The balance of payments
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A country has a deficit on trade in goods of $50bn and a surplus on trade in services of $70bn. Net primary and secondary income are both zero. The current account is:
Which situation makes a current account deficit least worrying?
A country runs a current account deficit of $30bn. Assuming the capital account is zero and measurement is accurate, the financial account must show:
Worked problems
Show your working.
Calculating the current account balance from its components. A country records: exports of goods $180bn, imports of goods $220bn, exports of services $95bn, imports of services $60bn, net primary income minus $12bn, net secondary income plus $8bn. Calculate the trade in goods balance, the trade in services balance and the overall current account balance.
Testing the Marshall-Lerner condition before and after adjustment. Immediately after a depreciation, a country's PED for exports is 0.3 and for imports is 0.4. Two years later they are 0.9 and 0.8. Apply the Marshall-Lerner condition in each period and describe the path of the current account.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
Why deflating the economy corrects a deficit at a high price
- A Since a proportion of all spending goes on imports, import volumes fall as spending falls.
- B The government raises taxes or interest rates to reduce aggregate demand.
- C The current account improves, because imports have dropped while exports are unaffected in the short run.
- D But the fall in demand also reduces demand for domestically produced goods, so output falls.
- E Firms respond by cutting output and employment, and unemployment rises.
- F The deficit has been reduced by making the country poorer rather than by making it more competitive, so the improvement disappears as soon as demand recovers.
- G Household disposable income and firms' investment both fall, so total spending declines.
Diagrams
Draw an AD/AS diagram showing contractionary policy shifting AD left, and mark the fall in real output and the price level. Beside it, draw a foreign exchange market showing a depreciation. Annotate which components of the current account each policy affects and by what route.
Draw the J-curve with the current account balance on the vertical axis, zero marked, and time on the horizontal axis. Mark the moment of depreciation, the initial deterioration, the trough, and the subsequent improvement to a position better than the starting point.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Discuss whether depreciation of the exchange rate is the most effective way to correct a persistent current account deficit. (13 marks)
Answers
Balance of payments: A record of all financial transactions between the residents of a country and the rest of the world over a period of time, usually a year.
B. The current account combines all components: minus 50 plus 70 equals plus 20, a surplus of $20bn. A goods deficit does not mean a current account deficit, which is exactly why the question is set this way.
B. Importing capital equipment raises future output and export capacity, so the borrowing funds an asset that will help service it. The other three describe deficits that either signal an underlying problem or depend on financing that could disappear at short notice.
B. The balance of payments balances as an identity. Spending $30bn more abroad than is earned must be financed by a net inflow of $30bn, whether through borrowing, selling assets or running down reserves. That inflow is recorded as a financial account surplus.
Step 1. Calculate the balance of trade in goods. 180 - 220 = minus $40bn. A deficit of $40bn on goods.
Step 2. Calculate the balance of trade in services. 95 - 60 = plus $35bn. A surplus of $35bn on services.
Step 3. Combine to get the balance of trade in goods and services. minus 40 + 35 = minus $5bn. The services surplus offsets most but not all of the goods deficit.
Step 4. Add the income balances. minus 5 + (minus 12) + 8 = minus $9bn. The current account is in deficit by $9 billion.
Step 5. Interpret the structure. This economy imports more goods than it exports but is a net exporter of services, which is typical of an advanced economy with a large financial or tourism sector. The negative primary income means more profit and interest leaves the country than enters, suggesting foreign ownership of domestic assets exceeds domestic ownership abroad.
Keep signs consistent throughout and show each stage. Method marks are available for the intermediate balances, so a single arithmetic slip costs one mark rather than the question.
Step 1. Apply the condition in the short run. 0.3 + 0.4 = 0.7, which is less than 1. The condition fails.
Step 2. Explain what that means in the short run. Demand is inelastic on both sides, so quantities barely move. Import volumes stay roughly constant while each import costs more in domestic currency, so the import bill rises. Export volumes stay roughly constant while each export earns less foreign currency. The current account deteriorates.
Step 3. Apply the condition after two years. 0.9 + 0.8 = 1.7, which exceeds 1. The condition now holds.
Step 4. Explain the long-run outcome. Buyers have had time to switch. Domestic consumers substitute towards home-produced goods, and foreign buyers respond to cheaper exports by ordering more. Import volumes fall and export volumes rise enough to outweigh the adverse price movement, so the current account improves beyond its starting point.
Step 5. Name the pattern. The current account worsens first and improves later, tracing a J shape over time. This is the J-curve, and it explains why a depreciation can appear to be failing for a year or more before it works, and why governments under pressure often abandon the policy just before it takes effect.
Elasticities are not fixed properties; they rise with the time allowed for adjustment. Stating that explicitly is what connects Marshall-Lerner to the J-curve rather than treating them as two separate facts to memorise.
B, G, A, C, D, E, F
- The government raises taxes or interest rates to reduce aggregate demand.
- Household disposable income and firms' investment both fall, so total spending declines.
- Since a proportion of all spending goes on imports, import volumes fall as spending falls.
- The current account improves, because imports have dropped while exports are unaffected in the short run.
- But the fall in demand also reduces demand for domestically produced goods, so output falls.
- Firms respond by cutting output and employment, and unemployment rises.
- The deficit has been reduced by making the country poorer rather than by making it more competitive, so the improvement disappears as soon as demand recovers.
Step 7 is the evaluation. Expenditure reducing treats the symptom: it works reliably and quickly, and it does nothing about the underlying competitiveness that caused the deficit. That is why it is a stabilisation measure rather than a solution.
Drawing both together makes the trade-off visible. Deflation improves the current account by suppressing imports through lower income, at the cost of output and jobs. Depreciation improves it by changing relative prices, at the cost of higher import prices and therefore inflation. Neither is free, and identifying which cost matters more in the circumstances given is the judgement examiners want.
Two details separate a good diagram from a vague one. Mark the point of depreciation on the time axis, since the curve only begins its descent there. And show the final position above the starting level, not merely back to it, because otherwise the diagram implies the depreciation achieved nothing. The depth and length of the trough depend on how quickly elasticities rise.
Define and frame: Define the current account and depreciation, and stress the word persistent, since a structural deficit implies a competitiveness problem rather than a temporary shock. State that effectiveness will be judged on whether the improvement lasts, and that the answer turns on elasticities, on the cause of the deficit and on the alternatives available.
Analysis: the case for depreciation: Run the expenditure-switching mechanism: exports cheaper abroad, imports dearer at home, volumes adjust, net exports rise. Note that it requires no fall in domestic demand, unlike deflation, so output and employment are supported rather than sacrificed. Under a floating rate it happens automatically in response to a deficit, which is an advantage over any policy requiring a decision.
Analysis: why it may not work: Apply Marshall-Lerner and the J-curve: the improvement requires elasticities summing above one, which typically fails in the short run, so the account worsens first. Dearer imports raise costs and inflation, which erodes the real depreciation and can leave competitiveness unchanged, as the real exchange rate calculation shows. Trading partners may retaliate or depreciate in turn. Foreign currency debt becomes dearer to service. And a supply response requires spare capacity that may not exist.
Analysis: the alternatives: Take both seriously. Expenditure reducing works reliably and fast but at the cost of output and jobs, and the improvement reverses when demand recovers. Protectionism switches expenditure without the inflation, but invites retaliation and protects inefficiency. Supply-side policy raising productivity and quality is the only approach that addresses a persistent deficit's cause, but it takes years and costs money.
Judgement: Conclude conditionally. Depreciation is most effective where elasticities are high, spare capacity exists, foreign currency debt is limited and the deficit reflects price uncompetitiveness. It is weak where demand is inelastic, the import share is high so inflation erodes the gain, or the deficit is structural. For a genuinely persistent deficit the honest conclusion is that depreciation buys time while supply-side improvement is what corrects it, and that the two are complements rather than rivals.