A country’s current account measures the inflow and outflow of the country’s goods, services, and investments. Thus, a current account deficit refers to a situation wherein the value of goods and services imported by the country is higher than the value of goods and services exported from the country.
The current account deficit can be calculated with the help of the below-mentioned formula:
Current Account Deficit (CAD) = Trade deficit + Net income + Unilateral transfers
- Trade deficit = Imports – Exports
- Net income = Income earned due to investments
- Unilateral transfers = Humanitarian aid, donation, etc.
Below, we have tried to elaborate on the components of the current account.
Components of current account
The current account has three main components, i.e., trade, income, and current transfer of capital.
Trade in goods and services is the most important component of the current account. There are high chances that a trade deficit alone can lead to current account deficit. This is because a trade deficit can offset the surplus in net income, direct transfers, and asset income.
Income refers to the country’s inflow and outflow in the form of salaries, foreign portfolio investments, foreign direct investments, etc. Trade and income are the two key components that provide the economy the required fuel to function.
- Current Transfers
Current transfers are essentially unilateral transfers such as donations, humanitarian aids and grants, official assistance, etc. It must be noted that current transfers do not impact the economic production of the country.
Causes of current account deficit
Some of the major factors that leads to current account deficit are mentioned below:
- Overvalued exchange rate
If the currency is overvalued, the imports of goods and services will be cheaper. This may result in higher quantity of imports. On the other hand, exports may become less feasible, consequently leading to a decline in the quantity of exports.
- High inflation rate
If there’s an enormous increase in the country’s inflation rate, the export of goods and services will become less competitive, and imports will become more viable. This can trigger current account deficit.
- Recession in other countries
If our country’s primary trading partners experience recession, then they will buy less of our exports, consequently leading to current account deficit.
- Economic growth
It may be surprising but sometimes economic growth can also lead to current account deficit. This is because if there is an increase in national average income, citizens will be more open to spending large amount of money on consumer goods. If domestic producers and manufactures fail to meet the demands of citizens, they may import goods from foreign countries. This is one of the advantages of current account deficit.
A current account deficit can take a toll on the country’s economic growth. Foreign investors may start questioning whether the economic growth will offer enough return on their investment. Moreover, it can also lead to inflation, and consequently lower standard of living for the citizens of the country. However, a current account deficit is not always harmful, as sometimes external debt may be used to finance profitable investments.