The Balance of Payments: Causes and Correction of Disequilibrium
The balance of payments is a record of all financial transactions between a country's residents and the rest of the world over a given period, made up of the current account and the financial and capital account.
Before you start
Make sure you're comfortable with these topics first:
Method
- Learn the structure of the balance of payments: the current account (trade in goods, trade in services, primary income, secondary income), and how it must, by definition, be offset by the financial and capital account.
- Learn the causes of a current account deficit: low international competitiveness, e.g. high relative unit labour costs or a strong exchange rate; a structural preference for imports; strong domestic demand growth relative to trading partners; or a lack of productive investment in export industries.
- Learn the expenditure-switching and expenditure-reducing approaches to correcting a deficit: expenditure-switching policies, e.g. a weaker exchange rate or tariffs, aim to switch spending from imports to domestic goods; expenditure-reducing policies, e.g. contractionary fiscal or monetary policy, aim to reduce overall spending, including on imports.
- Learn the Marshall-Lerner condition: a depreciation or devaluation will only improve the trade balance if the combined price elasticities of demand for exports and imports exceed 1.
- Learn the J-curve: even when the Marshall-Lerner condition holds, a depreciation can worsen the trade balance in the short run, because contracts are fixed and demand is inelastic, before improving it once demand adjusts over time.
- Practise reading a balance of payments data table, e.g. identifying whether the current account balance has improved or deteriorated, and by how much, between two years.
- Evaluate correction methods on their side effects, e.g. expenditure-reducing policies can raise unemployment and a weaker exchange rate can be inflationary, the time lags involved via the J-curve, and whether the deficit reflects a genuine problem or strong domestic growth being financed by capital inflows.
Worked example
A country's current account balance was minus 20bn in Year 1 and minus 32bn in Year 2, while nominal GDP was 800bn in Year 1 and 850bn in Year 2. Calculate the current account balance as a percentage of GDP in each year, and state whether the current account position has improved or worsened.
- Year 1: current account as a percentage of GDP = (-20 / 800) x 100 = minus 2.5 percent.
- Year 2: current account as a percentage of GDP = (-32 / 850) x 100 = approximately minus 3.76 percent.
- Compare the two: minus 3.76 percent is a larger deficit, further from zero, than minus 2.5 percent.
- Conclusion: the current account position has worsened between Year 1 and Year 2, both in absolute terms and relative to the size of the economy.
Practice questions
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Q1Name the four components of the current account.Show answer
Answer: Trade in goods, trade in services, primary income, and secondary income.
Q2Give one cause of a persistent current account deficit.Show answer
Answer: Poor international price competitiveness, e.g. relatively high labour costs or a strong exchange rate making exports expensive, or income growing faster than that of trading partners, pulling in more imports.
Q3Distinguish an expenditure-switching policy from an expenditure-reducing policy.Show answer
Answer: An expenditure-switching policy aims to shift spending from foreign to domestic goods, e.g. a weaker exchange rate or tariffs; an expenditure-reducing policy aims to cut overall spending, including on imports, e.g. higher interest rates or lower government spending.
Q4Explain what the J-curve shows about the effect of a depreciation on the current account over time.Show answer
Answer: The trade balance worsens immediately, because contracts are already priced and demand takes time to respond, then improves once export and import volumes adjust, so the current account traces a J shape.
Q5What does the J-curve describe?Show answer
Answer: The tendency for a trade balance to worsen in the short run after a depreciation, before improving over time, because demand for exports and imports is initially price inelastic.
Q6Give one policy a government could use to reduce a current account deficit by reducing overall domestic spending.Show answer
Answer: Raising interest rates, or cutting government spending, or raising taxes.
Q7A current account deficit is minus 15bn out of a GDP of 750bn. Express the deficit as a percentage of GDP.Show answer
Answer: (-15 / 750) x 100 = minus 2 percent.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain, using the Marshall-Lerner condition, why a depreciation of a currency might fail to improve a country's trade balance.
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Evaluate the policies available to a government to correct a persistent current account deficit.
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