Question

In many ways, the economy of a country is like the economy of a household. If the household spends more than it earns, then it faces difficult times. On the other hand, if it earns more than it spends, then it can save for a rainy day.

Discuss the relevance of this analogy to the economy of a country. In particular, discuss imports, exports, the balance of payments, and the strengthening or weakening of the nation’s currency.

Answer 1

Similar to a household, if the domestic demand in an economy exceeds its domestic supply, the shortage is covered by importing from other economies. Since an increase in import increases trade deficit, it gives rise to higher current account deficit.

An increase in import increases the demand for foreign currency and decreases the demand for domestic currency, which depreciates domestic currency. A domestic currency depreciation makes its exportable goods more competitive in global market, so export demand rises, which counteracts the increase in trade and current account deficit by raising exports and lowering imports.