rate. A number of candidates wasted time describing the causes of inflation or categorising inflation as cost-push or demand-pull. This was irrelevant to the question set and was not awarded any credit. Some referred to the short run, long-run distinction with reference to the Marshall-Lerner condition. This was a valid approach that was considered relevant development of the question.

lkml.PNG

lkml.PNG

lkml.PNG

lkml.PNG

Halftone Image of a Hand

The above material is protected and is not to be copied.

bottom of page