Q&A: Government deficit and current account deficit

What is Current Account Deficit and Government Deficit and do they have any effect on Aggregate Demand or Supply

This question flags up what seems to be a frequent confusion among students - the difference between a current account deficit and a government fiscal deficit

The current account refers to one part of a nation’s balance of payments accounts - a record of all international financial transactions with other countries.

The current account is the sum of four separate balances namely:

1. Net Trade in Goods (-£93bn)
2. Net Trade in Services (+£48bn)
3. Net Income from overseas assets (+£33bn)
4. Net Transfers (-£-14bn)

UK runs a current account deficit of £24bn in 2008 or 1.7% of GDP. In effect there was a net outflow of demand from the circular flow.

The government deficit refers to the budget deficit which is the difference between total government spending and total tax revenues. The UK government has run a budget deficit in every year since 2000 and the fiscal deficit is now major headline news because government sector borrowing is set to reach staggeringly high levels in 2009-10 and beyond. Ernst and Young forecast that UK government borrowing will shoot up to £180bn in 2009/2010 – equivalent to 12pc of GDP.

Both the current account deficit and the budget deficit have an effect on aggregate demand and also aggregate supply over time.

Current account
Depending on the cause of the current account deficit, a large and rising deficit in trade can hit demand for domestically produced goods and services. Many thousands of jobs depend directly and indirectly on the export sector and changes in export demand have effects in other sectors further down the supply chain (e.g. component suppliers for manufacturers and also the distribution and marketing industries). Likewise a rise in imports is a withdrawal from the circular flow of income and has a negative effect on AD.

But a current account deficit might also be due to a rise in imports of raw materials, components and new technology all of which might be required for an expansion of short run aggregate supply. Or, in the case of imports of new capital inputs, an increase in long run supply potential.

Budget deficit
A budget deficit might arise from higher government spending and/or a reduction in tax revenues. Both imply a net injection of income into the circular flow and therefore a hefty budget deficit ought to provide a boost or stimulus to demand.

But as we have said in previous blogs, there is a debate about just how effective a budget deficit is in stabilizing demand during a recession. One theory argues that extra government borrowing can crowd-out spending by the private sector thereby reducing the effect on demand and output.

There are also possible supply-side effects from government borrowing - this blog entry provides one clue to this.