A Two-Way Link
Definition
Current account of the balance of payments: the record of a country's trade in goods and services plus its primary and secondary income flows.
Cost-push inflation: a rise in the general price level caused by higher costs of production, such as dearer imported raw materials.
- Inflation and the balance of payments affect each other in both directions.
- Higher relative inflation makes exports dearer and imports cheaper, worsening the current account.
- A current-account deficit financed by a depreciating currency raises import prices, feeding back into inflation.
Key Idea
- Inflation above that of rivals worsens the current account by eroding competitiveness.
- A falling currency used to fund a deficit can itself add to inflation.
The Two Directions of the Link
- From inflation to the current account
- When a country's inflation exceeds its partners', its exports lose price competitiveness while imports look cheaper, so net exports (X − M) fall and the current account worsens.
- From the current account to inflation
- A deficit tends to weaken the currency, and the depreciation raises the £ price of imported food, fuel and components, causing cost-push inflation.
- The combined result
- The two effects can reinforce one another, pulling the economy away from both price stability and external balance.
Note
- What matters is relative inflation, so a country loses competitiveness whenever its prices rise faster than its rivals'.
- The size of the effect depends on the price elasticity of demand for exports and imports.
Example
- A country exports £300bn of goods and services in a year and imports £340bn.
- The £40bn deficit widens further if higher relative inflation makes exports dearer and cuts their volume.
Why It Is a Policy Conflict
- Curbing inflation may need tighter policy, such as a central bank raising rates, which also cools output and employment.
- Allowing a weaker currency can improve the trade balance but stokes imported inflation.
- So policymakers face a trade-off, and which objective they prioritise depends on whether inflation or the external deficit is the more urgent threat.
Does higher inflation inevitably worsen the current account?
- Often yes: if inflation runs above that of trading partners, exports lose price competitiveness and imports look cheaper, so net exports fall and the current account deteriorates.
- But the size, and even the direction, depends on the price elasticities of demand for exports and imports (the Marshall-Lerner condition): if trade flows are inelastic, dearer exports can still earn more revenue and the deficit need not widen, and a floating currency can depreciate to restore competitiveness.
- On balance, higher relative inflation tends to worsen the current account, but how far depends on elasticities, the exchange rate regime and whether rivals are inflating too, so the effect is a tendency that market adjustment and policy can partly offset.
Exam technique
- Explain how higher relative inflation worsens the current account.
- Explain the reverse link, showing how a falling currency adds to inflation.
- Present the outcome as a conflict between objectives to reach evaluation.
Common Mistake
- Do not treat inflation and the balance of payments as unrelated, since higher relative inflation worsens competitiveness.
- Do not forget the reverse link, because a falling currency used to fund a deficit can add to inflation.
Self review
- How does higher relative inflation affect the current account?
- Why does relative rather than absolute inflation matter?
- How can a current account deficit add to inflation?
- Why is this described as a policy conflict?
- What determines the size of the effect on the trade balance?
