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.