10.2.2—Balance of payments and inflation

If domestic inflation is higher than trading partners’ inflation, domestic goods may become less competitive, while imports become relatively attractive, tending to weaken the trade balance if quantities respond.

The effect depends on the exchange rate, quality, contracts, import content, demand elasticities and the time horizon. Inflation caused by a depreciation may be accompanied by an initial trade-balance worsening before quantities adjust.

A 6% domestic inflation rate against 2% abroad can make exports relatively expensive, but a productivity gain or currency depreciation may offset part of that loss.

Higher inflation does not mechanically cause a current-account deficit; relative prices, quantities and income flows all matter.