Science: Sociology

Foreign Trade/Current Account Deficit

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Economics Essay: Foreign Trade

a) Explain what is meant by a Current Account Deficit and why is it considered 'bad' to have an increasing CAD?

The Current Account Deficit generally means that our nation is spending more than it earns. This means that we have to borrow from other countries in order to pay for the things we purchase (imports). When we borrow from them we have to pay interest rates and these are additions to the original debt, therefor they increase the total debt owed.

It is considered a bad thing to have an increasing current account deficit because we are borrowing from other countries and then repaying them even more, due to interest rates. We are increasing the flow of money out of our economy and into a foreign economy.

Another reason why an increasing current account deficit is considered a bad thing is because it affects the exchange rate, as a reduction in the Australian dollar restricts the things we import.

b) What are the main reasons for Australia experiencing a sustained CAD?

Australia is experiencing a sustained current account deficit for many reasons. These reasons include: high interest rates, worsening terms of trade, high consumer spending and less saving, inflation, variations of the exchange rate, freight and tourism and international competitiveness.

The first reason is the fact that interest rates on existing debt are high as well as the fact that we don't save enough, adds a considerable cost onto the final debt. Higher interest rates drive us further into debt than we began with, leading to a greater debt.

Second is worsening of terms of trade. When import prices rise faster than export prices, the terms of trade will turn against us. We will sell what we make at a cheaper price than what we bought it for.

High consumer spending is another reason for the sustained current account in Australia. If the government spends more than it takes from people (taxes), a deficit budget occurs. This increases consumer spending even though we can't afford it.

Inflation also contributes to the current account deficit as it influences international competitiveness. If workers wages don't match the level of productivity, then businesses don't match overseas performance. This loses international competitiveness, another factor contributing to the current account deficit.

Freight is also a reason why the current account in Australia is sustained. Australia is such an isolated country and doesn't have a major shipping line. Therefore we must pay transport costs as well as higher insurance rates. These two factors add to the cost of imports once again.

Tourism also creates a higher current account deficit for Australia as it has been proven that we spend more money in foreign countries (e.g. on holidays) than they do here in Australia. Also, many foreigners want to invest in Australia, therefore they buy out businesses.

Different exchange rates are another contributing factor. The foreign debt is recorded in foreign currency. This means that if the Australian dollar depreciates then the principle and interest rates of the debt will also increase, leading to an increase in the total debt in turn.

c) What government policies/strategies could be implemented to reduce Australia's CAD?

External balance is when a country has a recurring and large account deficit. To reduce the current account deficit there are many things that can be done.

Depreciation is the first one. If there is depreciation in the Australian dollar, import prices will rise and export prices will fall, leading towards a high demand for exports and a reduction in the cost of imports.

Another way is to reduce inflation. With a high inflation rate there is an increase in a country's output against other countries. This leads towards higher demand for imports and a decreased demand for exports, also leading towards a reduction in the current account deficit.

Increased productivity is another way that the current account deficit can be reduced. If workers rate of productivity increased then so will the nations competitiveness. This will then increase exports, lowering the current account deficit.

Another method is to use tariffs and quotas on imported goods and services that would restrict the amount of imports that could be purchased. Reducing purchasing power means that we won't have the freedom to import as much as we do at the moment. This method wouldn't work really because as well as decreasing imports, exports would also decrease.

Reducing domestic spending and increasing savings is also is a way to reduce the current account deficit. If the government increased the budget surplus or decreased the budget deficit, then a reduction in aggregate demand would occur, causing a reduction in expenditure.

The government could also increase interest rates and decrease the money supply and then credit would become expensive, discouraging forms to invest. A reduction in investment means a reduction on imports.

The microeconomics reform is another way to decrease the current account deficit in Australia. This means that if industry became more efficient and aware, it would have better organization of production and distribution. This would mean we had less chance of creating a large current account deficit.