A revision note for AS economists on the current account of the balance of payments

Measuring the current account

* The current account of the balance of payments comprises the balance of trade in goods and services plus net investment incomes from overseas assets and net transfers

* Net investment income comes from interest payments, profits and dividends from external assets located outside the UK.

For example a UK firm may own a business overseas and send back some of the operating profits to the UK. This would count as a credit item for our current account as it is a stream of profits flowing back into the UK.

Similarly, an overseas investment in the UK might generate a good rate of return and the profits are remitted back to another country – this would be a debit item in the balance of payments accounts.

Transfers into and out of a country include foreign aid payments. For the UK the net transfers figure is negative each year, mainly due to the UK being a net contributor to the budget of the European Union. As a rich nation, the UK makes sizeable foreign aid payments to many other countries.

Trade balance in goods and services

What does a current account deficit mean?

Running a deficit on the current account basically means that the UK economy is not paying its way in the global economy. There is a net outflow of demand and income from the circular flow of income and spending.

The current account does not have to balance because the balance of payments also includes the capital account. The capital account tracks capital flows in and out of the UK. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign investment.

The capital account is not covered at AS level; you only need to understand the current account of the balance of payments.

What are the main causes of a current account deficit?

Why do some countries including the UK and the United States run persistently large trade deficits? Whilst other nations including China, Germany and Japan achieve big trade surpluses each year?

This is an example of the economics of causation – i.e. looking at an issue and trying to unravel some of the main causes. It is good for your evaluation skills to group the explanations for the record trade deficit in goods into short-term, medium-term and long-term factors. In general, shorter-term explanations tend to focus on demand-side factors whereas longer-term causes are often the result of supply-side factors.

1. High income elasticity of demand for imports – the income elasticity for imports is high so when consumer demand is strong, the volume of imported products grows quickly

2. Long-term decline in the capacity of manufacturing industry because of de-industrialization

3. There has been a shift of manufacturing production to lower-cost emerging market countries and then export products back into the UK. Many UK businesses have out-sources assembly of goods to other countries whilst retaining other aspects of the supply chain such as marketing and research within the UK.

4. The UK is a net importer of foodstuffs and beverages and has also seen a sharp rise in imports of oil and gas as our North Sea oil and gas production is long past its peak levels

5. The trade balance is vulnerable to shifts in world commodity prices and exchange rates. We import a large volume of raw materials, component parts and pieces of capital equipment.

The balance of payments and the standard of living

A common misconception is that balance of payments deficits are always bad for the economy. This is not necessarily true. In principle, there is nothing wrong with a trade deficit. It simply means that a country must rely on foreign direct investment or borrow money to make up the difference. And in the short term, if a country is importing a high volume of goods and services this is a boost to living standards because it allows consumers to buy more consumer durables.

The balance of payments and aggregate demand

1. When there is a current account deficit – this means that there is a net outflow of demand and income from a country’s circular flow. In other words, trade in goods and services and net flows from transfers and investment income are taking more money out of the economy than is flowing in. Aggregate demand will fall.

2. When there is a current account surplus there is a net inflow of money into the circular flow and aggregate demand will rise. Examples of countries than run with current account surpluses include China, Germany and Norway.