A) Components of the balance of payments, with particular reference to the current account, and the balance of trade in goods and services
The balance of payments consists of the:
AS students only need to learn about the current account of the balance of payments. Both the Capital and Financial account of the balance of payments will be covered later on in the course under topic 4.1.7 balance of payments.
The current account contains four different components:
- Trade in goods – This is the value of goods going out of the country (exports of goods) minus the value of goods coming into the country (imports of goods).
- Trade in services – This is the value of services going out of the country (exports in services) minus the value of services coming into the country (imports in services).
- Income – This is often in the form of remittances. Therefore net income would be the income sent back to the domestic country by workers working abroad – the income sent to foreign countries from workers working in the domestic country.
- Transfers – This includes payments such as EU fees or aid contribution.
It is important to remember to talk about value rather than quantity. Although a country may import more goods/services than they export, they could still run a trade surplus if the value of exports is greater than the value of imports. The UK currently has a trade surplus in services, but a trade deficit in goods. Overall, the UK has a current account deficit; however the deficit as a percentage of GDP is small and therefore the UK tend to ignore it. This is because the effect it has on AD and economic growth is minimal.
B) Current account deficits and surpluses
A trade deficit occurs when a country’s total import cost exceeds the value of their export revenue. On the other hand, a trade surplus occurs when the country’s export revenue exceeds the cost of their imports. In order to find out whether a country has a current account surplus or deficit, income and transfers would be combined with the net trade figure. For example, if income was a surplus, transfers were a deficit and net trade was a surplus, then the country is likely to have a current account surplus.
Causes of a current account deficit
- Strong domestic growth – An increase in AD means that domestic incomes increase. As a result of this, demand for goods/services increase. However, the majority of items that consumers consume are imported from abroad. Therefore, this increase in incomes is likely to increase the demand for imported goods/services thus leading to a current account deficit, as the total amount of money spent on imports increases.
- Recession overseas – Poor economic growth overseas results in a reduction in overseas incomes. This can be a big problem if the country is one of the main importers of domestic goods/services. The fall in incomes will result in a decrease in the demand for domestic goods/services and therefore a reduction in the revenue gained from exports.
- Strong exchange rate – This makes imports cheaper and exports more expensive. As a result of this, domestic goods/services become less competitive compared to those overseas, causing the demand for exports to decrease. In addition to this, imports become cheaper thus increasing the demand for them and therefore the total amount of money spent on imports coming into the country.
- High costs of production for domestic firms due to Low investment, Low productivity, High unit labour cost etc – Any increase in the costs of production leads to a rise in the cost of domestic goods/services. As a result of this, the price of domestic goods/services is likely to increase relative to other countries. This will cause a reduction in the demand for domestic exports and therefore a reduction in the total revenue gained from exports.
- High relative inflation – This increases the price of domestic goods/services in relation to those abroad, thus making them less competitive. As a result of this, the demand for exports will decrease leading to a reduction in the total revenue gained from exports.
- Poor quality goods – Despite domestic goods/services being cheaper in relation to those overseas, the demand for domestic goods/services may still be low. This is due to lower quality goods/services being less desirable to buy. If this is the case, then total export revenue is likely to be low.
- Depletion of resources – The domestic country may run out of certain resources that they were reliant on for export revenue. This is often the case for countries exporting resources that are finite such as oil. Eventually this resource will run out, meaning that the domestic country is unable to export the same amount of resources as they used to be able to. As a result of this, total export revenue decreases.
Supply side causes of a current account deficit tend to be more damaging then those caused by demand side issues. This is because supply side issues such as low productivity are often long term problems and cannot be solved in the short term.
C) The relationship between current account imbalances and other macroeconomic objectives
The main impact of a current account deficit is the effect that it has on aggregate demand. As net trade is a component of AD, a trade deficit will cause a reduction in AD and therefore economic growth. This is because there is less demand for domestic goods/services.