When countries have severe balance of payments difficulties caused by unsustainable current account deficits, they can approach the International Monetary Fund (IMF) for assistance. In providing financial assistance, the IMF generally insists that the country implement a series of policy changes designed to reduce the deficit. These programs are controversial as they tend to focus on demand reduction. Explain why demand reduction would solve a current account deficit problem. Would a program designed to increase the nation's gross domestic product (GDP) growth rate be a method of reducing a current account deficit? Why or why not?

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE: One of the views of the current account is that it is the difference between domestic product and national expenditure. Demand reduction is believed to be able to reduce the national expenditures and thus lower the current account deficit (or create a surplus). This should be the direct effect of demand reduction. (However, the demand reduction might reduce domestic production (GDP).) A program which is able to increase the nation's GDP growth rate could lead to a reduction in the current account deficit because, as already mentioned, the current account equals domestic production minus national expenditure.