Current and Financial Account Surpluses and Deficits
Current account deficits (or surpluses) and financial deficits (or surpluses) do not directly affect an economy. In fact, these deficits (surpluses) are actually the result of what is occurring in an economy, instead of being the cause. Trade deficits often occur when a nation's economy is growing faster than the economies of its trading partners. Rapid domestic growth increases the demand for imports, while slow or no growth with foreign economies can cause a decline in demand for the country's exports.
Trade balances are also affected by capital flows. If a nation's economy offers investment opportunities that are relatively better than other nations, then capital will flow into the country. With flexible exchange rates, this capital inflow will tend to increase the value of the nation's currency.
Economic statistics support the hypothesis that trade deficits are associated with investment opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant economic growth for the
Budget deficits and trade deficits tend to be linked
An increase in the
Causes of a Nation's Currency Appreciation or Depreciation
Factors that can cause a nation's currency to appreciate or depreciate include:
·Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to buy those goods. In order to buy those goods, they will need to buy the nation's currency. Countries with the lowest price levels will tend to have the strongest currencies (those currencies will be appreciating).
·Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the supply of their currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange rates involve the currencies of two countries. If a nation's central bank is pursuing an expansionary monetary policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners.
·Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation (appreciation). Suppose the price level increases by 40% in the
·Income Changes - Suppose that the income of a major trading partner with the
Effect of Monetary Policy
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