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Components and Causes of a Deficit in Current Account

Describe the four components of the current account of the balance of payments. Explain what might cause a deficit in this account. [8]

Category:

International Trade and Exchange Rates

[CIE AS level November 2017]

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Answer


Step ➊ : Define ‘current account of the balance of payments’ and 'current account deficit' in the introduction.


The current account on the balance of payments measures the inflow and outflow of goods, services, investment incomes and transfer payments. The current account consists of four parts. A current account deficit means that the combined debit items on the four parts exceed the combined credit items on the four parts.


Step ➋ : Describe the four components of the current account of the balance of payments.


➤ 2.1 The first component of the current account is the trade in goods.

This covers the exports and imports of goods such as cars, TVs and clothing. Exports give rise to credit items while imports give rise to debit items. The trade-in goods balance is the revenue earned from exports of goods minus the expenditure on the imports of goods. The trade in goods balance can also be called the balance of trade, the visible balance and the merchandise balance.

➤ 2.2 The second component of the current account is the trade in services.

This covers the trade in exports and imports of services, which may be referred to as ‘Invisibles’. Services include shipping, tourism, banking and insurance. A trade in services deficit occurs when revenue from the export of services is less than the expenditure on services bought from other countries.

➤ 2.3 The third component of the current account is investment incomes.

This includes income in the form of profits, interest and dividends earned on direct investment abroad and foreign earnings on investment in the country. For example, dividends paid on foreign shares by residents in the country appear as credit items, while interest paid to foreigners on bank accounts they hold in the country are debit items.

➤ 2.4 The fourth component of the current account is current transfers.

These cover payments made and receipts received for which there is no corresponding. The current account balance is the overall balance of the trade in goods, trade in services, income and current transfers.


Step ➌ : Explain what might cause a deficit in this account.


A current account deficit means that the combined debit items on the four parts exceed the combined credit items on the four parts. There are several causes of a current account deficit.

➤ 3.1 Economic growth may cause a current account deficit.

Economic growth is an increase in the production of economic goods and services, compared from one period of time to another. When firms increase their output, they may purchase more raw materials and capital goods from abroad. Import will increase. Also, economic growth will result in a higher disposable for consumers and an increase in demand for goods and services. If domestic producers cannot meet the domestic demand, consumers will have to import goods from abroad. Export revenue may also decline as a result of exports being diverted from the foreign to the domestic market

➤ 3.2 A declining economic activity in trading partners can cause a current account deficit.

If the other foreign countries that buy a domestic country’s imports experience recessions or slowdowns in economic growth, their import expenditure may fall or rise more slowly. A current account deficit that arises from either change in the economic cycle of the domestic economy or the economies of trading partners is sometimes referred to as a cyclical deficit.

➤ 3.3 A decline in competitiveness can cause a current account deficit.

There are a number of causes of a lack of international competitiveness. These include an overvalued exchange rate, a relatively high inflation rate, low labour and capital productivity. A high exchange rate can also cause a current account deficit as will raise export prices and lower import prices.

➤ 3.4 A current account deficit can be caused by a high rate of inflation or an appreciation of the currency.

This is because both inflation and a rise in an economy’s exchange rate will raise the price of exports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports. A current account deficit can also reduce the relative price of imports. As a result, both can cause a current account deficit. A current account deficit means that the value of goods and services imported is greater than the value of exports.


Step ➍ : Conclude.


To conclude the four components of a current account deficit are trade in goods, trade in services, investment incomes and current transfers. There are several factors that can cause a deficit in the current account including economic growth, a fall in competitiveness, a declining economic activity in trading partners and a high inflation rate.


♕ Marking scheme


For Knowledge and Understanding: A brief description of the four components is required. 1 mark for each component. (Up to 4 marks) For Application: Showing how for example inflation in an economy or changes in comparative advantage could cause a deficit. Allow any valid cause. (Up to 4 marks for any possible cause explained)

Candidates need to provide a brief explanation of each component of the current account. There are four components. Balance of goods, services, income (primary) and transfers (secondary). There are a number of possible causes of a deficit. These include inflation in an economy at a rate that exceeds the rate of inflation amongst competitors, shifts in comparative advantage. A decline in the demand for an economy’s exports and in some countries remittances might have an influence. The erection of trade barriers might also cause a deficit.

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