As imports become expensive, it will reduce the people’s disposable income to buy imported goods and services. This will result in a drop of standard of living of the people as high prices reduce the variety of goods that are available to people to choose from.
Another unfounded worry about the trade deficit is that it will saddle future generations with an unsustainable “foreign debt”. When a country spends more than it earns from imports, it may have to finance it through foreign loans. This would increase foreign debt, which could be risky if there are high interest rates and sustained current account deficits. If this foreign finance is spent on consumption rather than income producing investment, then the country’s export income will not grow adequately to service the debt. This may lead to even more borrowing to cover the deficits.
For example, US was borrowing more than $2 bn daily to finance its trade gap because of the trade deficit in the year 2006.
(http://news.bbc.co.uk/2/hi/business/6450565.stm)
A trade deficit has adverse impact on a country’s economic growth as it would decelerate the output and income of an economy. Fall in export prices is another implication of a trade deficit. The cost of production will fall as there is a downward pressure on the aggregate demand on net exports, thus making it difficult for local export industries to raise prices of their products.
There is also pressure for the government to change its macroeconomic policies such as contractionary monetary policy. That is increasing interest rates as a way of controlling the current account deficit. There by the government would be able to reduce the level of spending made on imports as the cost of capital is higher, but this would cause downturn in economic growth and hence create unemployment and would lead the economy to a recession.
According to the statistics the country having the largest current account surplus is Japan with a balance of US $ 165,600 million and USA with the biggest deficit of US $ 829,100 million.
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The United States have posted a trade deficit since 1970’s and a continuous deficit since 1976 till now. () The US economy has grown over the past 25 years while the current account deficit expanded compared with the years that it shrank. At times of rising deficits the US economy experienced positive effects on employment rate and manufacturing output but not when the deficit was contracting. Critics of trade liberalization often point to the trade deficit as proof that trade destroys job where exports create jobs and imports mean less domestic production and fewer jobs. Another problem with the trade deficit is that unsustainable foreign debts would saddle future generations and as a result it will spook the foreign investors and weaken US dollar.
On the other hand, it ignores the fact that trade deficits are linked to a strong, not a weak, dollar. The trade deficit will increase the acceptance of the dollar in the world economy as many foreigners accept dollar in return for their import payments. The best thing for the US economy would be to ignore the trade deficit and concentrate on having a strong economy to attract foreign investment. As long as investors around the world will see the United States as a safe and profitable haven for their savings, the trade deficit will persist, and Americans will be better off because of it.
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Government policies in mitigating a current account deficit in the short run would be to use expenditure switching policies. The government will be able to scale down the demand for imported products by using protectionist policies such as tariffs, quotas on imports. This will result in a shift in consumption of foreign goods to domestically produced goods.
For example, Last year US announced that they would put protectionism barriers if China does not take action to reform their currency. This policy was brought forward because of the fact that US had a high record of deficit in 2005 as there was a growing current account deficit with China. However, this policy would go against the principle of free trade hence leading to lower standards of living as there is less choice for consumers. This would also reduce the incentive for local firms to be efficient as there is no foreign competition.
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On the other hand the government will be able to make the exports more attractive to foreign buyers by subsidizing on exports to reduce the price of exports. Thus increasing the level of exports which would help to reduce the current account deficit.
A lower exchange rate could be another way to overcome the current account deficit. This means devaluing the currency against other currencies. As a result this would increase the prices of imports and reduce the prices of exports and hence improve the situation. Devaluation of the currency would also to help to boost the tourism industry, since foreigners’ currency will be relatively strong and their purchasing power will be higher which will encourage them to visit the country and spend more.
The Marshall Lerner condition states that devaluation will only improve the trade deficit, only if the elasticities of demand on imports and exports are greater than 1.
Example: Bangladesh has devalued his currency in year 1999, the Taka, by three percent in a bid to raise exports and boost foreign exchange reserves.
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Many economists also believe that the US dollar should be devalued in order to correct CAD. On the other hand this is expected to increase inflationary pressure and slow down the economy. (http://news.bbc.co.uk/2/hi/business/6054756.stm)
However, in the short run devaluation may not improve the current account deficit; hence it would worsen the deficit. This is due to the fact that in the short run, the demand for imports and exports is likely to be inelastic. This effect is known as the “J curve effect”.
If the economy is at point A (already at a deficit) then devaluation of the currency would move the economy to point B. This is because when contracts for imported goods have been signed, though it’s expensive they wouldn’t be able to switch from imports in the short run.
As time goes by consumers will find alternatives and local producers may increase supply, therefore improving the current account position in the long run.
(http://www.tutor2u.net/economics/content/topics/exchangerates/j_curve.htm)
The government could also use expenditure reducing policies in the long run to bring down the level of aggregate demand in an economy. Contractionary monetary and fiscal policy would be used to reduce the level of consumer spending on imports. By using contractionary monetary policy the government will be able to reduce the level of money supply in the economy hence reducing the level of imports and increasing the level of exports. But this would increase interest rate and reduce the level of local competitiveness. The contarctionary fiscal policy could be used to increase taxes and to reduce government expenditure. As income would reduce the level of imports would fall and reduce CAD.
Control of exchange rate systems by the government would also help to reduce deficit as locals will be unwillingly to buy foreign goods if it’s expensive. Supply side policies such as education training reducing unemployment benefit will increase the productivity of an economy and make its products more competitive in the foreign market. This will help to reduce the current account deficit in the long run.
Conclusion
Milton Friedman, the Nobel prize winning economist and father of Monetarism, believed that deficits would be corrected by the free markets as floating currency rates rise or fall with time to encourage or discourage imports in favor of the exports, reversing again in favor of imports as the currency gains strength.
(http://en.wikipedia.org/wiki/Balance_of_trade)
However, a prolonged current account deficit could be damaging to the economy and may lead to some serious economic implications. The government policies could be brought in to mitigate a current account deficit, but still there will be problems in overcoming the current account deficit.
(1646 words)
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