UK trade deficit

The UK has just recorded a record trade deficit on the Current Account. At 7% of GDP for the last quarter it is quite a large one.

The BBC article linked below describes what a trade deficit is and why running one might be a bad thing and when it can be coped with. Overall an excellent educational article on a current event.

I want to talk about why the trade deficit has widened and what it's implications are.

The UK economy grew in the last year. By 2.5% according to the latest data. That is actually quite high compared to the rest of the EU and other developed countries. As imports are a function of income economic growth means higher imports. (M = mY where M = total value of imports, m is the fraction of income spent on imports, known as the marginal propensity to import, and Y is Real GDP or national income.) So if a country grows faster than its trading partners it can expect its imports to grow faster than its exports.

The UK has recently seen a fall in the value of the Pound (a depreciation). This will make exports cheaper and imports more expensive so an improvement in the current account balance will follow if the Marshall-Lerner conditions are met. The chart below shows the UK pound against the US$.

 

The recent fall in the pound is seen clearly in the graph. So why has the UK current account not improved? The Marshall-Lerner conditions certainly apply to the UK. The answer lies in the J-Curve effect, the current account worsens before it improves because the UK Pound value of imports rise while the Pound value of exports remains the same after the depreciation.

We should also consider the impact on UK Aggregate Demand (AD). (X - M) is a component of AD and so this worsening current account will act as a drag on UK growth, at least until the J-Curve effect works through to an improvement in the Current Account deficit.

The BBC article is here

VCE students will find the article an excellent explanation of the significance of foreign debt. IB students will also understand the process of the depreciation of a currency and the application of both the Marshal Lerner conditions and J-Curve effect. All students should consider the impact of a larger Current Account deficit on the wider economy through AD/AS analysis.