AQA A-level Economics: The balance of payments and correcting imbalances (7136) – Revision Notes

These notes condense the AQA AS and A-level Economics specification (7135 and 7136), version 1.3, sub-section “The balance of payments” (4.2.6.3 in the combined PDF; 3.2.6.3 on the AQA website and this site’s map). The full explanations and longer worked examples are in the study guide; test yourself with the practice questions. See also the AQA A-level Economics hub, the checklist and the free diagnostics. All figures below are invented for illustration.

Definitions to know

Term	Meaning
Balance of payments	Record of transactions between residents and the rest of the world over a period
Current account	Goods, services, primary income, secondary income
Capital account	Small capital transfers and non-produced assets (such as rights to natural resources)
Financial account	Investment and lending flows, plus changes in reserves
Current account deficit	Payments out exceed earnings in on the current account
Current account surplus	Earnings in exceed payments out
Primary income	Net profits, interest, dividends and cross-border wages
Secondary income	One-way transfers: remittances, aid, subscriptions to international bodies
FDI	Investment giving lasting interest and control in a foreign business
Portfolio investment	Buying foreign shares or bonds without control
Expenditure-reducing	Policies that cut total demand, and so imports
Expenditure-switching	Policies that move spending from imports to domestic output

Memory line: the accounts always sum to zero (with errors and omissions), so a “deficit” means the current account.

Structure of the current account

Current account = goods balance
                + services balance
                + primary income balance
                + secondary income balance
Trade balance   = goods balance + services balance

Check the sign of each: exports and income received are credits; imports and income paid are debits. A deficit can arise even when the trade balance is positive if income paid abroad is large.

Worked reminder. Country C: goods 140 exports, 175 imports; services 88 and 61; primary income 30 received, 47 paid; secondary income 9 received, 21 paid. Balances: −35, +27, −17, −12. Current account = −37. Trade balance = −35 + 27 = −8.

Influences on the current account

Factor	Effect on the balance	Key evaluation
Higher productivity	Lowers unit costs, raises price competitiveness	Slow to build; wages may rise as fast
Higher relative inflation	Exports dearer, imports cheaper in comparison: worsens	Offset if the currency falls
Currency depreciation	Exports cheaper abroad, imports dearer at home	Needs elasticities summing to more than 1; time lags
Faster domestic growth	Imports rise with income	Cyclical, may reverse in a slowdown
Non-price competitiveness	Quality and design hold demand at higher prices	Hard to measure

Unit labour cost = wage per hour ÷ output per hour. Country D pays 15 per hour for 5 units: 3.00. Wages rise 4% and output per hour 8%: 15 × 1.04 ÷ (5 × 1.08) = 2.889, a fall of 3.7%.

Relative inflation. Home 3%, partners 5%: 1.03 ÷ 1.05 − 1 = −1.9%. Home goods become relatively cheaper, which supports the current account.

Exchange rate arithmetic. A fall from 0.80 to 0.72 foreign units per home unit is a 10% depreciation (0.72 ÷ 0.80 − 1). The other way round, a foreign good that cost 1 / 0.80 = 1.25 home units now costs 1 / 0.72 = 1.39: a rise of 11.1%.

Marshall-Lerner and the J-curve. Depreciation improves the balance if the export and import price elasticities of demand, added together, come to more than 1. In the short run both are low, so the balance may worsen before improving. (The specification does not name these, but they support evaluation.)

Worked reminder: depreciation. Exports 200, imports 260 (balance −60). Currency falls 5%; export elasticity 1.0, import elasticity 0.6, sum 1.6. Export volume +5%: 200 × 1.05 = 210. Import prices +5% and volume −3%: 260 × 1.05 × 0.97 = 264.81. New balance = 210 − 264.81 = −54.81, an improvement of 5.19. State the assumptions: full pass-through to import prices, home-currency export prices unchanged, supply able to meet extra demand.

Cyclical or structural? A deficit that appears in a boom and shrinks in a slowdown is cyclical, so waiting may be enough. A deficit that persists through the cycle points to weak competitiveness and needs supply-side action.

Investment flows

	FDI	Portfolio
Control	Yes	No
Time horizon	Long	Short, easily reversed
Benefits	Capital, technology, jobs, skills	Funds domestic firms and government
Risks	Profits flow out later; foreign control	Sudden outflow, currency falls, interest rates rise

Share example: a country receives 30 of FDI and 10 of portfolio inflows: FDI is 30 ÷ 40 = 75%. A higher FDI share usually means a more stable way of financing a deficit.

Policies: method in steps

Choosing and judging a policy

1. Name the policy and say whether it reduces or switches expenditure.
2. Give the mechanism in steps (for example: higher tax, lower disposable income, lower consumption, fewer imports).
3. Quantify if data allow (multiplier, import share).
4. Say which other objectives are hit.
5. Judge using size, speed, elasticities, retaliation and the cause of the imbalance.

Multiplier reminder. Multiplier = 1 ÷ (marginal propensity to save + marginal rate of tax + marginal propensity to import). With 0.1, 0.1 and 0.3 the multiplier is 2. A spending cut of 25 lowers income by 50 and imports by 0.3 × 50 = 15.

Type	Examples	Strength	Weakness
Expenditure-reducing	Tax rises, spending cuts, higher interest rates	Does not rely on elasticities	Costs output and jobs
Expenditure-switching	Depreciation, tariffs, quotas, export subsidies	Keeps demand up	Elasticities, retaliation, inflation
Supply-side	Training, infrastructure, innovation	Tackles root cause	Slow, uncertain

For a surplus, the reverse: expand demand, let the currency rise, open the market to imports.

Significance and global implications

• Larger deficits matter more when persistent, financed by short-term capital, caused by uncompetitiveness, and when the country cannot borrow in its own currency.
• A deficit may be benign when it finances investment that raises future output.
• A surplus may signal strength or weak domestic demand; it can fuel currency tension and inflation.
• Global: if a major deficit economy cuts demand and surplus economies do not expand, world demand falls (a contractionary bias). Large currency moves can start retaliation. Capital flows may reverse and shift interest rates worldwide.
• Shared adjustment (surplus countries expanding demand) lowers the cost.

Must-know distinctions

• Current account against balance of payments as a whole.
• Trade balance against current account.
• Primary against secondary income: payment for a factor of production against a transfer.
• FDI against portfolio.
• Reducing against switching.
• Cyclical against structural imbalance.

Quick self-test

1. Name the four parts of the current account.
2. Country E has goods −22, services +30, primary income −9, secondary income −6. Find the current account balance.
3. A deficit of 27 occurs in an economy with GDP of 600. Express it as a percentage of GDP.
4. Wages per hour are 15 and output per hour is 5. Wages rise 4% and output per hour 8%. Find the percentage change in unit labour cost.
5. Home inflation is 3% and partner inflation 5%. Find the change in relative prices.
6. State one difference between FDI and portfolio investment.
7. A spending cut of 25 with multiplier 2 and marginal propensity to import 0.3: find the fall in imports.
8. A currency moves from 0.80 to 0.72 foreign units. State the percentage depreciation.
9. Give one expenditure-switching and one expenditure-reducing policy.
10. Why might depreciation fail to improve the current account?

Answers

1. Goods, services, primary income, secondary income.
2. −22 + 30 − 9 − 6 = −7 (a deficit).
3. 27 ÷ 600 = 4.5%.
4. 15 × 1.04 ÷ (5 × 1.08) = 2.889 against 3.00, so −3.7%.
5. 1.03 ÷ 1.05 − 1 = −1.9% (home goods relatively cheaper).
6. FDI gives control and lasting interest; portfolio gives no control and is easily reversed.
7. Income falls 25 × 2 = 50; imports fall 0.3 × 50 = 15.
8. 0.72 ÷ 0.80 − 1 = −10%.
9. Switching: tariff, quota or depreciation. Reducing: higher income tax or lower government spending.
10. The sum of the price elasticities of demand for exports and imports may be below 1, or lags (J-curve) delay the gain; domestic inflation may also erode the advantage.

Where marks are usually lost

• Writing “deficit” without saying which account.
• Putting the sign of a debit the wrong way round, so a deficit becomes a surplus.
• Quoting a percentage of GDP without showing the division.
• Saying a weaker currency “makes exports cheaper” without linking it to elasticity and the current account.
• Treating FDI and portfolio investment as the same thing.
• Describing a policy without the step-by-step mechanism.
• Ignoring side effects on growth, unemployment and inflation when asked about other objectives.
• Concluding that every deficit is bad, with no judgement of size, cause or financing.
• Describing global effects only for the home country.

Official syllabus

AQA AS and A-level Economics (7135 and 7136), for first teaching from September 2015, version 1.3, 29 June 2022, published by AQA.