IB Economics HL 3.2.4 Alternative Views of Aggregate Supply Questions

Study the extract and data below and answer the questions that follow.
Britain's current account deficit

(1) In 2016 a public vote resulted in the decision that Britain would leave the European Union. This became known as "Brexit". Since the Brexit vote, the pound (Britain's currency) has fallen from almost US$1.50 to around US$1.30 against the pound as a result of investor uncertainty.

(2) Currency depreciation can be a very useful tool for countries when they have become locked in to an overvalued exchange rate. For example, in 1992 Britain abandoned its managed exchange rate system and the pound fell rapidly. Following this, the economy picked up quickly and the inflationary impact was limited. However, the circumstances at that time were very different; interest rates were 12 %, there was a lot of spare capacity in the economy and unemployment was 10 %. Now interest rates are just 0.5 % and unemployment is 5 %.

(3) Britain's current account deficit is at around 7 % of its gross domestic product (GDP), which is said to be "highly uncomfortable" (see Figure 1). Prior to the Brexit vote, the deficit was not seen as a concern due to the fact that Britain was very successful in attracting foreign direct investment. Now, foreign investors are uncertain about economic prospects and seem to be holding back on investments in Britain. The property market is also seeing signs of reduced demand.

(4) One economist said that "there is a substantial danger that the United Kingdom (UK) will find it increasingly hard to attract the inward flows of capital needed to finance the current account deficit, particularly given its recent credit rating downgrades and the very real possibility of more uncertainty". A ratings agency predicted that investment will fall by 5 % in 2017 because of the uncertain climate created by the Brexit vote. In addition, the country will struggle to attract foreign savers because interest rates are near zero.

(5) Theoretically, the fall of the pound will make British assets attractive to foreign investors. However, one research agency argues this may require a very steep depreciation of the exchange rate. It estimates that the pound/dollar exchange rate will settle at around US$1.42 to the pound. In order to eliminate the current account deficit the exchange rate would have to fall to a value of US $\$ 1.00$ to the pound. This is unlikely to happen.

(6) In theory, depreciation could be good for exports. Britain experienced one big depreciation in the pound in 2009, which reduced the current account deficit for a while, but the effect was only temporary.

(7) Another economist indicated that Britain's current account deficit will limit the government's flexibility in the use of demand-management policies.

Using a Keynesian AD/AS diagram, explain the meaning of the phrase "a lot of spare capacity in the economy" (paragraph (2).