AQA A-Level Economics · Revision notes

4.2.6.3 The Balance of Payments

The balance of payments is the record of all financial transactions between one country and the rest of the world over a period of time. This page covers the structure of the accounts, the meaning and significance of current account deficits and surpluses, why they arise, the policies used to correct them and their effects on other objectives, and why imbalances between the world's largest economies matter.

Components of the balance of payments

The current account

• Trade in goods: exports and imports of physical products.
• Trade in services: exports and imports of services such as finance, insurance, tourism and education.
• Primary income: investment income (profits, dividends and interest) and compensation of employees flowing into and out of the country.
• Secondary income: current transfers with nothing given in return, such as foreign aid, contributions to international organisations, and remittances sent home by migrant workers.

The capital account Records capital transfers, such as debt forgiveness and the transfer of ownership of fixed assets, and the purchase or sale of non-produced, non-financial assets such as patents. It is usually very small.

The financial account Records flows of financial assets and liabilities:

• Direct investment: acquiring a lasting interest in a business abroad, such as building a factory or buying a controlling stake.
• Portfolio investment: buying shares and bonds without control of the business.
• Other investment: mainly bank loans and deposits.
• Reserve assets: changes in the central bank's holdings of foreign currency and gold.

Overall the balance of payments must balance, once a balancing item for errors and omissions is included.

Key idea: A current account deficit is matched by a net inflow on the financial and capital accounts. A country with a current account deficit is financing it either by borrowing from abroad or by selling assets to foreign owners.

The balance of trade

The balance of trade in goods and services is exports of goods and services minus imports of goods and services. It is the largest part of the current account.

• A trade surplus means the value of exports exceeds the value of imports.
• A trade deficit means the value of imports exceeds the value of exports.

It helps to separate the two parts. The UK has run a large deficit on trade in goods for many years, partly offset by a surplus on trade in services, where financial and business services are strong exports.

Current account deficits and surpluses

• A current account deficit means more money flows out of the country on the current account than flows in. The country is spending more abroad than it earns.
• A current account surplus means more flows in than out.

Is a deficit a problem? It depends.

• A deficit caused by strong consumer spending on imports may signal that the economy is growing faster than its capacity.
• A persistent deficit can indicate a loss of international competitiveness.
• Small deficits as a share of GDP are less of a concern than large ones.

Evaluation: A deficit financed by long-term foreign direct investment into productive capacity is generally more sustainable than one financed by short-term borrowing.

Causes of current account deficits and surpluses

Causes of a deficit

• Low international competitiveness. High relative costs, low productivity or poor non-price factors such as quality and design make exports less attractive and imports more so.
• Strong domestic demand. Fast-growing incomes and consumption draw in imports, especially when domestic firms are already at capacity.
• A strong exchange rate. An appreciation makes exports dearer abroad and imports cheaper at home.
• Higher inflation than trading partners. Domestic goods become relatively more expensive.
• Structural change. The decline of manufacturing reduces the range of goods produced at home.
• Weak demand abroad. A recession in major trading partners reduces exports.
• Low national saving. A country that saves less than it invests must draw on savings from abroad, which shows up as a current account deficit.

Causes of a surplus are largely the reverse: strong competitiveness, high domestic saving, weak domestic demand relative to output, and an undervalued exchange rate.

Consequences of investment flows

Inflows of foreign direct investment can create jobs, bring in new technology and management skills, and raise productivity and exports. Over time, though, the profits earned by foreign owners flow out as primary income, which worsens the current account. Large inflows of portfolio investment and short-term bank deposits, sometimes called hot money, can push up the exchange rate and can be withdrawn quickly, causing the currency to fall sharply. Outward investment, in turn, earns profits and interest that flow back as primary income in future years.

Measures to reduce a current account deficit

Expenditure-switching policies encourage consumers at home and abroad to switch spending from foreign goods to domestic goods.

• Depreciation or devaluation of the currency, making exports cheaper and imports dearer.
• Protectionism, such as tariffs and quotas, which raise the price or restrict the quantity of imports. This risks retaliation and may break international trade rules.

Evaluation: Whether a depreciation improves the current account depends on how responsive trade volumes are to price. The Marshall–Lerner condition states that a depreciation improves the current account if the sum of the price elasticities of demand for exports and imports is greater than one. Because trade volumes take time to adjust, the current account may at first worsen before improving, a pattern known as the J-curve.

Expenditure-reducing policies cut overall spending, including spending on imports.

• Contractionary fiscal policy: higher taxes or lower government spending.
• Contractionary monetary policy: higher interest rates. These reduce imports but at the cost of slower growth and higher unemployment.

Supply-side policies improve competitiveness over the long term, for example through investment in education, training, infrastructure and research. They tackle the underlying causes but take a long time to work.

A current account surplus can be reduced by the same tools working in reverse: an appreciation of the currency, the removal of import barriers, or expansionary fiscal and monetary policy that raises domestic spending, including spending on imports.

Links with other macroeconomic objectives

The current account interacts with the other objectives, sometimes in conflict.

Economic growth. When incomes rise quickly, spending on imports rises too. Rapid growth tends to worsen the current account.

Inflation. If UK inflation is higher than in competitor countries, UK goods become relatively more expensive. Exports fall, imports rise and the current account worsens.

Unemployment. Policies that cut unemployment by boosting demand also raise imports. On the other hand, a fall in export demand reduces output and employment in exporting industries.

Exchange rate. A depreciation of the pound makes exports cheaper and imports dearer, which can improve the current account, but it also raises import prices and so adds to inflation.

This is why a stable current account appears among the macroeconomic objectives: an improvement in one area can come at a cost in another.

Significance of global trade imbalances

Some of the world's largest economies run persistent imbalances. Large economies such as China and Germany have run substantial surpluses, while the United States has run large deficits.

These imbalances matter because:

• They depend on continued financing. Deficit countries rely on surplus countries' willingness to lend to them or buy their assets. A sudden loss of confidence can force a sharp adjustment, with a fall in the currency and in domestic spending.
• They can contribute to financial instability. Large flows of saving from surplus countries into deficit countries can push down interest rates and fuel credit booms and asset price bubbles.
• They create political tension. Persistent deficits are often blamed on unfair trade practices or undervalued currencies, increasing pressure for protectionism.
• Adjustment is asymmetric. Deficit countries come under pressure to adjust, while surplus countries face less pressure, which can hold back global demand.

Interconnectedness through trade

International trade links economies together, so events in one country affect others.

• A recession in a major trading partner reduces demand for UK exports, slowing growth and raising unemployment in the UK.
• Growth in trading partners raises demand for UK exports.
• Supply shocks travel through trade. A rise in global energy prices raises costs in every country that imports energy.
• Global supply chains mean that disruption in one country can halt production in another.

The more open an economy is to trade, the more exposed it is to these effects.

Key terms

Common mistakes

• Saying the balance of payments is in deficit. It always balances overall; the current account is in deficit or surplus.
• Treating the balance of trade as the whole current account. Primary and secondary income are also included.
• Forgetting trade in services. For the UK, services partly offset the goods deficit.
• Assuming a depreciation always improves the current account. It depends on the Marshall–Lerner condition, and the J-curve means the improvement may be delayed.
• Presenting expenditure reducing as cost-free. It lowers imports by lowering growth and employment.
• Treating every deficit as a problem. How it is financed and why it exists both matter.
• Treating the objectives in isolation. Growth and lower unemployment can worsen the current account.
• Ignoring timescales. Supply-side measures address the root causes but work slowly.

How this has been examined

In the AQA papers indexed on this site, this topic has appeared in six formats:

• 25-mark "Assess" essay — asked once (2018)
• 25-mark "Evaluate" essay — asked once (2017)
• 15-mark "Explain" essay — asked twice across 2 series (2022 to 2025)
• 4-mark "Explain" data response — asked once (2018)
• 2-mark calculation — asked once (2020)
• 1-mark multiple choice — asked 4 times across 4 series (2018 to 2024)

Where this goes next

Net exports as a component of aggregate demand are covered in 4.2.2.3 The determinants of aggregate demand, and the trade-offs between a stable current account and other objectives in 4.2.3.4 Possible conflicts between macroeconomic policy objectives. How exchange rates are determined and managed is developed in 4.2.6.4 Exchange rate systems, the tariffs and quotas used as expenditure switching in 4.2.6.2 Trade, and the investment flows behind the financial account in 4.2.6.1 Globalisation.