When there is an account deficit, net flows and investments are taking more money out of the economy than it is flowing in. this causes a fall in aggregate demand. When there is a current surplus, there is a net flow and aggregate demand will rise.
Effects of deficits are:
- It leads to a loss if aggregate demand thus slower growth
- In the long run, persistent trade deficits undermine the standards of living
- Deficits can lead to loss of jobs in home-based industries
- Deficit countries need to import capital to achieve balance
- A deficit can lead to currency weakness and higher inflation
- A country may run short of vital currency reserves
- Currency deficit may lead to capital flight/ loss of investor confidence
A surplus in an economy may be caused by various factors among them;
- Export-oriented growth
- Foreign Direct Investment
- Undervalued exchange rate
- High domestic savings rates and low domestic consumption of goods and services
- Closed economy caused by a range of tariffs and non-tariff barriers.
- Strong investment income from overseas investments
Inflation not only creates problems within the economy but also in the sphere of external trade of a country, that is, country’s trade balances with the rest of the World. Country’s trade relations with the other countries involve exports and imports of goods and services and how much a country will export and import depends, amongst another thing, on the domestic price level and variation in it, that is, the rate of inflation.
Country’s transactions with the other countries, which are recorded in the balance of payments (BOPs), get adversely affected if the domestic price rise is high. The high rate of inflation in the domestic market makes domestic goods unattractive to the foreigners and therefore, reduces demand for exports. Moreover, because of high domestic prices, residents prefer to buy foreign goods which imply an increase in imports. The result of falling exports and increasing imports, on account of high domestic inflation, is the adverse disequilibrium in the BOPs which, if not kept within limits, can assume serious proportion and spell a BOPs crisis.
Policy mistakes in the form of high and unsustainable fiscal deficit financed through the creation of new money lead to unprecedented growth in money supply. The resulting inflation entails high growth in imports than exports and finally, leads to a very serious BOPs crisis involving a steep decline in foreign exchange reserves and the possibility of default on external payment front.
An upward movement in the price of an imported raw material will raise the cost of production in those sectors where the raw material is used and cause prices of finished products to move up. Similarly, change in the exchange rate of the currency can impact domestic inflation by changing the import prices.
In a free economy, where there are no restrictions on the free movements of goods, high domestic inflation relative to the inflation in the trade partners, can have a negative effect on exports and positive effect on imports. In other words, high domestic inflation will cause imports growth to exceed the growth in exports and thereby lead to a worsening of trade balance.
In a developing country setup, like that of India, where there are a plethora of restrictions on both imports and exports and imports are strictly regulated in a bid to achieve the objective of self-reliance, the impact of inflation on imports and exports cannot be ascertained very easily.
So in a developing country setup, the impact of inflation on imports and exports and trade balance cannot be ascertained and it, therefore, cannot be said that higher growth in imports than in exports and the negative trade balance always was the result of high domestic inflation.
Using the value of merchandise exports and imports to study the correlation between them and domestic inflation may not be the right way, as the prices of exports and imports are largely determined by the international forces. So to study the relationship between domestic inflation and merchandise trade, it makes sense to use quantity figures both for exports and imports, given by their index numbers, as they are largely determined by the domestic inflation.
The exchange rate of a currency, among other factors, is influenced by the domestic inflation. Under a flexible exchange rate system, though the exchange rate is determined by the demand and supply of the currency, what operates from behind the demand and supply are the factors like inflation. Foreign exchange reserves get not only impacted by the inflation, but they also affect it through their effect on domestic money supply. Foreign exchange reserves flow to that country which exhibits better macroeconomic management, one indicator of which is stable and low inflation.