Cambridge O Level Economics: Current account of the balance of payments (2281)

This guide covers all four outcomes in section 6.4 of the Cambridge O Level Economics 2281 syllabus for examination in 2026, which is available in the June and November series. It is not tiered. Every country, firm and figure below is invented for illustration and is not a real statistic. Money is in millions of an imaginary currency, the zel, unless stated. The syllabus lists calculation of deficits and surpluses on the current account and its component sections, so the sums matter as much as the theory. The syllabus says calculators may be used in the examination.

What this unit covers

Outcome	Skill required
6.4.1 structure	Name the four components, calculate each balance and the overall current account balance
6.4.2 causes	Give reasons for deficits and for surpluses
6.4.3 consequences	Explain what a deficit or surplus does to GDP, jobs, prices and the value of the currency
6.4.4 policies	Describe the available policies for a stable external position and judge their likely success

Related pages: revision notes, practice set, wider international trade practice, the Cambridge O Level Economics hub, the checklist and the free diagnostics.

6.4.1 Structure and balances

The current account is a yearly record of money moving in and out of a country, covering things bought and sold, income, and gifts. A flow in is a credit. A flow out is a debit. Each component has a balance: money in minus money out.

Component	Inflows (credits)	Outflows (debits)
Trade in goods	Exports of physical goods	Imports of physical goods
Trade in services	Foreign tourists, shipping and banking sold abroad	Citizens’ holidays abroad, foreign consultancy bought
Primary income	Wages, interest, profit and dividends earned abroad	Wages, interest, profit and dividends paid abroad
Secondary income	Gifts, remittances and aid received	Gifts, remittances and aid sent

Add the four component balances to get the overall balance: goods, then services, then primary income, then secondary income.

A positive total is a surplus. A negative total is a deficit. The balance on goods and services together is often called the trade balance.

Worked example 1: a deficit

Country K, one illustrative year, millions of zel:

Component	Money in	Money out	Balance
Goods	420	510	-90
Services	160	118	+42
Primary income	74	96	-22
Secondary income	52	38	+14

Goods and services together: -90 + 42 = -48. Current account balance: -90 + 42 - 22 + 14 = -56 million zel, a deficit. Country K’s GDP is 2,800 million zel. As a share of GDP the deficit is 56 ÷ 2,800 × 100 = 2.0%.

Country K sells services at a surplus, but the goods deficit is far larger. Do not judge the account from one line.

Worked example 2: a surplus

Country M, illustrative: goods exports 650 and imports 540; services exports 90 and imports 130; primary income received 45 and paid 31; secondary income received 20 and sent 36.

Balances: goods +110, services -40, primary income +14, secondary income -16. Total: 110 - 40 + 14 - 16 = +68, a surplus. GDP is 1,700, so the surplus is 68 ÷ 1,700 × 100 = 4.0% of GDP.

Worked example 3: finding a missing component

Country N has a current account deficit of 35. Its goods balance is -81, services +29 and secondary income +12. Known balances add to -81 + 29 + 12 = -40. The primary income balance is -35 - (-40) = +5.

6.4.2 Why deficits and surpluses arise

A deficit means the country buys more from the world, and pays more to it, than it earns. Possible reasons:

• Prices of its goods are high compared with rivals, so exports fall and imports rise.
• Its goods are lower quality or the country lacks the capacity to make what buyers want.
• Strong growth in incomes, so households and firms buy more imports.
• A high exchange rate that makes exports dear abroad and imports cheap.
• Exports concentrated in a few primary products whose world prices fall.
• Large profits and interest paid to foreign owners and lenders (primary income outflow).
• Large gifts, aid or remittances sent abroad (secondary income outflow).
• A recession among its main trading partners, which cuts their spending on its exports.

A surplus is the opposite pattern: goods that sell well abroad, a low exchange rate, high saving and low spending on imports, valuable raw material exports, large overseas assets earning income, or large remittances received.

Worked example 4: competitiveness

Country K’s cloth exporters raise their prices by 9% in a year. Their main rival raises prices by 4%. With a fixed exchange rate, relative price = 1.09 ÷ 1.04 = 1.048, so K’s cloth is about 4.8% dearer than before relative to the rival. Some foreign buyers switch to the rival. Exports fall and the goods balance worsens.

6.4.3 Consequences of deficits and surpluses

Impact on GDP and employment

Net exports (exports minus imports) are part of total demand. A growing deficit means demand leaks abroad. Chain for a deficit: imports exceed exports, net exports fall, total demand for home output falls, GDP is lower than it would be, firms cut output, and employment falls, especially in industries that compete with imports. A surplus does the opposite: more demand for home output, higher GDP, more jobs in export industries.

A deficit is not automatically bad. If the imports are machines that raise future output, the economy may grow faster later. A deficit caused by weak competitiveness is more worrying.

Impact on inflation

A surplus adds to demand, which may pull prices up if the economy is near full capacity (demand-pull inflation). A deficit lowers demand, so it may reduce price pressure. A different link runs through the exchange rate, shown below.

Impact on the foreign exchange rate

Under a floating rate, a deficit means more of the home currency is supplied (to buy foreign currency for imports) than demanded (by foreigners buying exports). The currency tends to fall. A surplus tends to raise it.

Under a fixed rate, the central bank must hold the rate steady by selling foreign reserves. Reserves are limited.

Worked example 5: how long can reserves last?

Country T runs a deficit of 40 a year and holds reserves of 130. If reserves cover the whole gap, they last 130 ÷ 40 = 3.25 years. After that the country must borrow, sell assets, or let the currency fall.

Worked example 6: exchange rate, PED and the goods balance

Country K’s currency falls from 1 zel = 2.00 marn to 1 zel = 1.60 marn (the marn is Country F’s currency). That is a 20% fall.

• Exports. A jacket priced at 100 zel costs foreign buyers 200 marn before and 160 marn after, a 20% price cut. If price elasticity of demand (PED) for K’s exports is 1.5, quantity demanded rises by 1.5 × 20 = 30%. Export revenue in zel rises 30%, because the zel price is unchanged. Goods exports: 420 × 1.30 = 546.
• Imports. A foreign machine priced at 400 marn costs 400 ÷ 2.00 = 200 zel before and 400 ÷ 1.60 = 250 zel after, a 25% rise. Suppose import demand has a PED of 0.4. Quantity then falls 0.4 × 25 = 10%. Spending in zel: 1.25 × 0.90 = 1.125, so imports go from 510 to 573.75.
• Outcome. Goods balance moves from 420 - 510 = -90 to 546 - 573.75 = -27.75. The deficit narrows. Because import demand is inelastic, spending on imports actually rises, so the improvement comes mainly from exports.

If both PED values were very low, the deficit could widen. The effect depends on PED, and buyers often take time to change habits.

Inflation again: imported costs

Suppose a bakery in K spends 35% of its costs on imported flour. A 25% rise in the zel price of imports raises its costs by 35% × 25% = 8.75%. Firms may raise prices, so a falling currency can cause cost-push inflation. A deficit can therefore lead to a lower exchange rate and then to higher prices.

6.4.4 Policies for balance of payments stability

“Stability” covers both extremes. Deficits are the usual concern, but a large persistent surplus can also be a problem for partner countries and may be reduced, for example by allowing the currency to rise or by lowering import barriers.

Policy	How it works	Main weakness
Higher taxes or lower government spending (deflationary fiscal policy)	Lower incomes reduce spending on imports	Slower growth, higher unemployment
Higher interest rates (monetary policy)	Less borrowing and spending; may attract foreign savings and raise the currency	Raises firms’ costs; a higher currency makes exports dearer
Tariffs, quotas	Raise the price of imports or limit their quantity	Retaliation; higher prices for consumers
Subsidies to exporters or import-competing firms	Cut costs so goods sell more abroad or at home	Costs the government; other countries may object
Lower exchange rate (devaluation under a fixed system, or encouraging a fall under a floating system)	Exports cheaper abroad, imports dearer	Depends on PED; raises import costs
Supply-side policies (training, infrastructure, research, investment)	Raise productivity and quality, so goods compete better	Slow; results uncertain

Worked example 7: a tariff

Country N imports 1,000 appliances a month at 80 zel each. It adds a 25% tariff. The price paid by buyers is 80 × 1.25 = 100 zel. If PED for these imports is 0.6, quantity falls 0.6 × 25 = 15%, to 850.

Payments to foreign sellers: before 1,000 × 80 = 80,000. After 850 × 80 = 68,000. Saving: 12,000 zel. The tariff itself goes to the government: 850 × 20 = 17,000 zel. Because demand is inelastic, the tariff reduces the quantity by only a modest amount, so the effect on the account is small. It also raises prices for consumers and invites retaliation.

Worked example 8: deflationary policy

A government cuts total spending by 60 million zel. If 20% of spending is on imports, imports fall by 60 × 0.20 = 12 million zel. The side effects can be larger than the gain: output and jobs also fall, which links to the syllabus conflicts between economic growth and balance of payments stability, and between full employment and balance of payments stability.

How effective might a policy be?

Judge a policy using these questions:

1. Cause. A policy that fits the cause works best. A deficit from high prices needs better competitiveness. A deficit from falling world prices of a single export needs diversification, not a tariff.
2. PED. Exchange rate and tariff changes depend on PED.
3. Time. Supply-side policies take years. Deflation can work faster but harms growth.
4. Size. A small deficit may not need action.
5. Other countries. Tariffs invite retaliation. Trading partners may be hurt by their own deficits.
6. Side effects. Inflation, unemployment and slower growth.

An evaluative answer reaches a judgement, such as: “Supply-side policy is most effective over the long run because it tackles the cause, but it is slow, so a country with a large deficit may need a short-run measure alongside it.”

Common errors

• Counting remittances as trade in services. They are secondary income.
• Treating a tariff as an import payment. The government receives it, not the foreign seller.
• Forgetting primary income, such as profit sent home by a foreign-owned firm.
• Assuming a falling currency always cures a deficit. The outcome turns on the PED values.
• Calling a deficit “bad” without checking its cause.
• Giving the balance as a positive number when imports exceed exports.

Official syllabus

The source is the Cambridge O Level Economics 2281 syllabus for 2026 (version 2), published by Cambridge International. This guide covers section 6.4.