6.3 Current account of the balance of payments

Components of the Current Account

The current account records all flows of goods, services, income, and transfers between a country and the rest of the world.

Main Components

1. Trade in Goods (Visible Balance)

  • Exports and imports of physical goods

2. Trade in Services (Invisible Balance)

  • Exports and imports of services (e.g. tourism, banking)

3. Primary Income

  • Income from factors of production:
    • Profits
    • Interest
    • Dividends

4. Secondary Income (Transfers)

  • One-way transfers:
    • Foreign aid
    • Remittances

Analysis

  • A country earning more from exports and income
    → improves current account balance
    → strengthens external position

Balance and Imbalances

Current Account Balance (CAB)

CAB=(Exports of goods + services)−(Imports of goods + services)+Net primary income+Net secondary income\text{CAB} = (\text{Exports of goods + services}) – (\text{Imports of goods + services}) + \text{Net primary income} + \text{Net secondary income}CAB=(Exports of goods + services)−(Imports of goods + services)+Net primary income+Net secondary income

Definitions

  • Surplus:
    • Exports + income > imports
    • Net inflow of money
  • Deficit:
    • Imports > exports + income
    • Net outflow of money
  • Surplus
    → increases foreign reserves
    → strengthens currency
  • Deficit
    → requires borrowing or capital inflows
    → may weaken currency

Calculations

Balance of Trade in Goods

Exports of goods−Imports of goods\text{Exports of goods} – \text{Imports of goods}

Balance of Trade in Services

Exports of services−Imports of services\text{Exports of services} – \text{Imports of services}

Balance of Trade (Goods + Services)

(Exports of goods + services)−(Imports of goods + services)(\text{Exports of goods + services}) – (\text{Imports of goods + services})

Current Account Balance (CAB)

Balance of trade+Net primary income+Net secondary income\text{Balance of trade} + \text{Net primary income} + \text{Net secondary income}

Causes of Current Account Imbalances

1. Exchange Rate Changes

  • Strong currency
    → exports expensive, imports cheap
    → deficit likely
  • Weak currency
    → exports cheaper, imports expensive
    → surplus more likely

2. Inflation Differences

  • Higher domestic inflation
    → exports less competitive
    → imports increase
    → deficit worsens

3. Economic Growth

  • Rapid domestic growth
    → higher incomes
    → more imports
    → deficit increases

4. Competitiveness

  • Poor quality or high costs
    → exports fall
    → deficit increases

5. Resource Endowment

  • Lack of raw materials
    → reliance on imports
    → deficit

6. Trade Policies

  • Protectionism
    → reduces imports
    → improves balance (short term)

Consequences of Current Account Imbalances

A. Current Account Deficit

Domestic Economy

Negative Effects

  • Rising debt
    → borrowing from abroad
    → future repayment burden
  • Unemployment
    → imports replace domestic production
    → job losses
  • Currency depreciation
    → higher import prices
    → cost-push inflation

Possible Positive Effects

  • Higher consumption
    → access to cheaper imports
    → improved living standards
  • Investment inflows
    → deficit financed by foreign investment
    → may boost growth

B. Current Account Surplus

Domestic Economy

Positive Effects

  • Economic growth
    → strong export demand
    → higher output and employment
  • Accumulation of reserves
    → financial stability

Negative Effects

  • Over-dependence on exports
    → vulnerable to global downturns
  • Inflationary pressure
    → high demand for exports increases AD
  • Opportunity cost
    → exporting more means fewer goods for domestic consumption

C. External Economy Effects

Deficit Countries

  • Increased reliance on foreign lenders
    → vulnerability to external shocks

Surplus Countries

  • May face pressure to reduce surplus
    → global imbalances and trade tensions

Evaluation

  • A small deficit or surplus is normal
    → reflects global trade dynamics
  • Persistent deficits
    → may be unsustainable
    → risk of debt crisis
  • Persistent surpluses
    → may indicate under-consumption
    → global imbalance issues

Final Summary

  • Current account includes:
    • Goods
    • Services
    • Primary income
    • Secondary income
  • Surplus = inflow; Deficit = outflow
  • Key causes:
    • Exchange rates
    • Inflation
    • Growth
    • Competitiveness
  • Consequences:
    • Deficit → debt, depreciation
    • Surplus → growth, but imbalance risks