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

This guide follows 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). It covers the accounts, the current account in detail, causes of imbalances, investment flows, correction policies, their side effects and the global implications. Every country, firm and figure is invented for illustration. The specification states no AS-only or A-level-only labels for this content.

Use it with the revision notes and the practice questions. The AQA A-level Economics hub and checklist show the wider course, and the free diagnostics test where to start. For the tools behind the policy sections, see aggregate demand and supply and conflicts between macroeconomic objectives.

What the specification asks for

Specification point	What you must be able to do
The three accounts	Distinguish what each one records, and see how they connect
Current account structure	Detailed knowledge: goods, services, primary income, secondary income
Deficit and surplus	Define and calculate them
Influences on the balance	Productivity, inflation, exchange rate and other factors
Investment flows	Consequences of flows; FDI against portfolio investment
Correction policies	Expenditure-switching and expenditure-reducing
Effects on other objectives	Side effects of correction
Significance and global implications	Judge how much a deficit or surplus matters, and what happens when a major economy corrects

The specification asks for detailed knowledge of the current account only and a general appreciation of the other accounts, so spend your time accordingly.

1. The three accounts

The balance of payments records all transactions between residents of one country and the rest of the world over a period.

• Current account: trade in goods and services, plus income flows.
• Capital account: small items such as capital transfers (debt forgiveness, for example) and the buying or selling of non-produced assets such as rights to natural resources.
• Financial account: flows of investment and lending: foreign direct investment, portfolio investment, bank loans and deposits, and changes in official reserves.

Because every transaction has two sides, the accounts together, including a small errors and omissions item, sum to zero. In the accounting sense the whole balance of payments cannot be in deficit. A reference to a “deficit” nearly always means the current account alone.

2. The current account in detail

Component	What it records	Examples
Trade in goods	Exports minus imports of physical goods	Machinery, food, fuel
Trade in services	Exports minus imports of services	Tourism, banking, transport, insurance
Primary income	Earnings from assets and labour abroad, less payments to foreign owners	Profits, dividends and interest on foreign assets; wages of cross-border workers
Secondary income	One-way transfers where nothing is supplied in exchange	Workers’ remittances, overseas aid, payments to international bodies

Current account balance = goods balance + services balance + primary income balance + secondary income balance. A negative total is a deficit (more is paid out than is earned); a positive total is a surplus.

Worked example 1. Country A has the following figures (invented, cu bn, a year labelled illustrative). GDP is 1,540.

Item	Credits (earned)	Debits (paid)	Balance
Goods	420	510	−90
Services	260	190	+70
Primary income	85	110	−25
Secondary income	20	52	−32

Current account = −90 + 70 − 25 − 32 = −77. The trade balance (goods plus services) is only −20, so most of the deficit comes from income flows. As a share of GDP: 77 ÷ 1,540 = 5.0%.

Suppose the capital account shows +3 and errors and omissions +2. For the identity to hold, the financial account must show a net inflow of 72, since −77 + 3 + 72 + 2 = 0. (Presentations vary; here a positive figure means net funds flowing in.) The deficit is financed by foreigners buying Country A’s assets or lending to it.

3. What influences the current account balance

Productivity and costs. Unit labour cost = labour cost per hour ÷ output per hour.

Worked example 2. Country A pays 24 per hour and produces 12 units per hour, so unit labour cost is 2.00. Country B pays 30 and produces 20 units per hour: 1.50. Next year A’s wages rise 5% and productivity 10%: 24 × 1.05 ÷ (12 × 1.10) = 1.909, a fall of 4.5%. B’s wages rise 3% and productivity 2%: 1.515, a rise of 1.0%. A’s cost gap narrows, which supports exports and import substitution over time, although A remains the dearer producer.

Inflation. What matters is inflation relative to trading partners.

Worked example 3. A’s prices rise 6% and its partners’ 2%, with the exchange rate unchanged. A’s goods become 1.06 ÷ 1.02 − 1 = 3.9% dearer relative to rivals. To restore the old price relationship, A’s currency would have to fall by 1 − 1.02 ÷ 1.06 = 3.8% (say from 0.500 to 0.481 of a B-unit).

The exchange rate. A fall (depreciation) lowers export prices abroad and raises import prices at home.

Worked example 4. The rate moves from 2.00 to 2.50 A-units per B-unit. An export priced at 600 A-units costs 300 B-units before and 240 after (−20%). An import priced at 40 B-units costs 80 A-units before and 100 after (+25%). Notice that A’s currency has lost 20% of its value in B-units (0.50 to 0.40), yet import prices rise 25%.

Elasticities and time. A depreciation improves the current account only if demand is responsive enough: the export and import price elasticities of demand must together exceed 1 (the Marshall-Lerner condition; the specification does not name it, but it is a standard evaluation tool).

Worked example 5. In Country D, exports are 400 and imports 500 (balance −100). The currency falls and import prices rise 10%; export prices abroad fall 10%. Assume export prices at home are unchanged.

• Elastic case: export elasticity 1.2, import elasticity 0.8 (sum 2.0). Export volume +12%: 400 × 1.12 = 448. Import volume −8%: 500 × 1.10 × 0.92 = 506. Balance = −58, an improvement of 42.
• Inelastic case: export elasticity 0.3, import elasticity 0.2 (sum 0.5). Exports 400 × 1.03 = 412; imports 500 × 1.10 × 0.98 = 539. Balance = −127, a worsening of 27.

Elasticities are low in the short run, so the balance may worsen first and improve later (the J-curve pattern).

Other influences: relative growth in incomes (fast domestic growth pulls in imports), non-price competitiveness (quality, design, reliability), commodity prices and protectionism abroad.

4. Investment flows

	Foreign direct investment (FDI)	Portfolio investment
What	Lasting interest and control: building a factory, buying a controlling stake	Buying shares or bonds without control
Motive	Long-term production, market access, lower costs	Return, diversification
Stability	Hard to reverse quickly	Liquid; can leave fast (“hot money”)

Consequences of inflows: they finance a current account deficit; FDI can bring capital, technology and jobs; the currency may appreciate, hurting competitiveness. Later costs: profits and dividends flow out as primary income debits, widening the deficit; portfolio inflows can reverse suddenly, forcing the currency down and interest rates up. Outflows do the opposite and build overseas assets that earn income later.

5. Policies to correct an imbalance

Expenditure-reducing policies cut total demand so that fewer imports are bought: raising taxes, trimming public spending or lifting interest rates.

Worked example 6. In Country A, of each extra unit of income 0.1 is saved, 0.2 is taxed and 0.2 goes on imports. Multiplier = 1 ÷ (0.1 + 0.2 + 0.2) = 2. Government spending is cut by 30. Income falls 30 × 2 = 60. Imports fall 0.2 × 60 = 12. A 60 fall in output buys only a 12 improvement in the deficit of 77: the policy is blunt and costly.

Expenditure-switching policies move demand from imports to home output: depreciation or devaluation (for example via lower interest rates), tariffs, quotas and export subsidies, or measures that raise competitiveness. They work without cutting total demand, but they depend on elasticities, invite retaliation and may breach trade rules.

Supply-side policies (education, infrastructure, innovation incentives) raise productivity and non-price competitiveness. They address structural causes but act slowly.

Correcting a surplus reverses these: expand demand, allow the currency to rise, and reduce barriers to imports. A surplus country faces less pressure to adjust.

6. Effects on other objectives

Policy	Current account	Growth	Unemployment	Inflation
Spending cuts or tax rises	Improves through lower imports	Falls	Rises	Falls
Depreciation	Improves if elasticities are high enough	AD rises, so growth up	Falls	Rises (dearer imports, demand pull)
Tariffs and quotas	Improves, but partners may retaliate	Mixed	Protects some jobs	Rises (dearer goods)
Supply-side policies	Improves slowly	Rises	Falls	Eases

Chain for evaluation: depreciation raises import prices, firms using imported inputs face higher costs, workers seek higher wages, and the competitiveness gain fades. Chain for reducing policies: lower spending cuts income, firms lay off workers, unemployment rises and the government gains less tax, which may worsen its budget.

7. How much does an imbalance matter?

A deficit matters more when it is large relative to GDP (Country A’s 5.0% would draw attention, though no fixed line separates safe from risky), persistent, financed by volatile portfolio flows or borrowing rather than FDI, and caused by weak competitiveness rather than an investment boom. Persistent deficits build foreign liabilities and future income outflows. A deficit may be harmless, even healthy, if it comes from imports of capital goods that raise future output, or if the country can borrow in its own currency.

A surplus can reflect strong competitiveness but also weak domestic demand and low living standards. It can build reserves yet cause currency appreciation, inflation and tension with trading partners. Judge by size, cause, financing, time frame and the exchange rate system.

8. The global picture

Every deficit has a matching surplus somewhere. If a major deficit economy corrects by cutting demand while surplus economies do nothing, world demand falls.

Worked example 7. Country A’s spending cut (example 6) lowers its imports from Country S by 12. S saves 0.15, pays 0.2 in tax and spends 0.25 on imports out of each extra unit of income, so its multiplier is 1 ÷ 0.6 = 1.67. S’s income falls 12 × 1.67 = 20. Total income lost across the two: 60 + 20 = 80, for a 12 improvement in A’s balance. If S instead expanded demand, adjustment would be shared. Other effects: depreciation by a large economy pushes partners’ currencies up and invites retaliation; capital flows may reverse; interest rate changes spread worldwide.

Common errors

• Calling the whole balance of payments in deficit; it always sums to zero.
• Counting a deficit on goods as the whole current account.
• Treating a falling currency as automatically improving the balance.
• Describing FDI as “just money moving”; it brings control and production.
• Forgetting that expenditure-reducing policies hurt growth and employment.
• Giving evaluation without judging size, cause or financing.

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.