Assess the Significance of an increase in the size of the deficit on the Current Account for the UK economy

The UK economy has been a favoured venue for overseas direct investment; the UK cannot always rely on inflows of financial capital into the economy to finance the current account deficit. The current account deficit is an indicator that UK production has deteriorated and it cannot keep up with the rest of the global economy. It indicates this as the UK consumers are spending more on foreign imports and UK producers are not responding to this rise in demand. This means that foreign investors may eventually take fright, lose confidence and take their money out. Or, they may require higher interest rates to persuade them to keep investing in an economy. Higher interest rates then have the effect of depressing domestic consumption and investment. This will therefore lead to a slow down in UK economic growth.

A large deficit in trade in goods and services represents an excess supply of the currency in the foreign exchange market and can lead to a sharp fall in the exchange rate. This would then threaten an increase in imported inflation and might also cause a rise in interest rates. A declining currency would help stimulate exports but the rise in inflation and interest rates would have a negative effect on demand, output and employment. If interest rates increased consumers are more likely to save, as they are not confident in the economy, they are also less likely to borrow. On one hand this would slow down the consumption of imported goods and holidays abroad but it would also slow down the consumption of the home market produce. Therefore this would lead to unemployment as demand had decreased and companies were losing money, this in turn would lead to a fall in the standard of living. Therefore causing a multiplier effect.

A depreciation of the pound sees the market value of the pound fall against other currencies. The economic effects of a lower pound take time to happen. A fall in the exchange rate makes imported goods and services more expensive in the UK. Producers may then pass on higher costs of imported components and raw materials onto consumers. This causes extra "cost-push" inflation. Wages may rise in response to this triggering off the possibility of a wage-price spiral. Exporters should benefit from a lower pound. Depreciation makes UK goods cheaper priced in a foreign currency. Demand for exports will grow faster if the demand for UK goods overseas is elastic. The demand for imports should fall, as imports become more expensive. However, some imports are essential for production or cannot be made in the UK and have an inelastic demand - we end up spending more on these when the exchange rate falls in value. This can cause the balance of payments to worsen in the short run this is known as the J-curve effect. Partly due to higher inflation and falling real incomes, wages may rise. This depends on what stage of the economic cycle the economy is in. When unemployment is high, workers may have little confidence that their wage demands will be met, this cause less incentive for people to work therefore the unemployment figures increase and the standard of living decreases.

Although an increase in the current account deficit causes problems for the UK economy if the deficit is mainly due to consumer expenditure a recession or slowdown should help to reduce the problem. Consumers cannot go on spending in excess of their income forever. Eventually they have to control their spending and start saving again to improve their own finances. Britain has sustained current account deficits of much larger proportions in the past and this has not provoked major crises of confidence in the international financial markets. Britain has one of the most open capital markets in the world. Thus far the country has proved attractive for overseas investment and financing a trade deficit in goods and services has not triggered a sharp collapse in the value of the sterling. As long as the investment continues the deficit on the current account is not overly significant.