The current account is a component of the balance of payments. The balance of payments account is a record of all financial dealings over a period of time between economic agents of one country and all other countries. The current account records the trade in goods and services, as well as transfers and income flows. We say that the current account is in deficit when imports are greater than exports. The UK has been in a current account deficit since 2000 of an average 2.4% of GDP. This means that what is flowing out of the UK from trade in goods and services are more than what is flowing into the country.
The UK currently has an inflation rate of 2.3% and has generally been quite low in the UK economy. However, before the financial crisis of 2008 – resulted by deregulation of banks in the US – the inflation rate was 2% and this then increased to 5.2% during the crisis. The first bank to go bankrupt was Lehman Brothers, which was then followed by many other banks that became bankrupt. This resulted in crashes in other economies around the world. So, what is the link between inflation rate and the current account deficit? Well, an increase in the inflation rate, increases the prices of commodities (a raw material that can be bought or sold) which means that the costs of production for firms increase too (as commodities are needed in order to make products). As well as this, as the inflation rate rises, real wages (nominal wages adjusted for inflation) begins to fall so trade unions (a supply-side policy) may negotiate for higher wages as their aim is to maximise their welfare at their work. This will also lead to an increase in costs of production for firms as wages are one of the biggest parts of a firms’ costs of production. Firms will then increase the price of the good or service in order to maximise their own utility (profit). So higher prices makes UK goods less competitive internationally, and demand for UK exports decrease relatively to imports. Therefore, as imports increase and exports decrease relative to each other, the current account deficit worsens. As the inflation rate has constantly been changing (increasing and then decreasing and then increasing again) in the UK, it means that our economy is constantly in a deficit.
Furthermore, a current account deficit can also be caused by a rise in the exchange rate. At present, exchange rates have been falling but during the Financial Crisis of 2008 exchange rates rose by around 25%. This was because people started to want to sell stocks and highly liquid assets for dollars. This demand for cash appreciated the dollar, same as in other countries with their currency. A rise in the exchange rate means that the pound is strong. This means that imports would be cheaper to buy and exports would be more expensive to buy. So the demand for imports rises and the demand for exports decreases. This means that the size of the current account deficit worsens as imports are greater than exports. Similarly, a fall in incomes abroad means that incomes of foreign buyers fall due to a lack of economic growth in their economy (perhaps a recession). This means that they will demand less of UK exports. This also increases the size of the current account deficit as exports decrease. The effects of the financial crisis of 2008 still haven’t entirely been removed as we can see looking at the current account deficit as it was the biggest following 2008.