← Back to the note

The answers print on a separate page at the end. Higher levels include the lower-level questions.

ExamPass · AS Level worksheet

The balance of payments

NameClassDate

Key terms

Define each term.

1
Balance of payments

Multiple choice

Circle the correct answer.

2

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:

  1. In deficit by $50bn
  2. In surplus by $20bn
  3. In deficit by $20bn
  4. In surplus by $70bn
3

Which situation makes a current account deficit least worrying?

  1. It is financed by short-term borrowing that can be withdrawn quickly
  2. It results from importing machinery that will raise future productive capacity
  3. It has persisted and widened for a decade
  4. It results from a loss of competitiveness in export industries
4

A country runs a current account deficit of $30bn. Assuming the capital account is zero and measurement is accurate, the financial account must show:

  1. A deficit of $30bn
  2. A surplus of $30bn
  3. A balance of zero
  4. Any value, since the accounts are independent

Worked problems

Show your working.

5

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.

Chains of reasoning

The steps are in the wrong order. Write the letters in the order that makes a linked chain.

6

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

7

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.

Answers

1

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.

2

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.

3

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.

4

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.

5

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.

6

B, G, A, C, D, E, F

  1. The government raises taxes or interest rates to reduce aggregate demand.
  2. Household disposable income and firms' investment both fall, so total spending declines.
  3. Since a proportion of all spending goes on imports, import volumes fall as spending falls.
  4. The current account improves, because imports have dropped while exports are unaffected in the short run.
  5. But the fall in demand also reduces demand for domestically produced goods, so output falls.
  6. Firms respond by cutting output and employment, and unemployment rises.
  7. 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.

7

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.