Current Account of the Balance of Payments

What the current account records

The balance of payments records all transactions between one country and the rest of the world. The current account is the part that records trade and income, not the buying and selling of assets.

▶

It has four sections:

Remittances matter enormously for many developing countries and are frequently what a data-response question is testing.

Current account balance = exports − imports (of goods and services), plus net income and transfers.

• Deficit: more money flowing out than in. Imports exceed exports.
• Surplus: more money flowing in than out. Exports exceed imports.

Causes of a current account deficit

• Loss of international competitiveness: domestic inflation higher than trading partners', or wages rising faster than productivity.
• A strong (appreciated) exchange rate, making exports dear and imports cheap.
• Strong economic growth at home, raising incomes so people buy more imports.
• Poor quality or design of domestic goods compared with foreign ones.
• Dependence on imported goods: energy, food or machinery a country cannot produce itself.
• A narrow export base, especially reliance on a few primary products with volatile prices.

Consequences of a deficit

• Falling demand for domestic output, since spending goes abroad → lower output and higher unemployment.
• Downward pressure on the exchange rate under a floating system, because supply of the currency exceeds demand. This is partly self-correcting, since a weaker currency makes exports more competitive.
• Borrowing from abroad or selling assets to finance the gap, creating future interest and profit outflows.
• Falling reserves under a fixed exchange rate, and reserves are finite.
• Loss of confidence among foreign investors.

But a deficit is not automatically bad. A deficit caused by importing machinery and capital goods may raise future productive capacity, which is very different from a deficit caused by borrowing to buy consumer goods. Making that distinction is one of the strongest evaluation points available.

Consequences of a surplus

A surplus is not automatically good either:

• Higher demand for domestic output raises output and employment, the benefit.
• But a large surplus can be inflationary, adding demand.
• It may mean domestic consumers are enjoying fewer imports than they could.
• It causes the currency to appreciate, eventually reducing competitiveness.
• It can cause trade tension with partner countries running matching deficits.

Policies to reduce a deficit

The trade-off to state: expenditure-reducing works fastest and costs the most in lost jobs; supply-side is slowest and most durable.

Worked example

A country has a persistent current account deficit because its goods are more expensive than foreign competitors'.

1. Domestic inflation has been higher than its trading partners'
2. its exports cost more abroad
3. export volumes fall
4. meanwhile cheaper foreign goods attract domestic buyers
5. imports rise
6. the current account moves further into deficit.

Policy option 1, depreciate the currency. Exports become cheaper abroad and imports dearer at home, so the balance may improve. But imported raw materials cost more, causing cost-push inflation that erodes the gain, and the improvement depends on demand being elastic.

Policy option 2, invest in education and technology. Productivity rises, so firms can produce better goods at lower cost and compete without needing a weak currency. But this takes many years and is expensive.

Judgement: depreciation buys time; only supply-side improvement fixes the underlying problem. A government facing an urgent deficit will likely use both.

Common exam mistakes

• Confusing the balance of trade (goods and services only) with the whole current account.
• Forgetting primary and secondary income, especially remittances.
• Saying a deficit is always harmful, without asking what is causing it.
• Saying a surplus is always good.
• Recommending protection without mentioning retaliation.
• Ignoring that expenditure-reducing policies raise unemployment.

Exam technique

Name the four sections of the current account when asked about its structure; that is usually four marks.

For causes and consequences. Always distinguish why the deficit exists. A deficit from importing capital goods deserves a different judgement from one caused by lost competitiveness.

For policy questions, organise by the three approaches, switching, reducing, supply-side, and compare them on speed versus durability.

Building an answer

4 marks, "Explain two causes of a current account deficit."

A high exchange rate makes exports expensive abroad and imports cheap at home, so export volumes fall and import volumes rise.
Strong domestic demand pulls in imports: as incomes rise, households buy more goods, a substantial share of which are produced overseas.

6 marks, "Analyse policies to reduce a current account deficit."

Expenditure-reducing policies cut total domestic demand, higher taxes or interest rates, so spending on imports falls with everything else. They work, but at the cost of lower output and higher unemployment.
Expenditure-switching policies redirect spending towards domestic goods: a depreciation makes exports cheaper and imports dearer, while tariffs and quotas restrict imports directly, though these risk retaliation.
Supply-side policies attack the underlying cause by improving competitiveness, investment in skills, infrastructure and technology so domestic goods are better and cheaper. This is the durable solution but the slowest.
A depreciation only improves the balance if the Marshall-Lerner condition holds, and the J-curve means it will worsen first.

What sits in the current account

A common error is treating "balance of payments" and "current account" as synonyms. The current account is one part; the financial and capital accounts record the flows of assets that must offset it.

Is a deficit always a problem?

Not necessarily, and saying so earns evaluation marks. A deficit financed by inward investment in productive assets may be sustainable and even beneficial, because that investment raises future output. A deficit driven by consumption of imported goods and financed by borrowing is far more concerning. Size relative to GDP, persistence, and how it is financed all matter more than the deficit's existence.

A real case to quote

The United States. It has run a current account deficit for decades, financed by the willingness of the rest of the world to hold dollar assets. It is the standard illustration that a persistent deficit need not cause a crisis when the deficit country issues the world's reserve currency, and equally that this is a privilege very few countries have.

Quick revision

• Current account: trade in goods, trade in services, primary income, secondary income.
• Deficit = imports exceed exports; surplus = the reverse.
• Causes of a deficit: lost competitiveness, strong currency, fast growth, narrow export base.
• Consequences: lower output and jobs, currency pressure, borrowing from abroad.
• A deficit is not automatically bad: it depends on what is being imported.
• A surplus can be inflationary and cause trade tension.
• Policies: expenditure-switching (fast, inflationary), expenditure-reducing (fast, costs jobs), supply-side (slow, durable).

Not the topic you were looking for? Describe what you are stuck on in your own words and we will take you to the notes that answer it.