Causes of Imbalances
Definition
Current account deficit: the current account records a net outflow, so spending on imports plus primary and secondary income paid abroad exceeds the matching inflows.
Current account surplus: the current account records a net inflow, so inflows exceed outflows.
- An imbalance reflects a country's price and non-price competitiveness together with the level of demand at home and abroad.
- Short-term cyclical factors, such as the stage of the trade cycle, can move the balance temporarily.
- Long-term structural factors, such as the mix of industries, can entrench a deficit or surplus.
Key Idea
- A deficit tends to arise when a country is less competitive or when domestic demand is strong.
- A surplus tends to arise when a country is highly competitive or when domestic demand is weak.
Price Competitiveness
- Higher relative inflation means domestic prices rise faster than competitors', so the country's exports become dearer abroad and imports relatively cheaper, cutting exports, raising imports and widening a deficit.
- An overvalued exchange rate means each £ buys more foreign currency, so the country's export prices rise in foreign-currency terms while import prices fall in £ terms, worsening the trade balance.
- Lower productivity growth raises unit labour costs relative to rivals, so firms must charge more, eroding export demand.
Example
- Suppose a country's prices rise +6% in a year while trading partners' rise +2%, lifting its price index to 106 versus 102.
- The country's goods are about +3.9% dearer relative to rivals, so export volumes fall and the deficit widens, though it depends on how price-elastic demand for those exports is.
Non-price and Structure
- Weak non-price competitiveness, such as poor quality, design or reliability, makes buyers switch to rivals even at the same price, so export demand falls.
- A narrow export base, such as reliance on a few commodities, exposes the balance to swings in world prices.
- Long-term structural change, such as deindustrialisation, shrinks export capacity and can entrench a deficit.
Note
- An oil exporter can swing from surplus to deficit when the world oil price falls, because $-denominated export revenue drops sharply.
- As lower-cost overseas competitors emerge, a high-cost export sector loses market share and the deficit widens over years.
The Level of Demand
- Strong domestic demand or rapid growth raises real incomes, so households buy more imports, lifting imports and widening a deficit.
- A recession among trading partners cuts their incomes, so their demand for a country's exports falls and the deficit widens.
- High domestic saving relative to investment leaves less import-intensive spending, so it tends to produce a surplus.
Example
- A consumer boom on imported cars and electronics pulls in imports and widens the deficit.
- A fast-growing economy importing machinery may run a deficit while it invests, which can be sustainable if that investment raises future export capacity.
- Whether a deficit is a problem therefore depends on why it has arisen.
Which cause of a deficit matters most for policy?
- The cause matters because it signals whether an imbalance will correct itself: a cyclical deficit driven by strong domestic demand often unwinds as growth slows, so no policy may be needed, whereas a structural deficit from lost competitiveness tends to persist and calls for supply-side measures.
- But the causes are hard to separate in practice: a deficit from importing machinery can look structural yet raise future export capacity, while a prolonged consumer boom can entrench import habits, so a single label rarely fits.
- The right response also depends on price elasticities: if demand for exports and imports is inelastic, a cheaper currency does little to close the gap, so knowing the cause is not sufficient on its own.
- On balance, the cause shapes the appropriate policy more than the headline figure does, but the judgement depends on how the deficit is financed, its size relative to GDP and how elastic trade flows are.
Exam technique
- Group causes into price competitiveness, non-price competitiveness and the level of demand.
- Separate short-term cyclical causes from long-term structural ones.
Common Mistake
- Do not confuse a cause of an imbalance with its consequences.
- Remember an imbalance can be a surplus, not only a deficit.
Self review
- Name three causes of a current account deficit.
- How does higher relative inflation affect the current account?
- How can strong domestic demand cause a deficit?
- Give one cause of a current account surplus.
