Current account of balance of payments Revision Notes

The current account is a key part of a country's balance of payments, summarising all transactions of goods, services, income, and transfers between residents and non-residents over a period, usually a year or a quarter. It reflects how much a country is earning from and spending on international trade and income flows.

A current account surplus means the country earns more from abroad than it spends, while a deficit means it spends more than it earns. These balances influence exchange rates, economic growth, and policy decisions.

• Current account = trade in goods + trade in services + primary income + secondary income.
• Surplus: exports and income receipts exceed imports and payments.
• Deficit: imports and payments exceed exports and income receipts.

Trade in goods involves the export and import of physical products such as machinery, food, clothing, and vehicles. It is often the largest component of the current account.

Exports of goods bring money into the country, while imports represent money leaving the country. A trade surplus in goods occurs when exports exceed imports; a deficit occurs when imports exceed exports.

For example, if a country exports £200 billion worth of cars and imports £150 billion worth of electronics, it has a goods trade surplus of £50 billion.

• Physical products crossing borders.
• Exports add to current account credits.
• Imports add to current account debits.
• Balance = exports − imports.

Trade in services covers intangible products such as tourism, banking, insurance, education, and transport. Like goods, services exports bring income, and imports represent spending abroad.

For instance, if many foreign tourists visit a country, spending on hotels and attractions counts as service exports. Conversely, if residents travel abroad and spend money, this counts as service imports.

Service trade balances can be smaller than goods but are increasingly important in modern economies.

• Intangible products like tourism and finance.
• Exports of services increase current account credits.
• Imports of services increase current account debits.
• Balance = service exports − service imports.

Primary income includes earnings from investments and employment abroad. This covers dividends, interest, profits from foreign direct investment, and wages earned by residents working overseas.

For example, if a country's companies earn £10 billion in profits from foreign subsidiaries, this is primary income inflow. If foreign investors earn £8 billion from investments in the country, this is an outflow.

The net primary income balance is the difference between income received from abroad and income paid to foreigners.

• Income from investments and work abroad.
• Includes dividends, interest, profits, wages.
• Net primary income = income received − income paid.

Secondary income consists of unilateral transfers where no goods or services are exchanged. This includes remittances sent home by workers abroad, foreign aid, and gifts.

For example, if migrant workers send £5 billion home, this is a credit in secondary income. If the country sends £3 billion in foreign aid, this is a debit.

These transfers affect the current account but do not involve reciprocal transactions.

• Unilateral transfers without exchange of goods/services.
• Includes remittances, foreign aid, gifts.
• Net secondary income = transfers received − transfers paid.

To calculate the current account balance and its components, sum the credits and debits for each element and find the net balance.

Consider a country with the following annual data (in £ billion):

Exports of goods: 250; Imports of goods: 300; Exports of services: 100; Imports of services: 80; Primary income received: 20; Primary income paid: 25; Secondary income received: 10; Secondary income paid: 5.

• Step 1: Calculate trade in goods balance = 250 − 300 = −50 (deficit).
• Step 2: Calculate trade in services balance = 100 − 80 = +20 (surplus).
• Step 3: Calculate primary income balance = 20 − 25 = −5 (deficit).
• Step 4: Calculate secondary income balance = 10 − 5 = +5 (surplus).
• Step 5: Sum all balances: (−50) + 20 + (−5) + 5 = −30 (current account deficit).

The current account of a country's balance of payments records all transactions related to trade in goods and services, income from investments, and transfers such as remittances. A current account deficit occurs when a country imports more goods, services, and income payments than it exports, meaning it spends more abroad than it earns. Conversely, a current account surplus happens when exports and income receipts exceed imports and payments abroad. Understanding why these imbalances occur is essential for analysing a country's economic position and policy needs.

• Current account deficit = imports + income payments > exports + income receipts.
• Current account surplus = exports + income receipts > imports + income payments.

One fundamental reason for current account imbalances is the relationship between a country's savings and investment. If domestic investment exceeds savings, the country must borrow from abroad, leading to a current account deficit. For example, a developing country investing heavily in infrastructure may import capital goods and finance this by borrowing internationally, causing a deficit.

On the other hand, if a country saves more than it invests domestically, it lends the surplus abroad, resulting in a current account surplus. For instance, a country with high household savings and limited investment opportunities may export capital by running a surplus.

• Deficit: Investment > Savings → borrowing from abroad → deficit.
• Surplus: Savings > Investment → lending abroad → surplus.

Exchange rates influence the cost of exports and imports, affecting the current account balance. A strong domestic currency makes imports cheaper and exports more expensive for foreign buyers, potentially increasing imports and reducing exports, which can cause a deficit.

Conversely, a weaker domestic currency makes exports cheaper and imports more expensive, encouraging export growth and reducing import demand, which can help generate a surplus. For example, if the British pound depreciates, UK exports become more competitive internationally, potentially improving the current account.

• Strong currency → cheaper imports, expensive exports → deficit risk.
• Weak currency → expensive imports, cheaper exports → surplus potential.

Differences in economic growth rates between countries affect current account balances. Rapid growth often increases domestic demand for imports, as consumers and firms buy more foreign goods and services, which can widen a current account deficit.

Slower growth or recession tends to reduce import demand, improving the current account balance. For example, if Country A grows faster than its trading partners, it may import more, leading to a deficit.

• Fast growth → higher import demand → deficit risk.
• Slow growth → lower import demand → surplus potential.

Trade policies such as tariffs, quotas, and subsidies affect the volume of imports and exports. Protectionist policies can reduce imports, potentially improving the current account balance, though they may provoke retaliation.

Competitiveness, including productivity and product quality, determines export success. Countries with competitive industries tend to have strong export performance, contributing to surpluses. For example, Germany’s competitive manufacturing sector supports its current account surplus.

• Protectionism can reduce imports → improve current account.
• High competitiveness → strong exports → surplus.

The current account of a country's balance of payments records transactions related to trade in goods and services, primary income (such as investment returns), and secondary income (such as remittances). A current account deficit occurs when a country imports more goods, services, and income payments than it exports, while a surplus means exports exceed imports. These imbalances affect key economic indicators including GDP, employment, inflation, and exchange rates through various channels. Understanding these effects is essential for analysing a country's economic health and policy decisions.

GDP measures the total value of goods and services produced within a country. A current account deficit often implies that domestic consumption and investment rely heavily on foreign goods and capital. This can reduce domestic production, leading to lower GDP growth or even contraction if domestic industries lose market share to imports.

Conversely, a current account surplus indicates strong export performance, contributing positively to GDP. For example, if Country A exports £10 billion worth of goods but imports only £7 billion, the net export component adds £3 billion to GDP, boosting economic output.

However, persistent deficits financed by borrowing can temporarily support GDP growth but may be unsustainable in the long term if foreign debt accumulates excessively.

Employment levels are closely linked to domestic production and export demand. A current account deficit can lead to job losses in sectors competing with imports, as domestic firms may reduce output or close due to foreign competition. For instance, if cheaper imported textiles flood the market, local textile factories may downsize, increasing unemployment.

In contrast, a surplus often reflects strong export industries that create jobs. For example, a country with a surplus in manufactured goods exports may see rising employment in factories and related services. However, the overall employment effect depends on the structure of the economy and labour market flexibility.

Current account deficits can cause depreciation of the domestic currency because more of the currency is sold to buy foreign currency for imports. A weaker currency makes imported goods and raw materials more expensive, pushing up the general price level and causing imported inflation.

On the other hand, a current account surplus tends to strengthen the domestic currency, making imports cheaper and potentially reducing inflationary pressures. For example, if the currency appreciates due to a surplus, imported electronics become less costly, which can help keep consumer prices stable or even lead to deflation in some sectors.

It is important to note that inflation effects depend on the openness of the economy and the proportion of imports in the consumer basket.

The current account balance directly influences demand and supply for a country's currency in foreign exchange markets. A deficit means the country needs more foreign currency to pay for imports than it earns from exports, increasing supply of its own currency and causing depreciation.

For example, if Country B has a large current account deficit, investors may sell its currency to buy foreign currencies, lowering its value. This depreciation can make exports cheaper and imports more expensive, potentially correcting the deficit over time.

Conversely, a surplus increases demand for the domestic currency, leading to appreciation. This makes exports more expensive and imports cheaper, which may reduce the surplus eventually. Exchange rate movements thus act as automatic stabilisers for current account imbalances.

One key policy to stabilise the balance of payments is adjusting the exchange rate. A depreciation of the domestic currency makes exports cheaper and imports more expensive in foreign currency terms. This tends to increase export volumes and reduce import demand, improving the trade balance component of the current account.

For example, if the British pound depreciates against the euro, UK goods become cheaper for eurozone buyers, potentially increasing UK exports to Europe. Simultaneously, European goods become more expensive for UK consumers, reducing imports.

However, the effectiveness depends on the price elasticity of demand for exports and imports. If demand is inelastic, changes in price have little effect on quantity traded, limiting improvement. Also, in the short term, contracts and habits may delay response, and inflationary pressures can erode competitiveness if import prices rise significantly. Therefore, exchange rate adjustments can be effective but are not guaranteed to restore balance quickly or fully.

• Depreciation improves export competitiveness and reduces import demand.
• Effectiveness depends on price elasticity of demand for exports and imports.
• Short-term lags and inflation can reduce policy impact.

Governments may impose tariffs (taxes on imports) or quotas (limits on import quantities) to protect domestic industries and reduce import spending, aiming to improve the current account.

For instance, a country facing a large deficit on manufactured goods might introduce tariffs on imported electronics to encourage consumers to buy domestically produced alternatives.

While these policies can reduce imports and support local producers, they risk retaliation from trading partners, leading to trade wars that can harm exports. Additionally, tariffs often raise prices for consumers and can reduce overall economic efficiency by protecting less competitive industries. Therefore, trade policies can provide short-term relief but may damage long-term trade relations and economic welfare.

• Tariffs and quotas reduce imports and protect domestic industries.
• Risk of retaliation and trade wars can harm exports.
• May increase consumer prices and reduce economic efficiency.

Fiscal policy, through government spending and taxation, influences aggregate demand and thus import and export levels. For example, reducing government spending or increasing taxes can lower domestic income and consumption, including spending on imports, improving the current account.

Conversely, expansionary fiscal policy can increase imports by boosting demand, potentially worsening the balance of payments.

For example, if a government cuts spending during a deficit period, consumers may buy fewer imported goods, helping reduce the deficit. However, contractionary fiscal policy can slow economic growth and increase unemployment, so it must be used carefully. Fiscal policy affects the balance of payments indirectly and is often combined with other policies for effectiveness.

• Contractionary fiscal policy reduces import demand by lowering aggregate demand.
• Expansionary fiscal policy can worsen the balance of payments by increasing imports.
• Indirect effect; must balance economic growth and employment concerns.

Each policy has strengths and limitations. Exchange rate adjustments are market-based and can be flexible but depend on elasticities and may cause inflation. Trade policies offer direct control over imports but risk retaliation and higher consumer costs. Fiscal policies influence demand broadly but may have undesirable side effects on growth and employment.

Effectiveness also depends on economic context: a country with diversified exports and flexible markets may benefit more from exchange rate changes, while one with strong trade partners may avoid tariffs to maintain relations.

In the long term, structural policies improving competitiveness and productivity are crucial for sustainable balance of payments stability, beyond short-term fixes.

• Policy choice depends on economic conditions and trade relationships.
• Short-term fixes may have negative side effects or provoke retaliation.
• Long-term structural improvements are essential for lasting stability.