Economics (9708) | Current account of the balance of payments

AS Level Economics (9708): International Economic Issues

The Current Account of the Balance of Payments (Syllabus 6.3)

Hello future economists! This chapter is all about understanding how a country manages its financial dealings with the rest of the world. Think of it as checking a nation's global "report card" or bank statement. The Balance of Payments (BoP) tracks all money flowing in and out of a country.

Our focus here is the Current Account—the most visible part of the BoP, recording day-to-day trade and income transfers. Mastering this topic is vital for understanding international competitiveness, exchange rates, and macroeconomic stability. Don't worry if international finance seems tricky; we’ll break it down into four simple categories!

1. Understanding the Current Account

The Current Account measures the flow of money into a country (receipts/exports, recorded as credits) and out of a country (payments/imports, recorded as debits), related to trade in goods, services, and income flows.

Key Concept: Credits and Debits

To keep track, remember the Golden Rule:

• Credit (+): Any transaction that brings money INTO the country (e.g., selling exports).
• Debit (-): Any transaction that takes money OUT OF the country (e.g., buying imports).

2. Components of the Current Account (6.3.1)

The Current Account is traditionally divided into four main sections. Learning these is essential for accurate calculations and analysis.

A. Trade in Goods (Visible Trade)

This is the most straightforward component. It measures the value of physical, tangible products exported and imported.

• Exports (Credit): Money earned from selling physical goods abroad (e.g., a German car company selling cars to the UK).
• Imports (Debit): Money paid for buying physical goods from abroad (e.g., a UK supermarket importing Spanish oranges).

Example: Raw materials, machinery, clothes, oil, food.

B. Trade in Services (Invisible Trade)

This measures the value of non-physical services exported and imported.

• Exports (Credit): Money earned when non-residents use domestic services (e.g., foreign tourists spending money in Paris, or a UK bank providing financial advice to an American firm).
• Imports (Debit): Money paid when domestic residents use foreign services (e.g., a German student paying tuition fees to a US university, or flying with a foreign airline).

Example: Tourism, banking, insurance, shipping, education, consultancy.

C. Primary Income (Net Factor Income from Abroad)

This records net flows of income earned from owning factors of production (Land, Labour, Capital, Enterprise) held in other countries. It often includes profits, interest, and wages.

• Credit: Income received by domestic residents from their investments or work abroad (e.g., profits earned by a multinational firm's overseas branch being sent home).
• Debit: Income paid to non-residents for their factor inputs used domestically (e.g., an Italian factory paying interest on a loan from a Japanese bank).

Memory Trick: Primary Income is WIRP (Wages, Interest, Rent, Profit) earned internationally.

D. Secondary Income (Net Current Transfers)

This records transfers of money between countries for which there is no corresponding economic activity or service provided in return. These are unilateral payments.

• Credit: Transfers received (e.g., receiving foreign aid or remittances from workers abroad sending money home).
• Debit: Transfers paid (e.g., giving foreign aid to another country, or contributions to international organisations like the UN).

3. Calculating the Current Account Balance (CAB) (6.3.2)

To determine if the Current Account is in surplus or deficit, we must calculate the balances step-by-step.

Calculation Steps:

1. Balance of Trade in Goods (Visible Balance):
      Exports of Goods (\(X_g\)) - Imports of Goods (\(M_g\))

2. Balance of Trade in Services (Invisible Balance):
      Exports of Services (\(X_s\)) - Imports of Services (\(M_s\))

3. Balance of Trade in Goods and Services (Trade Balance):
      Visible Balance + Invisible Balance

4. Current Account Balance (CAB):
      Trade Balance + Net Primary Income + Net Secondary Income

Current Account Imbalances (6.3.1)

• Current Account Surplus: When total credits (money in) exceed total debits (money out). This is generally seen as favorable, as the country is earning more globally than it is spending.
• Current Account Deficit: When total debits (money out) exceed total credits (money in). This means the country is consuming or spending more internationally than it is earning.

4. Causes of Current Account Imbalances (6.3.3)

Imbalances rarely happen by accident. They are often rooted in structural issues or short-term macroeconomic cycles.

Causes of a Current Account Deficit

A persistent deficit means a country is uncompetitive or its consumers have a high tendency to import.

• Lack of International Competitiveness: If domestic prices (due to high inflation) or production costs (high wages) rise faster than competitors, exports become expensive and imports become cheap, worsening the trade balance.
• Low Productivity/Quality: If domestic goods are of lower quality or fail to meet international standards (poor non-price factors), demand for domestic exports falls.
• High Domestic Income/Growth: During an economic boom, consumer income rises significantly. Since Imports (\(M\)) are often considered a function of National Income (\(Y\)), a strong boom often leads to a disproportionate surge in imports, widening the deficit.
• Exchange Rate Appreciation: If the currency strengthens, exports become more expensive for foreign buyers and imports become cheaper for domestic consumers, worsening the trade balance (the Marshall-Lerner condition suggests this effect might take time).
• Structural Issues: For example, an economy relying on primary commodity exports might suffer if global demand or prices for that commodity drop permanently.

Causes of a Current Account Surplus

A persistent surplus is often a sign of strong competitiveness or subdued domestic demand.

• High Competitiveness: Low production costs, high productivity, and high-quality goods (e.g., Germany’s dominance in manufactured goods).
• Low Domestic Demand/Slow Growth: If domestic consumers and businesses are spending less (low C and I), they import less, improving the trade balance.
• Exchange Rate Depreciation: A weak currency makes exports cheaper and imports expensive, favoring the trade balance.

Did You Know? China and Germany are famous for running large, consistent Current Account surpluses, mainly due to high export competitiveness and high domestic saving rates.

5. Consequences of Imbalances (6.3.4)

Whether a deficit or surplus is "good" or "bad" depends entirely on its size, persistence, and the underlying causes.

A. Consequences of a Current Account Deficit

A large, persistent deficit is worrying because it signifies a nation is living beyond its means.

Domestic Economy Impacts:

• Reduced Aggregate Demand (AD): Since the trade balance (\(X-M\)) is a component of AD, a deficit (where \(M > X\)) acts as a major leakage from the circular flow of income, dragging down AD and economic growth.
• Unemployment: Domestic industries that cannot compete with cheaper imports may shrink or close, leading to higher unemployment in those sectors.
• Inflation (if caused by overspending): If the deficit is driven by excessive consumer demand (a cyclical cause), it often occurs alongside high demand-pull inflation.

External Economy Impacts:

• Depreciation of the Exchange Rate: A deficit means demand for the country's currency (to buy exports) is less than the supply of its currency (to buy imports). This puts downward pressure on the currency value.
• Increased Foreign Debt/Borrowing: To finance the deficit (to pay for the imports), the country must borrow from abroad or sell domestic assets, increasing future liabilities (a link to the Financial Account).
• Loss of Confidence: Sustained deficits can signal a weak economy to international investors, potentially triggering capital flight.

B. Consequences of a Current Account Surplus

While often seen as a sign of strength, a large, persistent surplus also carries risks.

Domestic Economy Impacts:

• Increased Aggregate Demand (AD): Since a surplus (\(X > M\)) is a net injection into the circular flow, it boosts AD and can lead to high economic growth and low cyclical unemployment.
• Inflationary Pressure: If the economy is close to full capacity, the boost to AD from the surplus can result in demand-pull inflation.
• Under-consumption: A large surplus may indicate that domestic citizens are saving too much and consuming/investing too little (as seen in some export-led economies).

External Economy Impacts:

• Appreciation of the Exchange Rate: A surplus means demand for the country's currency exceeds supply, leading to appreciation. This makes future exports less competitive.
• International Tension: Countries running large surpluses (e.g., China) are often accused of 'hoarding' wealth and preventing other countries from exporting, leading to pressure for trade restrictions.
• Net Creditor Status: The country becomes a net lender to the rest of the world, building up foreign assets.

Key Takeaway for Evaluation

When assessing an imbalance, always ask: Is the deficit/surplus cyclical (short-term, due to growth rates) or structural (long-term, due to fundamental lack of competitiveness)? Structural imbalances are much harder to correct and are generally more concerning.