How do we record a country's transactions with the rest of the world?
The structure of the balance of payments, the current account and its components, the causes and consequences of current account deficits and surpluses, and policies to correct them.
An answer to AQA A-Level Economics 4.2.6, covering the structure of the balance of payments, the current account and its components, the causes and consequences of current account deficits and surpluses, and policies to correct an imbalance.
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What this dot point is asking
AQA wants you to explain the structure of the balance of payments and the current account, the causes and consequences of current account deficits and surpluses, and the policies that can correct an imbalance. Current account calculations and evaluation of a deficit appear regularly.
The structure of the balance of payments
The financial account records flows of investment and assets: foreign direct investment, portfolio investment (shares and bonds) and changes in reserves. The small capital account records transfers of capital assets such as debt forgiveness. A country running a current account deficit is, in effect, borrowing from or selling assets to the rest of the world to pay for the excess of imports over exports.
The current account
The UK typically runs a goods deficit partly offset by a services surplus (finance, insurance, education), with the overall current account in persistent deficit. Germany and China, by contrast, run large surpluses driven by manufacturing exports.
Causes and consequences
- Causes of a deficit. Strong domestic demand pulling in imports, an overvalued exchange rate, low productivity and poor non-price competitiveness (quality, design, reliability), or high relative inflation eroding price competitiveness.
- Consequences. A deficit must be financed by borrowing or selling assets (a financial account surplus). This can be sustainable for a strong economy attracting investment, but a persistent deficit driven by weak competitiveness can build up external debt, weaken the currency, and leave the economy vulnerable to a sudden stop in capital inflows. A large surplus can reflect strong competitiveness but may indicate weak domestic demand, as a surplus means the country lends to or buys assets from the rest of the world.
Policies to correct an imbalance
- Expenditure-reducing. Tighter fiscal or monetary policy lowers domestic demand and so reduces imports, but it also slows growth and raises unemployment.
- Expenditure-switching. A devaluation or depreciation of the currency, or tariffs and quotas, switches spending towards domestic goods. A depreciation works only if the Marshall-Lerner condition holds (the sum of the elasticities of demand for exports and imports exceeds one), and even then improves the balance only after the J-curve delay.
- Supply-side policies. Measures to raise productivity, skills and competitiveness improve the trade balance in the long run without sacrificing growth, though they take time to work.
Exam-style practice questions
Practice questions written in the style of AQA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
AQA 20194 marksAn economy records exports of goods of 300 billion, imports of goods of 380 billion, a services surplus of 40 billion and net primary and secondary income of minus 10 billion. Calculate the current account balance and state whether it is a deficit or surplus.Show worked answer →
A 4 mark calculation rewards correct components and a final figure.
- Trade in goods balance
- billion (a deficit).
- Add services and income
- billion.
- Conclusion
- The current account balance is minus 50 billion, a current account deficit, because total outflows exceed total inflows.
Markers reward summing all four components with correct signs and identifying it as a deficit. A common slip is forgetting the negative income figure.
AQA 20219 marksAssess the view that a persistent current account deficit is always a serious problem for an economy.Show worked answer →
A 9 mark assessment question needs balance and a judgement.
- Why it can be a problem
- A persistent deficit may signal weak competitiveness, requires financing by borrowing or asset sales, builds external liabilities, and can cause currency weakness and a loss of confidence.
- Why it may not be
- A deficit can reflect strong investment inflows and a growing economy; it is financed automatically by a financial account surplus; and for a reserve-currency economy it can be sustained for long periods.
- Judgement
- Severity depends on the cause (demand-led versus competitiveness), the size relative to GDP, how it is financed (stable FDI versus volatile hot money) and its persistence. Markers reward a conditional, supported conclusion rather than "deficits are bad".
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Sources & how we know this
- AQA A-level Economics (7136) specification — AQA (2015)