Key Terms
Balance of payments: A record of all the currency flows into and out of an economy within a particular time frame, usually a year.
Current account: The part of the balance of payments that records trade in goods and services
Capital (Financial) account: The part of the balance of payments that records capital flows in and out of the country
Current account: The part of the balance of payments that records trade in goods and services
Capital (Financial) account: The part of the balance of payments that records capital flows in and out of the country
Theory
What is the Balance of Payments?
The balance of payments is split into two sections:
| Current Account | Capital Account |
| ↓ | ↓ |
| Visibles (Goods) | Foreign Direct Investment |
| Invisibles (Services) | Outward Direct Investment |
| Portfolio Investment |
The current account is regarded as the most important part of the balance of payments as it reflects the economy's international competitiveness.
Cyclical deficits occur during the recovery or boom stage in the economic cycle. They are caused by increased demand for imports. There is no real concern if deficit is balanced against surpluses.
Structural deficits are substantial and persistent current account deficits. They may be a symptom of a weak domestic economy and lack of international competitiveness e.g. low levels of productivity and high domestic production costs.
1) High level of Economic Growth
When the economy is in boom investment and consumption is high. It is inevitable that some spending will leave the country in the form of imports.
2) Over Valued Exchange Rate
A high exchange rate causes export prices to be higher whilst imports become relatively cheaper.
3) Recession overseas
A recession overseas is the result of negative growth, this in turn leads to a lower rate of inflation for a foreign country.Low levels of inflation in a foreign country will reduce exports from the domestic economy and increase imports.
1) Low productivity
If domestic firms are unproductive, costs for firms will be higher resulting in higher prices than foreign competitors.
2) Low levels of investment
If investment in the domestic economy is low, then innovation will be low. Foreign competitors who have higher levels of investment will be more likely to be innovative, discovering cheaper and more efficient methods of production.
3) High relative inflation
If inflation in the domestic economy is relatively higher to inflation rates in foreign countries then exports will fall and imports will rise.
4) Fall in price of important mineral resource
Some economies rely on the export of specific resources e.g. Russia depends on oil. A fall in price when demand is inelastic will cause a sharp fall in total export revenue.
Types of Deficit
Cyclical Deficits
Cyclical deficits occur during the recovery or boom stage in the economic cycle. They are caused by increased demand for imports. There is no real concern if deficit is balanced against surpluses.
Structural Deficits
Structural deficits are substantial and persistent current account deficits. They may be a symptom of a weak domestic economy and lack of international competitiveness e.g. low levels of productivity and high domestic production costs.
Causes of Deficit
Demand-side Causes
1) High level of Economic Growth
When the economy is in boom investment and consumption is high. It is inevitable that some spending will leave the country in the form of imports.
2) Over Valued Exchange Rate
A high exchange rate causes export prices to be higher whilst imports become relatively cheaper.
3) Recession overseas
A recession overseas is the result of negative growth, this in turn leads to a lower rate of inflation for a foreign country.Low levels of inflation in a foreign country will reduce exports from the domestic economy and increase imports.
Supply-side Causes:
1) Low productivity
If domestic firms are unproductive, costs for firms will be higher resulting in higher prices than foreign competitors.
2) Low levels of investment
If investment in the domestic economy is low, then innovation will be low. Foreign competitors who have higher levels of investment will be more likely to be innovative, discovering cheaper and more efficient methods of production.
3) High relative inflation
If inflation in the domestic economy is relatively higher to inflation rates in foreign countries then exports will fall and imports will rise.
4) Fall in price of important mineral resource
Some economies rely on the export of specific resources e.g. Russia depends on oil. A fall in price when demand is inelastic will cause a sharp fall in total export revenue.
Case For - Running a budget deficit
1) Deficit may be an indicator of a strong economy / Better living standards
If the economy is experiencing strong economic growth, then a deficit may arise. This may be because economic growth results in higher employment and therefore higher levels of income. Some of this income is likely to leak out of the economy onto imports. In this case a deficit is not a bad thing.
2) Reduced Rate of Inflation
An increase in imports represents a leakage from the circular flow. This causes the AD curve to shift left. This reduces inflationary pressure which may be benefitial if the economy is close to productive capacity.
3) Future Growth
Deficits do not matter if the excess of imports is financing future economic growth. Large imports of capital goods may increase the trade deficit in the short-run. But in the long-run productivity may increase therefore lowering cost, reducing inflationary pressure and making the economy more competitive.
4) A current account deficit is only a small percentage of GDP
The IMF calculate the UK’s current account balance to be -3.34% of GDP. This indicates that in reality, deficits have little impact on the domestic economy.
5) Deficit may be a 'one off'
If the economy has a strong history of balance of payment surpluses then the emergence of a deficit may simply be 'one off' and the result of a relatively poorer year for the economy. In this case a deficit may not be regarded as a problem.
6) Not a problem if balanced against capital account
If a current account deficit is balanced against a capital account surplus then the balance of payment reaches equilibrium. Even though the current account is in deficit, the government could still achieve it's macro-economic objective of equilibrium on the balance of payments.
If the economy is experiencing strong economic growth, then a deficit may arise. This may be because economic growth results in higher employment and therefore higher levels of income. Some of this income is likely to leak out of the economy onto imports. In this case a deficit is not a bad thing.
2) Reduced Rate of Inflation
An increase in imports represents a leakage from the circular flow. This causes the AD curve to shift left. This reduces inflationary pressure which may be benefitial if the economy is close to productive capacity.
3) Future Growth
Deficits do not matter if the excess of imports is financing future economic growth. Large imports of capital goods may increase the trade deficit in the short-run. But in the long-run productivity may increase therefore lowering cost, reducing inflationary pressure and making the economy more competitive.
4) A current account deficit is only a small percentage of GDP
The IMF calculate the UK’s current account balance to be -3.34% of GDP. This indicates that in reality, deficits have little impact on the domestic economy.
5) Deficit may be a 'one off'
If the economy has a strong history of balance of payment surpluses then the emergence of a deficit may simply be 'one off' and the result of a relatively poorer year for the economy. In this case a deficit may not be regarded as a problem.
6) Not a problem if balanced against capital account
If a current account deficit is balanced against a capital account surplus then the balance of payment reaches equilibrium. Even though the current account is in deficit, the government could still achieve it's macro-economic objective of equilibrium on the balance of payments.
Case Against - Running a budget deficit
1) Deficits reduce growth
Exports minus imports (X-M) are a component of aggregate demand. If imports are greater than imports then this means there is a reduction in growth. Reduction in growth results in a number of disadvantages for the economy such as higher unemployment, lower business confidence and greater wealth inequality.
2) A macro-economic objective is not being achieved
A macro-economic objective not being achieved is evidence of loss of competitiveness. This may cause foreign investors to loose confidence in the U.K economy they may even withdraw their assets. This could cause a negative multiplier effect. However a current account deficit does not necessarily represent a loss of competitiveness.
Imports support exports
Industries in the U.K. e.g. car manufacturers rely heavily on the import of components
3) Lack of international competitiveness
A deficit on the balance of payments may signal that U.K. goods have either worsned in quality or have failed to innovate at the rate of other economies. For this reason consumers have stopped importing goods from the U.K.
4) Deficit suggests living beyond means
A deficit indicates that a country is consuming at a point beyond its production possibility frontier. This is bad because it means that debt is being accumulated which at some point will need to be paid back along with the interest repayment.
5) Structural Deficits If a deficit is long-term or caused by a supply-side factors, then it may become a structural deficit. This signalls that there is something fundamentally wrong with the economy. In the long-run this will most likely require large volumes of spending by the government to correct the structural issue.
Exports minus imports (X-M) are a component of aggregate demand. If imports are greater than imports then this means there is a reduction in growth. Reduction in growth results in a number of disadvantages for the economy such as higher unemployment, lower business confidence and greater wealth inequality.
2) A macro-economic objective is not being achieved
A macro-economic objective not being achieved is evidence of loss of competitiveness. This may cause foreign investors to loose confidence in the U.K economy they may even withdraw their assets. This could cause a negative multiplier effect. However a current account deficit does not necessarily represent a loss of competitiveness.
3) Lack of international competitiveness
A deficit on the balance of payments may signal that U.K. goods have either worsned in quality or have failed to innovate at the rate of other economies. For this reason consumers have stopped importing goods from the U.K.
4) Deficit suggests living beyond means
A deficit indicates that a country is consuming at a point beyond its production possibility frontier. This is bad because it means that debt is being accumulated which at some point will need to be paid back along with the interest repayment.
5) Structural Deficits If a deficit is long-term or caused by a supply-side factors, then it may become a structural deficit. This signalls that there is something fundamentally wrong with the economy. In the long-run this will most likely require large volumes of spending by the government to correct the structural issue.
Evaluation
Whether a deficit is a bad think may depend on these factors:
Cyclical deficit results from increase in spending on imports during boom. This may be easily balanced out by surpluses at other stages in the economic cycle.
Structural deficits may indicate low levels of productivity and high domestic costs of production.