Cambridge A Level Economics: Balance of payments accounts and correcting policies (9708) – Revision Notes

These notes condense section 11.1 (outcomes 11.1.1 to 11.1.3) of the Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. Topics 7 to 11 are A Level content, so this unit is not examined at AS. For full explanations and longer worked examples, read the study guide. Then test yourself with the practice questions. Course pages: hub and checklist. Find weak spots with the free 10-minute diagnostics. All figures below are invented for illustration, in billions of currency units (bn cu).

11.1.1: the accounts at a glance

Account	Contents	Notes
Current account	Goods, services, primary income, secondary income	Largest and most watched
Capital account	Capital transfers (such as debt forgiveness), non-produced non-financial assets	Usually small
Financial account	Direct investment, portfolio investment, other investment, reserve assets	Shows how deficits are funded
Net errors and omissions	Balancing item	Corrects for measurement gaps

Identity. Current + capital + financial + net errors and omissions = 0. The convention here is that a financial account inflow, including a fall in reserves, is positive. Check the sign convention in any data.

Key definitions

• Direct investment: a lasting stake in a foreign business, for example a new plant. Stable and adds capacity.
• Portfolio investment: shares and bonds without control. More mobile.
• Hot money: short-term funds that move for interest rate or exchange rate gains.
• Reserve assets: foreign currency and gold held by the central bank.
• Disequilibrium: a persistent imbalance, especially on the current account, or one that cannot be financed sustainably.

Method: completing the accounts

1. Work out each current account line as credits minus debits.
2. Add the lines to get the current account balance. Keep the signs.
3. Add the capital account balance.
4. Total the financial account lines, using the stated convention.
5. Net errors and omissions = minus the sum of the other three.
6. Check the grand total is zero. Express a balance as a percentage of GDP if asked.

Quick reminder

Country L: goods −18, services +9, primary income −4, secondary income +2. Current account = −18 + 9 − 4 + 2 = −11. Capital account = +1. If errors are zero, the financial account must be +10, because −11 + 1 + 10 = 0.

11.1.2: policies and their routes

Policy	Route to the balance of payments	Main benefit	Main limit
Fiscal (contractionary)	Lower income, lower imports (mpm); lower inflation	Direct, fairly quick	Cuts growth and jobs; weak if mpm is low
Monetary (higher rate)	Lower demand and imports; hot money inflow	Improves financial account	Higher exchange rate hurts exports; hot money can leave
Supply-side	Higher productivity, quality; lower unit costs; attracts investment	Lasting, keeps output	Slow, costly, uncertain
Protectionist	Dearer imports, switch to home goods	Quick	Retaliation, higher prices, rule breaches
Exchange rate (lower rate)	Cheaper exports, dearer imports	Raises home demand	Needs elasticities high enough; J curve; imported inflation

Fiscal policy method

1. Multiplier = 1 ÷ (mps + mpt + mpm).
2. Change in income = change in spending × multiplier.
3. Change in imports = mpm × change in income.

Reminder: mps 0.10, mpt 0.20, mpm 0.20 give withdrawals of 0.50 and a multiplier of 2. A cut in spending of 9 lowers income by 18 and imports by 3.6.

Unit labour cost method

Unit labour cost index = (1 + wage growth) ÷ (1 + productivity growth).

Reminder: wages +5% and productivity +2% give 1.05 ÷ 1.02 = 1.029, a rise of 2.9%, which hurts competitiveness.

Tariff method

1. New price = old price × (1 + tariff rate).
2. Change in quantity % = PED × % price change.
3. Payment to foreign suppliers = new quantity × the original price (the tariff goes to the government).

Reminder: a good costs 50 and 100 units are bought. A 10% tariff gives a price of 55. With PED −2, quantity falls 20% to 80. Payments to foreign suppliers fall from 5,000 to 4,000.

Exchange rate method

1. Work out the home-currency price changes for exports and imports.
2. Apply the elasticities to volumes.
3. Compare the new export and import values.

Reminder: a 5% fall in the currency with export PED 1.0 and import PED 0.8. Exports 100 become 100 × 1.05 = 105. Imports 120 become 120 × 1.05 × 0.96 = 121.0. The deficit narrows from 20 to about 16.

Monetary policy chain

Higher interest rate, then hot money inflow, then higher demand for the currency, then a higher exchange rate, then dearer exports and cheaper imports. Set this against the fall in import spending from lower income. The financial account improves while the current account may not.

Supply-side chain

Better education, infrastructure and research, then higher productivity and quality, then lower unit costs and stronger non-price competitiveness, then more exports, fewer imports and more direct investment. Always add that the effect is slow and uncertain.

11.1.3: switching versus reducing

	Expenditure-reducing	Expenditure-switching
Idea	Cut total spending, including on imports	Move spending from imports to home goods
Examples	Contractionary fiscal policy, higher interest rates	Depreciation or devaluation, tariffs, quotas, subsidies
Output and jobs	Fall	Rise if spare capacity
Inflation	Falls	May rise
Suits	Deficit from excess demand	Deficit from weak competitiveness

Supply-side policy is neither neatly switching nor reducing. It raises capacity and competitiveness over time.

Must-know distinctions

• Balance of payments versus current account. The whole account balances. The current account is one part.
• Deficit versus debt. A deficit is measured over a period, while debt is the total owed at a point in time.
• Direct versus portfolio investment. One is a lasting stake, the other is more mobile.
• Revaluation, devaluation, appreciation, depreciation. Government changes under a fixed rate versus market moves under a floating rate. Section 11.2 deals with these.
• Tariff revenue versus outflow. Tariff revenue stays at home. Only the amount paid to foreign suppliers leaves.

Evaluation checklist

• Does the policy match the cause?
• How large and how elastic are the trade flows?
• How long will it take?
• What does it cost in growth, jobs and inflation?
• Who might retaliate or withdraw funds?
• Is the deficit a problem at all, given its size and funding?

Finish with a judgement that names a condition, such as “if the elasticities are high enough” or “if there is spare capacity”.

Quick self-test

1. Goods: credits 150, debits 172. Services: 64 and 50. Primary income: 20 and 26. Secondary income: 5 and 7. Calculate the current account balance.
2. Using question 1, the capital account is +3 and net errors and omissions are +1. Find the financial account balance.
3. State two components of the financial account.
4. mps 0.25, mpt 0.15, mpm 0.10. Government spending falls by 6. Find the fall in income and in imports.
5. Classify each policy as expenditure-switching or expenditure-reducing: a higher interest rate; a tariff; a devaluation; a cut in government spending.
6. Wages rise 5% and productivity rises 2%. Find the change in unit labour cost.
7. A good costs 50 and 100 units are bought. A 10% tariff is imposed and PED is −2. Find the new payment to foreign suppliers.
8. Why can a rise in interest rates worsen the current account while improving the financial account?
9. Why might a deficit funded by hot money be riskier than one funded by direct investment?
10. Give one reason why a depreciation might fail to improve the current account.

Answers

1. Goods −22, services +14, primary −6, secondary −2. Total = −16.
2. −16 + 3 + 1 + financial = 0, so financial account = +12.
3. Any two of: direct investment, portfolio investment, other investment, reserve assets.
4. Withdrawals = 0.5, so the multiplier is 2. Income falls 12. Imports fall 0.10 × 12 = 1.2.
5. Higher interest rate: reducing. Tariff: switching. Devaluation: switching. Cut in government spending: reducing.
6. 1.05 ÷ 1.02 = 1.029, so unit labour cost rises 2.9%.
7. Price 55, quantity 80, so the payment is 80 × 50 = 4,000, down from 5,000.
8. A higher rate attracts hot money, which raises the exchange rate and so makes exports dearer and imports cheaper. This can offset the fall in import spending from lower demand.
9. Hot money can leave quickly if rates or confidence change, forcing a sharp fall in the currency or reserves. Direct investment is long term and adds capacity.
10. Trade may be inelastic (the sum of the elasticities is too low), or the effect may come slowly because of the J curve, or imported inflation may erode the gain.

Where marks are usually lost

• Writing the financial account with the wrong sign, or leaving out the reserves line.
• Calling the current account “the balance of payments”.
• Treating tariff revenue as money paid abroad.
• Listing policies without linking each one to the cause of the deficit.
• Giving a tariff as an expenditure-reducing policy.
• Claiming depreciation always works, with no mention of elasticities or time.
• Missing the exchange rate effect of a rise in interest rates.
• Closing an evaluation by repeating points rather than giving a verdict that states its condition.

Official syllabus

Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028, section 11.1 (Cambridge University Press & Assessment).