In 1994, the UK had a balance of payments current account deficit. Please explain the possible effects that this deficit might have on the economy. Also, discuss what the UK government could have done to reduce or eliminate this current account deficit. The balance of payments is a record of one country’s trade dealings with the rest of the world.
Any transaction involving UK and foreign citizens is calculated in sterling (UK pounds). Dealings that result in money entering the country are credit (plus) items, while transactions that lead to money leaving the country are debit (minus) items. The balance of payments can be split up into two sections: 1. the current account, which deals with international trade in goods and services; and 2. transactions in assets and liabilities, which deal with overseas flows of money from international investments and loans. The current account consists of international dealings in goods (visible trade) and services (invisible trade).
Invisible trade includes payments for overseas embassies and military bases, interest, profit, and dividends from overseas investment, and earnings from tourism and transportation. The cause of the deficit was that the UK imported more visible goods than it exported, and there was a net deficit on transfers. Our service earnings plus overseas incomes did not exceed our service payments plus investment income paid abroad sufficiently to prevent the balance on the current account from being well in deficit. The state of the trade balance is extremely important since changes in imports and exports have an important bearing on the real economy and, in particular, on output and employment. In the longer run, a persistent deficit, if it cannot be offset by a surplus on invisibles, will have serious implications.
It will handicap the conduct of macroeconomic policy. Its effect will be to increase instability of exchange rates and/or interest rates as the UK becomes dependent on inflows of hot money to finance the deficit. Higher interest rates are also likely to cause a reduction in real investment and therefore economic growth. The current account deficit might also be financed by increased sales of assets to overseas firms and residents, which in the long run will lead to an increased outflow of interest, profits, and dividends. The balance of payments always balances because of official financing. However, a balance of payments deficit means a persistent and large negative balance for official financing.
This can be the result of excessive purchases of foreign goods and services or excessive UK investment overseas. In the short term, a balance of payments deficit can be corrected by continuing to borrow foreign currency, increasing interest rates to attract overseas investors, imposing exchange controls, or imposing tariffs and import quotas. In the long run, the government can correct a balance of payments deficit by reducing demand in the economy for all goods, including imports. Reducing UK inflation rates or encouraging a depreciation of the sterling will also help. The correct measures to remedy a deficit will depend on its cause and the exchange rate regime.
A short-term deficit can be dealt with by running down reserves or by borrowing. Another short-term measure is to raise interest rates to encourage the inflow of money. When there is a more fundamental payments deficit, other methods will have to be taken. The following shows ways in which the government can tackle the problem of a deficit in the current accounts.
Deflation occurs when the demand for imports is restrained by limiting the total level of demand in the country through fiscal and monetary policies. Protectionism involves cutting off all imports and therefore protecting the domestic market from foreign competition. Devaluation refers to a fixed exchange rate dropping the external price of a currency, as the UK did in 1967 when the rate changed from ?1=$2.80 to ?1=?2.40. This is known as a devaluation, which makes exports appear cheaper to foreigners while making imports more expensive for domestic customers.