Cambridge International AS and A Level Economics: Balance of payments accounts and correcting policies (9708)

This guide covers section 11.1 (Policies to correct disequilibrium in the balance of payments), 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 1 to 6 are AS Level content and topics 7 to 11 are A Level content, so this unit is A Level only. The AS content, including the current account, is assumed knowledge. All countries and figures below are made up as illustrations and are not real statistics. Money is in billions of krona units (bn ku) unless stated.

Use the Cambridge A Level Economics hub and the printable checklist to track progress. Next, use the revision notes and the practice questions. Related pages: the AS current account guide, floating exchange rates, protectionism and the multiplier. To find weak spots first, take a free 10-minute diagnostic.

What this guide covers

Outcome	What you must be able to do
11.1.1	Describe the components of the balance of payments accounts: current account, financial account and capital account
11.1.2	Explain the effect of fiscal, monetary, supply-side, protectionist and exchange rate policies on the balance of payments
11.1.3	Distinguish expenditure-switching from expenditure-reducing policies

11.1.1: the three accounts

The balance of payments is a record of all the dealings that a country’s residents have with foreign residents during a given period. Money flowing in is a credit (+). Money flowing out is a debit (−).

Account	What it records
Current account	Trade in goods, trade in services, primary income (wages, interest, profit and dividends) and secondary income (transfers such as aid and remittances)
Capital account	Capital transfers, such as forgiveness of a debt, and the purchase or sale of non-produced, non-financial assets such as land-use rights. It is usually small
Financial account	Cross-border ownership of financial and real assets: direct investment, portfolio investment, other investment (such as bank deposits and loans) and reserve assets

Direct investment is a lasting stake in a foreign firm, for example by setting up a plant or buying a majority holding. Portfolio investment is the purchase of shares or bonds without control. It is more mobile, and short-term flows driven by interest rate differences are called “hot money”. Reserve assets are the foreign currency and gold the central bank holds.

This guide counts a financial account inflow as positive, meaning foreigners acquiring claims on the country, or the country drawing down its reserves. Presentations differ on the sign, so check the convention in any data you meet.

Every transaction has two sides, so the whole balance of payments sums to zero:

current account + capital account + financial account + net errors and omissions = 0

Net errors and omissions is the balancing item for measurement mistakes. A current account deficit is therefore matched by net inflows on the other accounts. In accounting terms the balance of payments always balances. Disequilibrium means a persistent imbalance on one account, especially the current account, or a position that cannot be financed sustainably.

Worked example 1: reading a full account

Country K, one illustrative year, bn ku:

Item	Credits	Debits	Balance
Goods	210	241	−31
Services	95	83	+12
Primary income	30	37	−7
Secondary income	14	11	+3

Current account balance = −31 + 12 − 7 + 3 = −23. The capital account is +4 − 2 = +2. The financial account shows net inflows: direct investment +9, portfolio investment +7, other investment +3 and reserves drawn down +3, a total of +22.

Net errors and omissions = −(−23 + 2 + 22) = −1. Check: −23 + 2 + 22 − 1 = 0.

GDP is 640, so the deficit is 23 ÷ 640 × 100 = 3.6% of GDP.

Interpretation matters more than arithmetic. Direct investment funds 9 of the 22, and it tends to be stable and adds to capacity. Portfolio investment of 7 can reverse quickly. Reserves supply 3, and reserves are finite. A deficit funded by long-term investment is easier to sustain than one funded by hot money or reserves.

11.1.2: policies and their effect

Each policy works through a different route. Note which account it hits first and what it does to the others.

Fiscal policy

Tight fiscal policy, meaning less government spending or higher taxes, cuts aggregate demand and national income. Lower income reduces imports, through the marginal propensity to import (mpm). It can also lower inflation, which improves price competitiveness over time.

Worked example 2. Country K has a marginal propensity to save of 0.10, to be taxed of 0.20 and to import of 0.25. The government cuts spending by 10.

• Withdrawals: 0.10 + 0.20 + 0.25 = 0.55
• Multiplier = 1 ÷ 0.55 = 1.82
• Fall in income = 10 × 1.82 = 18.2
• Fall in imports = 0.25 × 18.2 = 4.5

Imports fall by 4.5, about a fifth of the 23 deficit. Yet output falls 18.2, so each unit of improvement costs about 4 units of output (18.2 ÷ 4.5). The policy is blunt: it lowers spending on home goods as well as on imports.

Monetary policy

Higher interest rates reduce borrowing and consumption, so income and imports fall. They also attract hot money, which improves the financial account. But the extra demand for the currency raises the exchange rate, which makes exports dearer and imports cheaper, working against the current account.

Worked example 3. A rise in the interest rate lifts Country K’s exchange rate by 4%. Export prices abroad rise 4%. Price elasticity of demand (PED) of exports is 1.2 and of imports is 0.9. Goods exports are 210 and goods imports are 241.

• Export volume falls 1.2 × 4 = 4.8%, so exports = 210 × 0.952 = 199.9
• Import prices at home fall 4% and volume rises 0.9 × 4 = 3.6%, so imports = 241 × 0.96 × 1.036 = 239.7
• New goods balance = 199.9 − 239.7 = −39.8, against −31 before

The goods balance worsens by 8.8. The higher rate also cuts income, which lowers imports, so the net effect on the current account depends on which force is larger. The financial account gains meanwhile. Monetary tightening can improve the overall position while worsening the current account.

Supply-side policy

Education, training, infrastructure, research and competition policy raise productivity and quality. Unit labour cost (wage cost per unit of output) falls when productivity grows faster than wages.

Worked example 4. Wages rise 4% and output per worker rises 6.5%. Unit labour cost changes by 1.04 ÷ 1.065 = 0.977, a fall of 2.3%. If firms pass this on fully and export PED is 1.4, export volume rises about 1.4 × 2.3 = 3.2%. Export value is 210 × 0.977 × 1.032 = about 211.7, a gain of under 2.

The gain is small because export demand is only moderately elastic and prices fell. The benefit comes mainly from better quality and a stronger base, which can also attract direct investment. The effect is slow and uncertain, but it keeps output and jobs.

Protectionist policy

Tariffs, quotas, subsidies to home producers and administrative barriers aim to cut import spending.

Worked example 5. Country K imports 120 units of a good at 25 ku each, so it pays foreign suppliers 3,000 ku. A 15% tariff lifts the buyer’s price to 28.75 ku. PED is −1.6.

• Quantity falls 1.6 × 15 = 24%, to 91.2 units
• Payments to foreign suppliers = 91.2 × 25 = 2,280, a fall of 720
• Tariff revenue = 91.2 × 3.75 = 342 (this stays at home)

The more elastic the demand, the larger the fall in the outflow. Risks include retaliation, higher prices for consumers and firms using imported inputs, and a breach of trade agreements. Protection treats a symptom: it does not remove the cause of weak competitiveness.

Exchange rate policy

A lower exchange rate (a depreciation under a floating rate, or a devaluation of a fixed rate) makes exports cheaper abroad and imports dearer at home. Whether the current account improves depends on how responsive trade is, the Marshall-Lerner condition covered in section 11.2. The effect also builds slowly (the J curve). Here the aim is to see the link to the balance of payments.

Worked example 6. The currency falls 10%. Exports are 200 and imports are 240, with home-currency export prices unchanged and import prices up 10%.

• If export PED is 0.7 and import PED is 0.6 (sum 1.3): exports = 200 × 1.07 = 214; imports = 240 × 1.10 × 0.94 = 248.2. Balance = −34.2, up from −40.
• If export PED is 0.3 and import PED is 0.4 (sum 0.7): exports = 206; imports = 240 × 1.10 × 0.96 = 253.4. Balance = −47.4, worse.

Depreciation also raises import prices, which can add to inflation, and it makes foreign debts dearer to repay in home currency.

11.1.3: expenditure-switching and expenditure-reducing

Expenditure-reducing policies cut total spending in the economy, so import spending falls along with everything else. Examples: contractionary fiscal policy and higher interest rates.

Expenditure-switching policies change relative prices so that spending moves from foreign goods to home goods, without cutting total spending. Examples: depreciation or devaluation, tariffs, quotas and subsidies.

Supply-side policy fits neither neatly. It aims to raise capacity and competitiveness, which makes home goods more attractive over time.

Feature	Expenditure-reducing	Expenditure-switching
Effect on aggregate demand	Falls	Home demand rises as spending switches
Effect on output and jobs	Falls	Rises if there is spare capacity
Effect on inflation	Falls	May rise (dearer imports, extra demand)
Main risk	Recession, unemployment	Retaliation, inflation, elasticity too low
Speed	Within a year or two	Depends on elasticities and time lags

Expenditure-reducing policy suits a deficit caused by excess demand and inflation. Expenditure-switching policy suits a deficit caused by weak competitiveness, but it needs spare capacity so that home firms can supply the extra demand. Without it, the extra demand just raises prices.

Evaluating policy choices

A judgement needs a condition. Weigh:

• The cause. Excess demand, weak competitiveness and a fall in a commodity price need different answers.
• The size and funding of the deficit. A small deficit funded by long-term investment may need no policy.
• Elasticities and the mpm. These decide how much any policy achieves.
• Time. Supply-side effects take years. A devaluation works slowly at first.
• Costs to other objectives. Growth, jobs and inflation can all worsen.
• Reactions. Partners may retaliate, and investors may move funds.
• Exchange rate regime. Under a fixed rate the government cannot let the currency adjust itself.

A strong answer picks a policy, explains the chain, names the main risk and states when the policy would succeed.

Common errors

• Writing “the balance of payments is in deficit” when you mean the current account. Overall the accounts sum to zero.
• Putting a reserves drawdown on the wrong side, or forgetting the sign convention.
• Treating a tariff as expenditure-reducing. It switches spending towards home goods.
• Saying depreciation always improves the current account without referring to elasticities.
• Ignoring the financial account effect of a higher interest rate.
• Naming policies without a link to the cause of the deficit.

Official syllabus

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