International Trade, Globalisation and Exchange Rates: Question 5

Worked solution

Part (a): Defining the current account

The current account of the balance of payments is a record of the value of a country’s transactions with the rest of the world over a given period (usually a year). It is made up of four components:

• trade in goods, exports minus imports of physical goods;
• trade in services, exports minus imports of services (e.g. tourism, insurance, transport);
• primary income, net flows of profit, interest and dividends paid between countries;
• secondary income, net transfers such as workers’ remittances and foreign aid.

Part (b): Calculating the balance

Doverly’s current account balance is the sum of all four components, taking care to keep each one’s sign:

$-450 + 130 + 40 - 20 = -300$

Since the overall balance is negative, Doverly is paying out more (through these transactions) than it is earning. Doverly’s current account is in $\boxed{\textbf{deficit}}$ of $300 million.

Part (c): A possible cause of the deficit

Doverly’s current account deficit (largely driven by the trade in goods component, -$450 million) could be caused by Doverly experiencing higher inflation than its trading partners. If prices in Doverly rise faster than prices abroad:

• Doverly’s exports become less price-competitive in foreign markets, so export revenue falls (or grows more slowly than it otherwise would).
• Foreign goods become relatively cheaper for Doverly’s own consumers compared with domestically produced goods, so import spending rises.

Both effects push the trade in goods balance further into deficit, dragging the whole current account balance down.

(Other syllabus-based causes would also be acceptable, such as an overvalued exchange rate making exports dearer and imports cheaper, rising domestic incomes increasing demand for imports, or Doverly’s export industries being less productive or competitive than those of its trading partners.)

Part (d): Two consequences for Doverly’s economy

Consequence 1. Lower growth and higher unemployment. A persistent deficit means more money is leaving Doverly (to pay for the excess of imports and other net outflows) than is entering from abroad. This represents a leakage from Doverly’s circular flow of income: if it is not offset elsewhere, aggregate demand is lower than it would otherwise be, which can slow economic growth and increase unemployment, particularly in industries that produce exports or compete with imports.

Consequence 2 (downward pressure on the exchange rate. To pay for the net outflow recorded in the deficit, Doverly’s residents and firms need to buy more foreign currency than foreigners want to buy of Doverly’s own currency. In the foreign exchange market, this greater demand for foreign currency relative to demand for Doverly’s currency tends to push down the value of Doverly’s currency) a depreciation, which may, over time, help correct the deficit by making Doverly’s exports cheaper and its imports dearer.

Final answers

• (a) The current account records a country’s trade in goods, trade in services, primary income and secondary income with the rest of the world.
• (b) $-450+130+40-20=-300$, so Doverly has a current account deficit of $300 million.
• (c) E.g. higher inflation in Doverly than in its trading partners, making exports less competitive and imports more attractive.
• (d) E.g. lower aggregate demand/growth and higher unemployment, and downward pressure on (depreciation of) Doverly’s exchange rate.