IB Economics HLTopic 4 — The Global EconomyPaper 1, 2 & 3Evaluation~12 min read
Living With a Current Account Deficit
A country running a current account deficit is spending more abroad than it earns abroad, year after year. Whether that is a crisis or a non-event depends almost entirely on why it is happening and how it is being paid for. Answers that treat every deficit as a disaster are the ones that lose marks.
📚 What you need to know
A persistent current account deficit means consistently spending more on imports than is earned from exports.
It puts downward pressure on the currency, because the country keeps supplying its own money to world markets.
It is financed by selling assets or borrowing, so foreign ownership and external debt rise.
Central banks may raise interest rates to attract inflows and support the currency.
Governments can do nothing, or use expenditure switching, expenditure reducing or supply-side policies.
Every one of those policies has a real cost, which is where the evaluation marks are.
What a persistent deficit does
Notice the first box does two jobs. The falling currency is what worries investors, and it is also the mechanism that begins to close the deficit on its own.
Effect
Why it happens
Depreciating currency
The country is constantly supplying its own currency to world markets to pay for imports, so supply exceeds demand and the price falls.
Higher interest rates
To stop the currency sliding, the central bank raises rates to attract foreign and portfolio investment, which raises demand for the currency.
More foreign ownership
The deficit must be financed by capital inflows, which often means selling domestic firms, property and shares to foreign buyers.
Rising external debt
Where financing comes from borrowing rather than asset sales, the stock of debt owed abroad grows year after year.
Worsening credit rating
If the deficit looks unsustainable, rating agencies downgrade the country, pushing up the interest it must pay on new borrowing.
Policy conflicts
Fixing the deficit usually means cooling domestic demand, which clashes with goals for growth and employment.
Weaker long-run growth
A chronic deficit can signal that the economy is leaning on external finance rather than on its own productivity.
Is a deficit always a problem? No.
This is where the best answers separate themselves. Ask three questions before you judge.
🧩 Three questions before you call a deficit dangerous
How big is it relative to GDP? A deficit of 1% of GDP is background noise. One above 5% sustained for years is a genuine warning sign.
What is being imported? A country importing machinery and technology is building future productive capacity. A country importing consumer goods on credit is not.
How is it financed? Long-term FDI is stable money that stays. Short-term portfolio flows can reverse in days, which is what turns a deficit into a crisis.
A deficit financed by hot money is a completely different animal from one financed by factories being built. Same number in the accounts, very different level of risk. Say this and you are writing at the top band.
What a government can do
Only the last option raises what the country is actually able to sell. The other three work by changing prices or squeezing demand.
The four options in more detail
Policy
Benefits
Costs
Do nothing
Under a floating rate the deficit is self-correcting. The currency depreciates, imports become dearer and fall, exports become cheaper and rise, and the balance improves without any government action.
Other forces can stop the currency falling, so correction may never arrive. In the meantime domestic firms competing with imports can go under, and the longer it drags on the more firms delay investing.
Expenditure switching
Tariffs, quotas and devaluation shift consumers from imported goods to domestically made ones, which cuts import spending and supports home producers.
Protection invites retaliation. Trading partners put tariffs on your exports, which cancels out the improvement and can leave the balance no better.
Expenditure reducing
Higher taxes or lower government spending cut disposable income, so households buy fewer imports and the deficit shrinks.
Cutting demand cuts demand for everything, not just imports. Output falls, growth slows and unemployment rises.
Supply-side policies
Better skills, infrastructure and technology raise the quality of exports and lower production costs, so exports become genuinely more competitive.
Results take years to appear, and government spending on subsidies, training or infrastructure always has an opportunity cost.
Language check. Expenditure switching changes what people buy. Expenditure reducing changes how much they buy in total. Mixing these up is one of the most common errors on this topic.
Worked examples
WORKED EXAMPLE 1
A country has run a current account deficit averaging 6% of GDP for five years, financed mainly by short-term portfolio investment. Explain why this is more risky than a deficit of the same size financed by FDI. [4]
Step 1: what portfolio money is
Shares and bonds bought by foreign investors who can sell them at any time.
Step 2: what happens if confidence falls
Investors sell, convert back to their own currency, and the supply of the local currency jumps. The currency falls sharply.
Step 3: the funding gap
The deficit still exists but the money financing it has gone, forcing emergency rate rises or borrowing.
Step 4: why FDI is different
A factory cannot be sold and shipped out in a week, so FDI is stable financing.
Same deficit, very different risk of a sudden crisis
WORKED EXAMPLE 2
Evaluate the use of expenditure reducing policies to correct a persistent current account deficit. [15-style plan]
How it works
Raising income tax or cutting government spending lowers disposable income, so households buy fewer imports and the deficit narrows.
Strength
It is fast and within the government’s direct control, unlike waiting for a currency to depreciate.
Weakness 1
It cuts demand for domestic output as well, so GDP growth slows and unemployment rises.
Weakness 2
It does nothing about competitiveness, so the deficit returns as soon as demand recovers.
Judgement
Useful as a short-term brake, poor as a long-term fix. Pair it with supply-side measures that raise export quality.
Treats the symptom quickly, leaves the cause untouchedsay what it depends on: the size of the deficit, how close the economy is to full employment, and the elasticity of import demand
💡 Exam tip
Always express the deficit as a share of GDP before judging it. Absolute figures mean nothing on their own.
Say how it is financed. Hot money versus FDI is the sharpest evaluation point available on this topic.
Remember that under a floating rate there is an automatic correction mechanism. Governments do not always have to act.
Name the policy families precisely: switching, reducing, supply-side. Vague answers about “government policies” score poorly.
Every policy has a cost. Match each benefit with its cost and you have written the evaluation without needing a separate paragraph.
⚠ Common mix-up
A current account deficit is not a budget deficit. One is about trade with the world, the other about government finances.
Deficits are not unpaid bills. They are financed every year by capital inflows — that is what the mirror rule means.
Switching is not reducing. Switching redirects spending; reducing shrinks it.
Protectionism is not a clean solution. Retaliation can leave the balance unchanged and both countries worse off.
A deficit is not automatically a sign of a weak economy. Fast-growing economies importing capital goods often run one on purpose.
Up next: The Marshall-Lerner Condition and the J-Curve — the HL rule that tells you whether a depreciation will actually work.
Want this explained one-to-one?
Book a free session with an experienced IB Economics tutor and get your trickiest topics made simple.
