Edexcel A-Level Economics · Revision notes

4.1.7 Balance of Payments

The balance of payments was introduced in Theme 2 as one of the macroeconomic objectives. This topic goes further: the full structure of the accounts, why current account imbalances arise, what governments can do about them, 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.

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.

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.

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.

Key terms

Common mistakes

• Saying the balance of payments is in deficit. It always balances overall; the current account is in deficit or surplus.
• 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.
• Ignoring timescales. Supply-side measures address the root causes but work slowly.

How this has been examined

In the Edexcel papers indexed on this site, this topic has appeared in five formats:

• 1-mark multiple choice — asked twice across 2 series (2018 to 2025)
• 2-mark calculation — asked once (2018)
• 2-mark "Explain" short answer — asked once (2018)
• 4-mark "Explain" data response — asked once (2025)
• 25-mark "Evaluate" essay — asked once (2024)

Where this goes next

The introduction to the current account is 2.1.4 Balance of payments, and net trade as a component of AD is 2.2.5 Net trade (X-M). Exchange rate changes and their effects on trade are developed in 4.1.8 Exchange rates, the drivers of export performance in 4.1.9 International competitiveness, and the tariffs and quotas used as expenditure switching in 4.1.6 Restrictions on free trade.