Current Account Flashcards
What is the current account (what does it measure) and what is it comprised of?
- It measures the inflow and outflow of: goods, services, investment incomes and transfer payments
- It is comprised of: net trade in goods (i.e. visible trade), net trade in services (i.e. invisible trade), net investment incomes (i.e. primary income) and net transfers (i.e. secondary income)
How do you calculate the current account balance of payments?
Add up all of the components (net trade in goods + net trade in services + net primary income + net secondary income)
Why does the UK have a persistent current account deficit?
- The UK has a large deficit on the trade in goods and a high marginal propensity to import goods, e.g. 50% of UK food is imported
- ^ this is due to the shrinking of the primary and secondary sectors associated with the shift from an industrial to post industrial economy
- Surplus on services compensates for this to an extent but isn’t enough
What % of the GDP does the current account deficit make up?
8% of GDP
Name a harmful effect of a current account deficit (Hint: financial account)
- The deficit has to be financed by a financial account surplus
- ^ this means foreign firms/ individuals purchase UK assets (e.g. UK firms) which creates a vulnerability as foreign firms are not incentivised to engage in long term investment
- ^ for example Tata steel of India owns much of the steel industry and closed a plant in Port Talbot harming the local authority to open an identical plant in India
- Also foreign owners of UK property will push up property prices affecting geographical mobility of labour
Name a harmful effect of a current account deficit (Hint: dependence on services)
- The UK relies on the export of financial services to ensure the deficit isn’t too damaging
- ^ if demand for these services falls the deficit may become unsustainable
- The UK also relies on capital in-flows to finance the deficit
- ^ if the UK is no longer an attractive prospect for international investors this will fail
- e.g. the ex Bank of England governor Mark Carney said the UK economy depends on the ‘kindness of strangers’ meaning we rely on foreign investors
Name a harmful effect of a current account deficit (Hint: import of goods)
- The UK is vulnerable to supply-side shocks ,due to the reliance of imported goods, which can create higher prices
- ^e.g. the Ukraine war caused a supply-side shock to natural gas prices
- ^ this increased costs to households especially as gas is price inelastic
- Firms are also vulnerable, supply-side shocks can increase the cost of production
Name a harmful effect of a current account deficit (Hint: lack of demand for UK goods)
- The deficit in the UK is caused by a weak manufacturing sector which prevents the UK taking advantage of export led growth (increased derived demand for labour causing less unemployment and more economic growth)
- ^this would address the inequality and structural unemployment in previous industrial areas
- ^ would also reduce the large sovereign debt
- ^ would also put upward pressure on the Sterling which would make imports cheaper
Why is the current account deficit not necessarily harmful?
1) may be a sign of a booming economy with more demand for imported luxury goods
2) may be the case that a developing economy is importing capital goods to increase industrialisation (e.g. Brazil)
3) may have a surplus but won’t translate into higher standards of living and increased demand for imports for various reasons (e.g. Botswana)
4) a deficit isn’t harmful if there is a way to finance it, for the UK foreign capital (such as foreign firms investing in UK assets) is very big and finances the deficit
Expenditure reduction strategies
1) increase interest rates: credit becomes more expensive, loan repayments increase and saving is incentivised = less imports
2) increase taxes: less disposable income = less imports
Evaluations for expenditure reduction strategies
1) these strategies will reduce AD, depending on the state of the economy this causes less growth, more unemployment etc
2) these strategies are too broad, the deficit is caused by some markets more than others which would need to be targeted
Expenditure switching strategies (incentivise consumers to switch from importing goods to buying domestic)
Make domestic goods more price competitive by introducing tariffs (tax paid to import goods) meaning importing firms will increase price as it is a cost of production
Evaluation for expenditure switching strategies (incentivising)
- invites retaliatory action from the exporting country which can cause a trade war
- reduces consumer surplus in the importing country = higher prices for consumers and firms/ imported inflation
- insignificant tax revenue gained
- tariffs reward inefficiency and create dead weight loss
Expenditure switching strategies (manipulating the exchange rate)
Manipulate the exchange rate by depreciating the currency against the currency of the exporting country making it more expensive to import
^ exchange rate can either be floating (determined by market forces) or fixed (managed by the central bank)
Evaluation for expenditure switching strategies (manipulating exchange rate)
- likewise to tariffs it can lead to a trade war
- makes the assumption that a weak currency will reduce demand for imports and encourage purchase of domestic goods/ exports
- only works if the combined elasticity of imports and exports > 1
- assumes that there are domestic substitutes
- UK has a floating exchange rate
