Edexcel A-Level Economics · Revision notes

2.1.4 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. For the macroeconomic objectives, the part that matters most is the current account, which records trade and income flows.

Components of the balance of payments

The balance of payments has three accounts.

The current account records:

• Trade in goods: exports and imports of physical products, such as cars, machinery, food and fuel.
• Trade in services: exports and imports of services, such as financial services, tourism, insurance and education.
• Primary income: income flowing into and out of the country from ownership of assets abroad and work abroad, such as profits, interest and dividends on investments, and wages.
• Secondary income: transfers where nothing is given in return, such as foreign aid, payments to international organisations, and money migrants send home.

The capital account records a small set of transfers, such as debt forgiveness and the purchase or sale of non-produced assets like patents. It is usually very small.

The financial account records flows of investment: foreign direct investment, portfolio investment in shares and bonds, and changes in reserves.

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.

Overall, the balance of payments always balances, once errors and omissions are included. A current account deficit must be matched by a surplus on the financial and capital accounts. In other words, a country with a current account deficit is financing it by borrowing from abroad or by selling assets to foreign owners.

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.

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.

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

• Treating the balance of trade as the whole current account. Primary and secondary income are also included.
• Saying the balance of payments is "in deficit". Overall it balances; it is the current account that is in deficit or surplus.
• Assuming every deficit is a problem. How it is financed, how large it is and why it exists all matter.
• Forgetting trade in services. For the UK, services partly offset the goods deficit.
• Treating the objectives in isolation. Growth and lower unemployment can worsen the current account.

How this has been examined

This topic has not appeared as a standalone question in the Edexcel papers indexed on this site.

The current account returns in much more detail at A-level in Theme 4, and the indexed questions on deficits, surpluses and measures to correct them sit there.

Where this goes next

The deeper treatment, including causes of deficits and measures to correct them, is 4.1.7 Balance of payments. Net exports as a component of aggregate demand are in 2.2.5 Net trade (X-M), and the effect of the exchange rate on the current account in 4.1.8 Exchange rates. The conflicts between objectives are examined in 2.6.4 Conflicts and trade-offs between objectives and policies.