0455 · 6.4Current account of the balance of payments

Current account components

0:00A country can sell cars overseas, welcome foreign tourists, receive investment income, and send money to relatives abroad. These activities all create international transactions. Recording them helps us understand how an economy connects with the rest of the world. By the end, you will understand current account balances, their causes, their consequences, and the policies governments can use. Exports are goods and services sold abroad, while imports are goods and services bought from overseas.

0:26Export earnings bring money into the domestic economy. Payments for imports flow out to foreign producers. Receipts from abroad add to the current account balance, while payments abroad subtract from it. The balance of payments records a country’s transactions with the rest of the world. Its current account records trade in goods and services, primary income, and secondary income. Think of these as four sections in an international transactions statement.

0:50Each section compares money received from abroad with money paid overseas. Trade in goods records exports and imports of physical products. Examples include food, clothing, machinery, and fuel. Its balance equals the value of goods exported minus the value of goods imported. This is also called the visible balance because the products are tangible objects. Trade in services covers intangible products sold to foreign residents and those bought from abroad.

1:16Tourism, banking, and transport are familiar examples. When a foreign visitor pays a domestic hotel, the country earns export revenue from services. A resident paying for accommodation overseas is buying an imported service. Wages, profits, interest, and dividends make up primary income. This component records those earned from abroad minus those paid overseas. This income arises from supplying work or owning investments. For example, a resident might receive interest from a foreign bank account.

1:43Profits paid to an overseas owner enter the payments side of this section. Finally, secondary income records transfers received from abroad minus transfers sent overseas. A transfer is a payment with no goods, services, or assets supplied in return. Workers’ remittances are money sent home by people working abroad, and foreign aid given as a grant also belongs here. Classifying transactions correctly requires attention to their purpose. Interest received on an overseas investment belongs under primary income because it rewards ownership of that investment.

2:14Money sent home to support relatives is secondary income, since the sender receives nothing in return. A payment for an international flight enters trade in services because it purchases transport.

Calculating current account balances

2:24A current account surplus occurs when total receipts exceed total payments across its four components, and a deficit occurs when payments exceed receipts. To calculate any component balance, subtract payments from receipts. The sign then tells us whether that section contributes positively or negatively to the overall balance. For example, suppose goods exports are eighty billion dollars and goods imports are one hundred and five billion dollars. The goods balance equals exports minus imports.

2:51Eighty billion dollars minus one hundred and five billion dollars gives minus twenty-five billion dollars. This is a goods deficit because payments exceed receipts. The same country exports services worth forty-six billion dollars and imports services worth twenty-eight billion dollars. Its services balance is exports minus imports once more. Taking twenty-eight billion dollars from forty-six billion dollars leaves eighteen billion dollars. Services therefore contribute a surplus, and it partly offsets the deficit in goods.

3:21Primary income receipts are nineteen billion dollars, while payments abroad are thirty billion dollars. For income flows, the balance is receipts minus payments. Nineteen billion dollars minus thirty billion dollars gives minus eleven billion dollars. This section adds another deficit because overseas owners and workers receive more than domestic residents earn abroad. Transfers sent overseas total eight billion dollars, and secondary income receipts are fourteen billion dollars. The same rule of receipts minus payments applies.

3:49When eight billion dollars is subtracted from fourteen billion dollars, the secondary income balance is six billion dollars. This surplus reduces the overall gap between money coming into the country and payments going abroad. The current account balance equals the sum of its four component balances. Minus twenty-five billion dollars plus eighteen billion dollars gives minus seven billion dollars. Subtracting eleven billion dollars produces minus eighteen billion dollars. Adding six billion dollars gives minus twelve billion dollars, so the current account has a deficit of twelve billion dollars.

4:21A second country has a goods surplus of twenty-four billion dollars and a services surplus of sixteen billion dollars. Its primary income balance is minus five billion dollars, and its secondary income balance is three billion dollars. Adding the goods and services balances gives forty billion dollars, and the primary income deficit reduces this to thirty-five billion dollars. With three billion dollars more from secondary income, the current account has a surplus of thirty-eight billion dollars.

Causes of account imbalances

4:48Reasons for current account deficits and surpluses often begin with price competitiveness. This is the ability to compete with foreign producers through prices. A foreign exchange rate is the price of one currency in terms of another. A high exchange rate makes exports more expensive to foreign buyers and imports cheaper for domestic residents. Foreign customers may therefore purchase fewer exports, while domestic households buy more imported products. Export earnings can fall as import spending rises.

5:16The effect on the trade balances depends on how strongly quantities respond to those price changes. A relatively low exchange rate can support a surplus through the opposite price effects. Inflation is a sustained increase in the general price level. If domestic prices rise faster than those abroad, locally produced goods can become less competitive. Buyers may switch towards foreign alternatives, so export earnings fall, import spending rises and the current account moves towards deficit.

5:42Poor quality or unreliable delivery can also reduce export sales. Productivity is output per unit of input. Low productivity raises costs per item, so exporters struggle to match foreign prices, while higher productivity lets firms offer competitive prices. Reliable products and strong overseas demand also support exports. A country specialising in products that foreign customers want may therefore develop a current account surplus. Higher domestic incomes often increase spending on imports, especially when households want products made overseas.

6:13Meanwhile, rising incomes abroad can increase demand for the country’s exports. Changes in oil or food prices also affect countries that import these necessities. Their import bills can rise even when the quantities purchased change very little. Income flows and transfers can change the balance independently of trade. Large profits paid to foreign owners can create a primary income deficit. Substantial income from overseas investments can support a surplus. Remittances and foreign aid received from abroad may also offset a deficit in goods or services.

Effects of current account balances

6:45Gross Domestic Product, or G D P, is the total value of goods and services produced within a country over a period. Real G D P is G D P adjusted for inflation. If exports fall, domestic producers receive fewer orders, so real G D P can decrease. Firms then require fewer workers, so employment falls. A deficit caused by imports replacing domestic production can have similar consequences for employment.

7:10However, its cause matters when judging the effect on G D P. Imported machinery can increase future productive capacity. A country expanding rapidly may also import more because household incomes and business spending are rising. Stronger exports can raise real G D P and employment because firms need additional production to meet foreign demand. A surplus created by depressed domestic spending tells a different story. Households may purchase few imports because their incomes are low.

7:36The balance alone therefore gives limited information about the economy’s overall health. Inflation can also respond in different ways. Strong export demand may push prices upwards when firms have little spare capacity. Cheaper imports can restrain inflation by reducing prices and production costs. If a deficit contributes to a falling currency value, imported fuel and materials become more expensive, so prices face upward pressure. A deficit can put downward pressure on a floating exchange rate.

8:03Import payments require foreign currency, so residents supply their own currency to obtain it. Strong export receipts can support the domestic currency because foreign buyers need it to make payments. Other international financial flows also influence the eventual exchange rate. A persistent deficit must be financed through other international transactions or a reduction in foreign currency reserves. These reserves are holdings of foreign currencies kept by the central bank. Borrowing can create future interest payments, which add to the primary income deficit.

8:34Investment from abroad can provide finance while also building productive capacity. The sustainability of a deficit therefore matters alongside its size.

Policies to improve the balance

8:41Policies to achieve balance of payments stability aim to prevent persistent, unsustainable imbalances. Governments usually seek a manageable current account position over time. The most effective response addresses the underlying cause. Reducing spending, changing relative prices, and improving competitiveness work through different mechanisms. Expenditure-reducing policies lower total spending in the economy. Contractionary fiscal policy uses higher taxation or lower government spending to reduce demand. Higher income tax leaves households with less disposable income, so purchases of imports can fall.

9:14However, weaker demand for domestic products can also reduce real G D P and employment. Contractionary monetary policy can use higher interest rates to reduce borrowing and spending. Households may postpone purchases, while firms buy less imported equipment. This can lower import payments and ease inflationary pressure, although lower demand for domestic output slows economic growth and raises unemployment. Higher interest rates may also attract foreign financial investment and strengthen the currency, so exports become less competitive.

9:44Expenditure-switching policies encourage buyers to choose domestic products instead of imports. One form of protection is a tariff, which is a tax on imports. Higher import prices make domestic alternatives relatively attractive, so the goods balance can improve. However, foreign retaliation can reduce exports, while expensive imported materials raise domestic production costs. An import quota is a limit on the quantity of a product that can enter a country. It restricts imports directly, although buyers may switch towards other overseas products.

10:14Protection also reduces competitive pressure on domestic firms. Its effectiveness is greater when affordable domestic substitutes are available, but consumers face less choice. Depreciation is a fall in the value of a currency in a floating system. A central bank can encourage it by lowering interest rates. Depreciation makes exports cheaper to foreign buyers and imports more expensive domestically. The trade balance improves if the resulting quantity changes raise export earnings and reduce import expenditure sufficiently.

10:43Essential imports and existing contracts can delay that improvement. A weaker currency also raises the domestic cost of imported fuel, machinery, and components. Those increases can feed into inflation and reduce exporters’ cost advantage. Producers need spare capacity to fulfil additional overseas orders. Exchange rate changes therefore work best when buyers respond strongly and firms can expand production. Supply-side policies aim to increase productive capacity and improve efficiency. Training can raise productivity, while better transport infrastructure reduces delivery costs.

11:16These changes help domestic firms compete through price, quality, and reliability. However, such policies require funding and often take time to improve the current account. Investment in renewable energy can reduce dependence on imported fuel over time. Initially, purchases of equipment from abroad may increase the goods deficit. Later, lower fuel imports can strengthen the current account while reducing greenhouse gas emissions. Environmental sustainability and external stability can support each other, although the benefits arrive gradually.

11:46A persistent surplus may also justify action, particularly when domestic spending is unusually weak. Higher government spending or lower income tax can increase demand and purchases of imports. Real G D P and employment may rise if spare capacity exists. When the economy is already near capacity, inflation is a greater risk.

Exam technique and recap

12:06Keep the four sections separate when interpreting a question. A deficit in goods can be offset by surpluses elsewhere, so the whole account requires all four balances. Wages, profits, interest, and dividends belong under primary income, while remittances and aid belong under secondary income. The purchase of an overseas asset is recorded outside the current account. For calculations, use receipts minus payments and retain each negative sign when adding component balances.

12:32A positive final result identifies a surplus; a negative result identifies a deficit. Always give the currency and scale stated in the question. In multiple-choice questions on classification, check what the payment is for. A reward for work or investment is primary income, and a payment with nothing in return is secondary income. Each command word sets the depth an answer needs. Define asks for the precise meaning of a term, and state asks you to express the answer in clear terms.

13:00An explain answer sets out purposes or reasons, why or how something happens, through a linked chain. To analyse, examine a change in detail to show the relationships. Higher domestic incomes increase households’ ability to spend. Some additional expenditure goes towards imported goods and services. Import payments therefore rise while other current account transactions stay unchanged. Once total payments exceed total receipts, the country has a current account deficit. Discuss requires a structured examination of both sides before a justified judgement.

13:30Depreciation makes exports cheaper abroad, which can increase sales and export earnings. Higher import prices encourage domestic substitutes, potentially reducing import expenditure. Both changes can narrow the deficit when quantities respond sufficiently. However, essential imports may remain necessary even after their prices rise, so the import bill grows and the deficit can widen. Imported production costs can also rise, so exporters lose part of their price advantage. On balance, depreciation will usually reduce the deficit when demand responds strongly and domestic firms have spare capacity.

14:02Under those conditions, larger export receipts and reduced import spending can outweigh the cost increases. The current account combines trade in goods, trade in services, primary income, and secondary income. Calculate each balance using receipts minus payments, then add the four results. A current account surplus occurs when total receipts exceed total payments across its four components, and a deficit occurs when payments exceed receipts. Prices, competitiveness, incomes, investment earnings, and transfers explain why balances change.

14:34Their effects on G D P, employment, inflation, and exchange rates depend on the underlying cause. Expenditure-reducing, expenditure-switching, and supply-side policies each tackle a different mechanism. Understanding those mechanisms lets you judge both their effectiveness and their costs.