4.6.4 (HL)—Current account and exchange rate

A persistent current-account deficit increases the economy’s need for foreign financing. If investors reduce their willingness to supply that finance, demand for the currency may fall and depreciation can make imports dearer and exports more competitive.

The response is not automatic: capital inflows can support the currency, and the trade balance reacts according to elasticities, capacity and time. Separate the accounting identity from the causal story about confidence and exchange-rate adjustment.

Current-account transactions directly enter the currency market: foreign buyers of exports create demand for the domestic currency, while domestic buyers of imports create its supply. A larger deficit caused by import demand or weaker exports tends, other things equal, to shift currency supply right or demand left and depreciate a floating rate; a surplus tends toward appreciation. Draw the relevant demand/supply shift, but allow financial inflows, reserves or policy to offset it, so an accounting deficit alone does not mechanically determine the rate.