Current account of balance of payments | IGCSE Class 10 Economics Notes

This note covers the structure of the current account of the balance of payments (trade in goods, trade in services, primary income and secondary income), how a current account deficit or surplus is calculated, the causes of deficits and surpluses, their consequences for GDP, employment, inflation and the foreign exchange rate, and the policies a government can use to restore balance of payments stability.

What is the current account of the balance of payments?

The balance of payments is a record of all the transactions between the residents of a country and the rest of the world over a given period, usually a year.

It has two main parts: the current account and the capital account (in the newer classification, a financial account is also separated out, but transactions in financial assets such as bonds and equity shares are the main item moved into it).

The current account is the record of a country's trade in goods and services together with its income and transfer flows with the rest of the world.

It does not record the buying and selling of assets such as shares, bonds or property; those transactions belong to the capital or financial account.

A country that spends more abroad on its current account than it earns must finance the gap by borrowing or by selling assets, which shows up as a surplus on its capital account.

A current account is in balance when receipts equal payments. A current account surplus exists when receipts are greater than payments; the country is, in effect, a net lender to the rest of the world.

A current account deficit exists when payments are greater than receipts; the country is a net borrower from the rest of the world.

What are the components of the current account?

The current account is built from four groups of transactions.

Trade in goods

Trade in goods covers the exports and imports of physical, visible products. The difference between the value of a country's exports of goods and its imports of goods is called the balance of trade (BOT), also known as the trade balance.

Exports of goods are a credit (receipt) item; imports of goods are a debit (payment) item.

Trade in services

Trade in services covers earnings and payments for invisible items such as banking, shipping, tourism and software services.

When a country's residents provide a service to a foreigner, for example a software firm selling its services to a client in another country, this is a credit item; when residents buy a service from abroad, for example a tourist paying for a hotel room in another country, this is a debit item.

Primary income

Primary income is income earned from the factors of production working across borders. It includes wages earned by residents working abroad, and interest, profit and dividends on investments held abroad, net of what a country pays out to foreign owners of assets inside its own borders.

This is the income return on labour and capital that has moved internationally.

Secondary income

Secondary income covers transfer payments: receipts and payments made without any good or service being given in return. These include workers' remittances sent home by migrants, gifts between individuals, and grants between governments.

Draw a single box labelled "Current account" with four boxes feeding into it from the left: "Trade in goods" (exports minus imports of physical products), "Trade in services" (banking, tourism, shipping, software), "Primary income" (wages, interest, profit, dividends earned abroad net of what is paid out) and "Secondary income" (remittances, gifts, grants). Arrows from each box point into the current account total.

How is a current account deficit or surplus calculated?

The balance of trade is found first, then combined with the net value of services, primary income and secondary income to give the overall current account balance.

Trade Balance = X − M, where X is the value of exports of goods and M is the value of imports of goods. A positive figure is a trade surplus; a negative figure is a trade deficit.

Net Invisibles = S + PI + SI, where S is the net balance on trade in services, PI is net primary income and SI is net secondary income (transfers). Net invisibles can be positive even when the trade balance is negative.

Current Account Balance = BOT + NI, where BOT is the balance of trade and NI is net invisibles. A current account surplus arises when this total is positive; a current account deficit arises when it is negative.

Worked example 1. A country records exports of goods of $150 million and imports of goods of $240 million. Its net trade in services is $30 million, its net primary income is −$10 million and its net secondary income (transfers) is $32 million.

Answer: Trade balance = 150 − 240 = −$90 million (a trade deficit). Net invisibles = 30 + (−10) + 32 = $52 million. Current account balance = −90 + 52 = −$38 million.

The country has a current account deficit of $38 million: its net invisibles surplus does not fully offset its trade deficit.

Worked example 2. A different country records exports of goods of $500 million and imports of goods of $650 million. Net trade in services is $40 million, net primary income is −$20 million and net secondary income is $30 million.

Answer: Trade balance = 500 − 650 = −$150 million. Net invisibles = 40 + (−20) + 30 = $50 million. Current account balance = −150 + 50 = −$100 million.

This country has a larger current account deficit than the first example, driven mainly by its wider trade deficit in goods.

What causes a current account deficit?

A current account deficit means a country's payments to the rest of the world exceed its receipts. Several factors push a current account towards deficit.

1. Rising domestic incomes raise spending on imports: imports depend positively on domestic income, so when domestic income (Y) grows faster than the rest of the world's income, a country's imports tend to grow faster than its exports.
2. An appreciation of the exchange rate makes a country's exports more expensive to foreign buyers and imports cheaper for domestic buyers, which can widen a trade deficit.
3. Relatively high domestic inflation makes domestically produced goods less price competitive against foreign goods, reducing exports and encouraging consumers to buy imports instead.
4. A high marginal propensity to import means a large share of any rise in income is spent on imports rather than on domestic output, so growth is accompanied by a widening trade gap.
5. Large net outflows of primary income, for example profits repatriated by foreign-owned firms, or large net transfer payments abroad, can also push a current account into deficit even when trade in goods is roughly balanced.

The marginal propensity to import is the fraction of an extra unit of income that is spent on imports. It is written as m in M = M̄ + mY, where M̄ is autonomous imports (imports that occur regardless of income) and m lies between 0 and 1.

What causes a current account surplus?

A current account surplus arises for broadly the opposite reasons. If foreign income grows faster than domestic income, foreign demand for a country's exports rises faster than its own demand for imports, widening a trade surplus.

A depreciation (or deliberate devaluation) of the exchange rate makes exports cheaper abroad and imports dearer at home, which tends to increase export volumes and reduce import volumes, other things being equal.

Lower domestic inflation relative to trading partners keeps goods price competitive and supports export growth.

A country can also run a surplus if it receives large net primary income, for example interest and dividends on assets it holds abroad, or large net inward transfers such as remittances from citizens working overseas.

A surplus means the country is, overall, lending to the rest of the world rather than borrowing from it; the counterpart of a current account surplus is a net outflow on the capital account, as the surplus country acquires foreign assets or lends abroad.

What are the consequences of a current account deficit?

Effect on GDP and employment

Exports add to a country's aggregate demand because they are an injection into the circular flow of income; imports are a leakage, since spending on imports is spending that goes to foreign producers rather than domestic ones.

In the national income identity for an open economy, Y = C + I + G + NX, where C is consumption, I is investment, G is government spending and NX is net exports (exports minus imports).

A widening current account deficit, driven by falling net exports, directly reduces NX and so tends to reduce equilibrium national income (Y) and the output and employment of domestic firms that compete with imports, unless offset by rises in consumption, investment or government spending.

Because some of any rise in income leaks out as spending on imports, the open economy multiplier is smaller than the closed economy multiplier, so a given stimulus to spending produces a smaller rise in domestic output and employment the larger the marginal propensity to import.

Effect on inflation and the exchange rate

A persistent current account deficit tends to put downward pressure on the exchange rate, since the deficit country is, on balance, demanding more foreign currency (to pay for imports) than foreigners demand of its own currency.

A falling (depreciating) exchange rate raises the domestic price of imported goods, which can feed through into higher inflation.

If the deficit must be financed by running down official foreign exchange reserves or by increasing borrowing from abroad, this can also undermine confidence in the currency.

Worked example 3. If c (the marginal propensity to consume) = 0.8 and m (the marginal propensity to import) = 0.3, the open economy multiplier is 1 / (1 − c + m) and the closed economy multiplier is 1 / (1 − c).

Answer: Closed economy multiplier = 1 / (1 − 0.8) = 1 / 0.2 = 5. Open economy multiplier = 1 / (1 − 0.8 + 0.3) = 1 / 0.5 = 2.

If autonomous demand rises by 100, a closed economy's output rises by 500, but an open economy's output rises by only 200, because part of the extra spending leaks abroad as imports rather than supporting domestic output.

What are the consequences of a current account surplus?

A current account surplus generally supports higher domestic output and employment in the short run, since net exports are adding to aggregate demand rather than subtracting from it; firms producing exportable goods and services tend to see rising orders and may increase hiring.

A persistent surplus also tends to put upward pressure on the exchange rate, since the surplus country is, on balance, supplying more of its own currency than it is demanding in foreign currency as it sells more abroad than it buys.

An appreciating currency makes imports cheaper, which can help to hold down inflation, but it also makes the country's own exports more expensive abroad over time, which can gradually reduce the surplus as foreign buyers switch to cheaper alternatives elsewhere.

A very large and sustained surplus may also mean a country is accumulating large foreign exchange reserves or foreign assets rather than raising domestic consumption or investment.

What policies can achieve balance of payments stability?

Governments have several tools available to narrow a current account deficit (or a surplus) and restore balance of payments stability, though each has drawbacks.

1. Exchange rate policy. Under a fixed exchange rate system, the government can devalue its currency (officially lower its fixed value against other currencies) to make exports cheaper and imports dearer and narrow a deficit, or revalue its currency (officially raise its fixed value) to make exports dearer and imports cheaper and narrow a surplus. Under a flexible (floating) system, exchange rate movements can automatically help correct a deficit or surplus as market forces of demand and supply adjust the rate without government intervention.
2. Official reserve sales or purchases. Under a fixed or managed exchange rate, a central bank can sell foreign exchange reserves to meet an excess demand for foreign currency (supporting a deficit country's currency) or buy up foreign currency to absorb an excess supply (preventing unwanted appreciation in a surplus country). This only works while reserves last and does not remove the underlying cause of the imbalance.
3. Expenditure-reducing (deflationary) policies. Raising interest rates, raising taxes or cutting government spending reduces domestic income and spending, which reduces spending on imports and so narrows a trade deficit, but at the cost of lower output and higher unemployment.
4. Expenditure-switching policies. Tariffs (taxes on imports) and quotas (quantitative limits on imports) are trade barriers that can switch domestic and foreign spending towards domestic output, reducing imports directly, though they risk retaliation from trading partners and raise costs for domestic consumers and firms that rely on imported inputs.
5. Policies to reduce a surplus. A government that wants to reduce a persistent surplus can do the opposite: expansionary policies such as lower interest rates, tax cuts or higher government spending raise domestic incomes and spending on imports; removing tariffs and quotas lets more imports in; and allowing or engineering an appreciation (or revaluation) makes exports dearer and imports cheaper.
6. Supply-side measures. Policies that raise the competitiveness and productivity of domestic exporters, for example investment in skills, infrastructure or research, can raise exports and reduce reliance on imports over the longer term without the direct costs of deflation or protectionism.

Managed floating, in which the central bank intervenes only occasionally to moderate exchange rate swings rather than fixing the rate outright, is widely used as a middle path: it keeps some of the automatic adjustment of a floating rate while limiting sharp, destabilising movements.

Worked example 4. A government devalues its currency so that the exchange rate changes from $1 = 50 units of domestic currency to $1 = 70 units of domestic currency. A domestic exporter's product, priced at 350 units of domestic currency, is sold abroad.

Answer: Before devaluation, the dollar price of the export was 350 ÷ 50 = $7.00. After devaluation, the dollar price of the same export is 350 ÷ 70 = $5.00.

The product is now cheaper in dollar terms for foreign buyers, which should increase the quantity demanded of the export and help to narrow a trade deficit, provided foreign demand is sufficiently responsive to the lower dollar price.

How effective are these policies likely to be?

No single policy is guaranteed to restore balance of payments stability, and most involve trade-offs.

Devaluation or depreciation only improves the trade balance if demand for exports and imports is sufficiently price elastic; if demand is inelastic, the same quantity of goods is traded at worse prices and the deficit can initially worsen before (if at all) improving.

Deflationary policies reduce a deficit but at the direct cost of lower output and higher unemployment, which may be politically and socially unacceptable.

Protectionist measures such as tariffs and quotas can provoke retaliation from trading partners, which may reduce a country's exports and leave both sides worse off.

Reserve sales can only continue as long as reserves last, and heavy, visible use of reserves can itself trigger speculative pressure on a currency if markets doubt a government's ability to maintain its exchange rate.

Supply-side policies to raise competitiveness tend to work only in the long run, so they do little to correct an urgent, short-term imbalance. In practice, governments often combine several of these policies rather than relying on just one.

Going beyond the syllabus

The current account is one half of the wider balance of payments; the other half, the capital account (or in the newer classification, the capital and financial accounts), records international transactions in assets such as shares, bonds and loans, rather than trade and income flows.

Because the overall balance of payments must balance (current account plus capital account is identically zero once reserve changes and errors and omissions are included), a current account deficit is always matched by a net inflow on the capital account: the deficit country is, in effect, borrowing from or selling assets to the rest of the world to pay for the gap.

This link helps explain why persistent current account deficits are often associated with rising external debt or foreign ownership of domestic assets over time.

Glossary

• Current account — the part of the balance of payments recording trade in goods, trade in services, primary income and secondary income.
• Trade in goods — exports and imports of physical, visible products.
• Trade in services — exports and imports of invisible services such as banking, tourism, shipping and software.
• Primary income — net income earned from factors of production working abroad, such as wages, interest, profit and dividends.
• Secondary income — net transfer payments received or made without any good or service in return, such as remittances, gifts and grants.
• Balance of trade — the difference between the value of a country's exports and imports of goods.
• Net invisibles — the combined net balance on trade in services, primary income and secondary income.
• Current account deficit — a situation where a country's current account payments to the rest of the world exceed its receipts.
• Current account surplus — a situation where a country's current account receipts from the rest of the world exceed its payments.
• Net exports (NX) — the value of a country's exports minus the value of its imports.
• Marginal propensity to import — the fraction of an extra unit of income that is spent on imports rather than domestic goods.
• Exchange rate — the price of one country's currency in terms of another currency.
• Depreciation — a fall in the value of a currency against other currencies under a floating exchange rate system.
• Appreciation — a rise in the value of a currency against other currencies under a floating exchange rate system.
• Devaluation — a deliberate, official reduction in the fixed value of a currency against other currencies.

Common errors and misconceptions

• Misconception: the current account is the whole balance of payments. Correct: the balance of payments also includes the capital (and financial) account, which records transactions in assets, not goods, services or income.
• Misconception: a trade deficit and a current account deficit are the same thing. Correct: the trade balance covers only goods; a country can have a trade deficit but a current account surplus (or vice versa) if net invisibles (services, primary income, secondary income) are large enough to offset it.
• Misconception: a current account deficit always means a weak economy. Correct: a deficit can also reflect strong domestic demand or investment, drawing in imports; whether it is a problem depends on how it is financed and whether it persists.
• Misconception: devaluation always improves the trade balance immediately. Correct: the improvement depends on the price elasticity of demand for exports and imports; inelastic demand can worsen the trade balance before it improves.
• Misconception: a current account surplus is always good for a country. Correct: a persistent surplus can mean forgone domestic consumption or investment, and can cause the exchange rate to appreciate, eventually hurting exporters.
• Misconception: appreciation and devaluation mean the same thing. Correct: appreciation is a market-driven rise in a floating currency's value; devaluation is a deliberate, official cut in a fixed currency's value.
• Misconception: only exports affect aggregate demand. Correct: imports are a leakage from aggregate demand, so net exports (exports minus imports), not exports alone, is what enters the national income identity.

Exam-style questions with model answers

Q1. Define 'current account deficit'. [2 marks]

1. A current account deficit is a situation where a country's payments on its current account (for trade in goods, services, primary income and secondary income combined) to the rest of the world are greater than its receipts from the rest of the world over a given period.

Q2. A country records exports of goods of $300 million, imports of goods of $380 million, net trade in services of $25 million, net primary income of −$15 million and net secondary income of $20 million. Calculate the country's current account balance. [3 marks]

1. Trade balance = 300 − 380 = −$80 million.
2. Net invisibles = 25 + (−15) + 20 = $30 million.
3. Current account balance = −80 + 30 = −$50 million, a current account deficit of $50 million.

Q3. Distinguish between primary income and secondary income, giving an example of each. [3 marks]

1. Primary income is income earned from factors of production working across borders, net of what is paid to foreigners; for example, interest and dividends a country's residents earn on investments held abroad.
2. Secondary income is a transfer received or paid without any good or service given in return; for example, remittances sent home by migrant workers.
3. Primary income is a return on factors already supplied internationally, whereas secondary income involves no corresponding exchange of a good, service or factor of production.

Q4. Explain two causes of a current account deficit. [4 marks]

1. If domestic income grows faster than income in the rest of the world, domestic spending on imports rises faster than foreign spending on the country's exports, since imports depend positively on domestic income, widening a trade deficit.
2. If the domestic exchange rate appreciates, exports become more expensive for foreign buyers and imports become cheaper for domestic buyers, which tends to reduce export revenue and increase import spending, pushing the current account towards deficit.

Q5. Explain two consequences of a current account surplus. [4 marks]

1. A current account surplus adds to a country's aggregate demand, since net exports are positive, which can raise domestic output and employment in industries producing exportable goods and services.
2. A persistent surplus tends to cause the country's exchange rate to appreciate, since the country is supplying more of its own currency than it is demanding in foreign currency, which can gradually make its exports less price competitive abroad.

Q6. Analyse how a depreciation of a country's exchange rate could affect its current account balance. [6 marks]

1. A depreciation lowers the value of the domestic currency against foreign currencies, so foreign buyers need less of their own currency to buy the same quantity of exports, making exports cheaper abroad.
2. A depreciation makes imports more expensive in domestic currency terms, since more units of domestic currency are now needed to buy the same quantity of foreign goods.
3. If demand for exports and imports is price elastic, the fall in export prices should raise the quantity of exports sold, and the rise in import prices should reduce the quantity of imports bought, both of which improve the trade balance.
4. If demand is price inelastic, export revenue may fall even as export prices fall (because quantity does not rise enough), and import spending may rise even as import prices rise (because quantity does not fall enough), so the current account balance could initially worsen rather than improve.
5. The overall effect therefore depends on the combined price elasticity of demand for exports and imports, and may take time to work through as buyers adjust their behaviour.

Q7. Discuss whether or not a government should be concerned about a persistent current account deficit. [8 marks]

1. A persistent current account deficit must be financed by a capital account surplus, meaning the country is continually borrowing from or selling assets to the rest of the world, which can raise external debt or foreign ownership of domestic assets over time.
2. A widening deficit reduces net exports, which can lower aggregate demand, domestic output and employment in industries that compete with imports, unless offset by rising consumption, investment or government spending elsewhere in the economy.
3. A persistent deficit tends to put downward pressure on the exchange rate, and a depreciating currency can raise the domestic price of imports, contributing to inflation.
4. However, a deficit is not automatically harmful: it may reflect strong domestic investment (for example in capital goods bought from abroad) that raises future productive capacity, or it may reflect temporarily high consumer spending during a period of rising incomes.
5. Whether concern is justified depends on how the deficit is financed: if it is financed by stable, long-term capital inflows such as foreign direct investment, it is more sustainable than if it depends on short-term, volatile borrowing that could be withdrawn quickly.
6. On balance, a government should monitor the size, persistence and financing of a current account deficit rather than treat any deficit as automatically a problem, since the underlying cause and how it is financed matter more than the existence of a deficit itself.

Key takeaways

• The current account records trade in goods, trade in services, primary income and secondary income between a country and the rest of the world.
• The balance of trade is exports of goods minus imports of goods; net invisibles adds services, primary income and secondary income.
• A current account surplus means receipts exceed payments; a deficit means payments exceed receipts.
• Rising domestic incomes relative to foreign incomes, currency appreciation and high domestic inflation are common causes of a current account deficit.
• A current account deficit must be financed by a matching surplus on the capital account, often through borrowing or asset sales.
• Imports are a leakage and exports an injection into aggregate demand, so a larger current account deficit can reduce domestic output and employment.
• A higher marginal propensity to import makes the open economy multiplier smaller than the closed economy multiplier.
• Policies to correct balance of payments imbalances include exchange rate adjustment, reserve sales, expenditure-reducing policies, expenditure-switching policies and supply-side measures.
• Devaluation or depreciation only improves the trade balance if demand for exports and imports is sufficiently price elastic.

Test yourself

What four components make up the current account?

Trade in goods, trade in services, primary income and secondary income.

What is the formula for the balance of trade?

Trade Balance = X − M, where X is exports of goods and M is imports of goods.

Give one example of a primary income flow and one example of a secondary income flow.

Primary income example: interest or dividends earned on foreign investments. Secondary income example: remittances sent home by migrant workers.

Why does a rise in domestic income relative to foreign income tend to cause a current account deficit?

Because imports depend positively on domestic income, so faster domestic income growth raises import spending faster than export revenue grows, widening the trade gap.

What happens to the exchange rate if a current account deficit persists?

The exchange rate tends to depreciate, because the country is demanding more foreign currency to pay for imports than foreigners demand of its currency.

Name two policies a government could use to reduce a current account deficit.

Devaluing or allowing depreciation of the exchange rate, and expenditure-reducing policies such as raising interest rates or taxes to cut domestic spending on imports.

Why might devaluation fail to improve the trade balance?

If demand for exports and imports is price inelastic, the change in quantity traded may be too small to offset the change in prices, so the trade balance could worsen rather than improve.