The structure and measurement of the balance of payments, the causes of current account imbalances, and policies to correct them.

What this dot point is asking

WJEC wants you to explain the structure and measurement of the balance of payments, the causes and consequences of current account imbalances, and the policies that can correct them.

The answer

Structure of the balance of payments

The current account has four components: trade in goods (visible trade, such as cars and oil), trade in services (invisible trade, such as finance and tourism), primary income (interest, profits and dividends earned on investments abroad and paid to foreigners), and secondary income (current transfers such as foreign aid and remittances). The capital and financial account records foreign direct investment, portfolio investment and changes in reserves. In principle the accounts balance overall (a current account deficit is financed by a financial account surplus, an inflow of capital), which is why a persistent current account deficit means a country is, in effect, borrowing from or selling assets to the rest of the world.

Causes and consequences of imbalances

A current account deficit is not automatically a problem: it can reflect strong investment funded by capital inflows, and a country can run a deficit for many years if foreigners are willing to hold its assets. But a large, persistent deficit driven by weak competitiveness can signal trouble: it must be financed by borrowing or selling assets, may put downward pressure on the exchange rate, can be a drain on aggregate demand, and may be unsustainable if confidence falls. A surplus, conversely, can reflect strong competitiveness but may also indicate weak domestic demand. The consequences therefore depend on the cause and on how the imbalance is financed.

Policies to correct a deficit

Expenditure-reducing policy works because lower domestic demand reduces spending on imports, improving the current account, but at the cost of slower growth and higher unemployment. Expenditure-switching through a depreciation makes exports cheaper and imports dearer, improving the balance if the Marshall-Lerner condition holds (and subject to the J-curve); protection (tariffs, quotas) switches spending to domestic goods but risks retaliation and forgoes the gains from trade. Supply-side policy, raising productivity, skills and innovation to improve competitiveness, is the most sustainable solution because it lets exports grow with the economy, but it acts slowly. The exam reward is matching the policy to the cause and weighing the trade-offs.

Examples in context

Example 1. The persistent UK current account deficit. The UK has run sustained current account deficits, reflecting a deficit in trade in goods (partly offset by a surplus in services such as finance) and swings in investment income. The deficit has been financed by capital inflows, illustrating how a current account deficit is mirrored by a financial account surplus. The debate over whether it is sustainable, and whether it reflects weak competitiveness, is a recurring exam context.

Example 2. Surpluses and the limits of switching policy. Large, persistent surpluses in some exporting economies show the other side of imbalance and the limits of policy: a country cannot easily force its trading partners to adjust, and a deficit country relying on a depreciation may find competitors devaluing too. This illustrates why current account imbalances are difficult to correct unilaterally and why supply-side competitiveness, rather than the exchange rate alone, is stressed as the durable solution.

Try this

Q1. Name the four components of the current account. [2 marks]

• Cue. Trade in goods, trade in services, primary income (investment income), and secondary income (current transfers).

Q2. Explain one expenditure-switching policy to reduce a current account deficit. [3 marks]

• Cue. A depreciation of the currency makes exports cheaper and imports dearer, switching spending towards domestic goods and improving the current account if the Marshall-Lerner condition holds; alternatively, protection switches spending to domestic goods but risks retaliation.