Explain how changes in various economic factors affect a country’s current account balance

Introduction

When a country like the UK engages in international trade, it will obtain receipts from and make payments for current transactions in goods and services abroad. A current account balance can be defined as the disparity between a country’s receipts from and payments for current transactions with other countries (OECD Factbook, 2009 pp. 86). Current transactions entail exports and imports of goods and services. Services may include passenger transport, financial services, insurance, international freight, tourism and income consisting of salaries and wages, dividends, property income, transfers and interest (OECD Factbook, 2009 pp. 86).

A country’s current account can either be in deficit (imports payments exceed exports receipts) or surplus (exports receipts exceed imports payments). Marcel et al. (2010) reported that the US had a current account deficit of about 7% of GDP in 2006. However a change in some economic factors in 2008 could be associated with an improvement of about 5% of GDP in the US current account balance. This essay evaluates how changes in economic factors will affect a country’s current account balance by reviewing changes in the following factors:

• Economic growth
• Change in trade policy
• Exchange rates
• Inflation
• Unemployment

Economic growth

This is a measure of productivity that aggregates the total value of products produced in an economy. According to Sun (2011, pp. 82-94), theoretical and empirical evidence shows a correlation between high structural changes in the composition of an economy and economic growth. He affirms that structural changes, like an improvement in productivity or labour reallocation (labour moving from one sector to another), usually accompany economic growth. His study unveils profound output growth in most sectors in Asian countries which has stemmed from improvements in productivity.

Sun (2011, pp. 82-94) indicates that during times of economic growth there is also a tendency for savings to increase. Growth in output and increased savings implies that the country’s reliance on imports will decrease, surplus produce will be exported and private companies will have more disposable income for reinvestment which will subsequently increase production. This cycle will most certainly have a positive impact on the country’s current account balance. Notably, during periods of regressing growth, the inverse is the likely possibility.

Change in trade policy

A study by Ramakrishna (2011) on India’s economy and its approach to trade liberation indicates a linkage between trade policy and the macro variables like current account balances. According to the study, India’s aggressive attempt to undertake unilateral trade policy measures like the removal of trade restrictions and subsidies; the introduction of market oriented exchange rate policies; the exclusion of trade barriers, etc. has contributed to great improvements in many macro variables. The study cited empirical findings indicating that, in comparison to the adverse balance of payment problems dating from the 1990s which were partly caused by very restrictive trade measures, trade liberalisation (as a change in trade policy) has had a significantly positive impact on India’s current account balances.

In order to boost the export sector, India has developed the Special Focus Initiatives (SFI) for priority sectors like agriculture, leather and footwear which represent a third of India’s exports and are also a vital source of employment (Ramakrishna 2011). This is a clear indication of how a change in trade policy will have either a positive or negative impact on current account balances.

Exchange rate

The exchange rate is when the price of the UK Pound (or any other currency) is expressed in US dollars (or another currency) (Krueger, 1983). The increase in the price of a country’s currency will most certainly make its products more expensive on the international market. For example, if a car that costs £30,000 in the UK and $40,000 in the USA; at an exchange rate of £1:1.5, the UK car will cost $45,000 in the USA and the USA car will cost £26,666 in the UK. Notice that if the exchange rate increased to £1:2, the UK car would cost $60,000 in the USA and the USA car would cost £20,000 in the UK.

This indicates that an increase in the exchange rate of a country’s currency will increase the price of its products abroad, thus making them less attractive and subsequently reducing the receipts from exports. Likewise, a reduction in the exchange rate, as shown by the case of the USA car, will reduce the price of the product abroad thus making it more attractive to buyers and subsequently increasing the receipts from exports. This scenario also shows that when the pound appreciates, imports will become cheaper and the reverse applies when the pound depreciates.

Inflation

Dwivedi (2010) defines inflation as a substantial and persistent rise in price levels over a period of time. During inflationary periods products are more expensive; people attempt to save money so they spend less and this can eventually spill over into unemployment. A country with high inflation and therefore expensive products will struggle to sell them abroad. Inflation definitely has an adverse effect on the volume of exports and consequently a country’s current account balances.

Unemployment

Unemployment is when a person is not engaged in subsistence economic activity (Khayr al-Din and Kheir-El-Din, 2008). This can be caused by people moving between jobs, significant changes in the structure of an economy, automation (when technology replaces people), and, probably, changes in seasons. When people are unemployed they spend less. This will most certainly lead to loss of profits which would have otherwise been reinvested to produce more products for export. Likewise, the ability to import will be curtailed owing to the country’s limited purchasing power.

Conclusion

In conclusion, it is vital to stress the significance of the current account balance as a macro variable and to note its sensitivity to variations in all economic factors. Change in economic growth, trade policy, exchange rate, inflation and unemployment, amongst others, will create either a current account deficit or a surplus. It should also be noted that none of the factors work in isolation and that a change in one economic variable will most certainly trigger a change in another.

Bibliography,

Anne O. Krueger (1983) Exchange-Rate Determination

G. Ramakrishna (2011) India’s Trade policy: Impact on Economic Growth, Balance of Payment and Current Account Deficit [Online] Available on http://content.ebscohost.com.ezproxy.liv.ac.uk/pdf27_28/pdf/2011/B742/01Jan11/67660116.pdf?T=P&P=AN&K=67660116&S=R&D=bth&EbscoContent=dGJyMNHX8kSeprc4xNvgOLCmr0uep7BSs6q4SrCWxWXS&ContentCustomer=dGJyMOzprkmvqLJPuePfgeyx44Dt6fIA (Accessed on 9 February 2012)

Hana Khayr al-Din and Hanaa Kheir-El-Din (2008) Egyptian Economy: Current challenges and future prospects [Onlin] Available on http://books.google.co.uk/books?id=sXk4XDaI0WkC&pg=PA139&dq=unemployment+definition&hl=en&sa=X&ei=F_YkUYXEGMix0QWy9YCgDw&sqi=2&redir_esc=y#v=onepage&q=unemployment%20definition&f=false (Accessed on 9 February 2012)

OECD Factbook (2009) Economic, Environmental and Social Statistics: By Organisation for Economic Co-Operation and Development

Marcel Fratzscher, Luciana Juvenal, Lucio Sarn (2010) European Economic Review Asset prices, exchange rates and the current account. Vol. 54 issue 5

Yi Sun (2011) International Review of Economics and Finance Volume 2 Issue 1p2 82-94 [Online] Available on http://www.sciencedirect.com.ezproxy.liv.ac.uk/science/article/pii/S1059056010000511 (Accessed on 9 February 2013)