Pearson Edexcel International Advanced Level Economics: Balance of payments and competitiveness (YEC11)

This guide teaches statements 1 and 3 of 4.3.3 Balance of payments, exchange rates and international competitiveness in the Pearson Edexcel International Advanced Subsidiary/Advanced Level Economics specification (Issue 2, June 2018). The specification lists Units 1 and 2 as International AS (IAS) units and Units 3 and 4 as the extra International A2 (IA2) content. This is Unit 4, Developments in the global economy, so it belongs to the full International Advanced Level only, not IAS. Every country, firm and figure below is invented and illustrative.

Related pages: the revision notes, the practice questions, the course hub, the printable checklist and a free diagnostic. For background see macroeconomic objectives and conflicts and supply-side policies. Statement 2 (exchange rates and their effects) is taught separately and is not repeated here.

What the specification asks for

Ref	You must be able to
4.3.3 (1a)	Explain the components: the current account, and the capital and financial accounts
4.3.3 (1b)	Explain causes of current account deficits and surpluses
4.3.3 (1c)	Explain measures to reduce a current account imbalance
4.3.3 (1d)	Explain the significance of global trade imbalances
4.3.3 (3a)	Measure competitiveness: relative productivity, relative unit labour costs, relative export prices
4.3.3 (3b)	Explain factors influencing competitiveness
4.3.3 (3c)	Explain and assess measures to increase it
4.3.3 (3d)	Explain advantages of being competitive and problems of being uncompetitive

1. The accounts (1a)

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

Account	Records	Examples
Current	Payments for goods and services, income, transfers	Goods (visible trade); services (invisible trade); primary income (wages, interest, profits and dividends earned abroad less paid abroad); secondary income (transfers such as workers’ remittances and aid)
Capital	Small transfers of capital	Debt forgiveness, assets moved by migrants
Financial	Cross-border investment and lending	Foreign direct investment (FDI), portfolio investment in shares and bonds, bank loans and deposits, reserves

Trade in goods plus trade in services is the balance of trade in goods and services. Here a capital inflow counts as positive. Some published tables use the opposite sign for the financial account, so check the convention. Because each transaction has two sides, the three accounts plus net errors and omissions sum to zero.

Worked example 1. Country A (billion currency units, cu; GDP 1,100).

Goods:      exports 410 - imports 470 = -60
Services:   exports 160 - imports 120 = +40
Primary income (net)                   -25
Secondary income (net)                 -10
Current account                        -55   (-55/1,100 = -5.0% of GDP)
Capital account                         +3
Financial: FDI +30, portfolio +35, other -15 = +50
Net errors and omissions                +2
Total: -55 + 3 + 50 + 2 = 0

Country A pays for its deficit by net borrowing and by selling assets to foreigners. A “balance of payments deficit” in everyday use normally means the current account.

2. Causes of deficits and surpluses (1b)

Deficit causes:

• Fast domestic demand growth. Rising incomes raise imports. The effect is larger when the income elasticity of demand for imports is high.
• Low competitiveness. High unit labour costs or poor quality push consumers towards imports and away from exports.
• A high exchange rate, which raises export prices abroad and lowers import prices at home.
• Structural weaknesses, such as too few export industries, or reliance on a commodity whose world price falls.
• Net income outflows, when past borrowing leaves large interest and profit payments abroad.

Surplus causes are the reverse: strong competitiveness, a low exchange rate, high saving and weak domestic demand, or export earnings from resources.

Worked example 2. Country D imports 200 and exports 190 (cu billion), a balance of -10. Real GDP rises 3% and the income elasticity of demand for imports is 2.5. Foreign incomes rise 3% and the income elasticity of demand for D’s exports is 1.5.

Imports: +2.5 × 3% = +7.5%  → 200 × 1.075 = 215
Exports: +1.5 × 3% = +4.5%  → 190 × 1.045 = 198.55
Balance: 198.55 - 215 = -16.45  (deficit widens by 6.45)

Evaluation: a deficit caused by a temporary boom may reverse when growth slows. A structural deficit caused by weak competitiveness will not.

3. Reducing an imbalance (1c)

Type	Measure	Weakness
Expenditure-reducing	Higher taxes, lower government spending, higher interest rates to cut incomes and imports	Costs output and jobs; slow if firms and households are unresponsive
Expenditure-switching	Lower exchange rate; tariffs, quotas or subsidies	Retaliation, higher costs for firms using imports, breaks trade agreements
Supply-side	Better education, investment, infrastructure	Slow; uncertain; costly

Worked example 3. Country C wants imports to fall by 12. The marginal propensity to import is 0.25.

Fall in income needed = 12 ÷ 0.25 = 48
Share of GDP of 1,000 = 4.8%
With a multiplier of 2.5, spending must be cut by 48 ÷ 2.5 = 19.2

The correction is costly: output falls 4.8% to remove 12 of imports. This is why expenditure-reducing policy is a weak tool for large deficits, and why supply-side policy is preferred for a lasting fix. For a surplus country, the reverse (higher spending, a stronger currency) is the correction.

4. Global imbalances (1d)

Global trade imbalances arise when some countries run large, persistent surpluses and others matching deficits. Surplus countries lend to deficit countries through the financial account.

Why they matter:

• Deficit countries accumulate foreign liabilities, so more income flows abroad.
• Heavy reliance on foreign lenders risks capital flight, a fall in the currency and sudden austerity if confidence goes.
• Surplus countries may hold weak domestic demand, which depresses world demand.
• Tensions rise, with pressure for protection and competitive depreciation.
• Surplus countries bear the risk that deficit countries cannot repay.

Chain of reasoning: persistent deficit → rising foreign debt → larger income outflows → lenders doubt repayment → capital flight and currency fall → higher import prices and inflation → forced spending cuts and slower growth. Evaluation: the risk depends on what the borrowing finances (productive investment can raise future exports), on the size of the deficit relative to GDP, and on whether debts are in the home currency.

Worked example 4. Country A starts with net external liabilities of 300 and runs a deficit of 55 a year for 5 years, financed by borrowing.

Liabilities after 5 years: 300 + 5 × 55 = 575
Interest at 4%: before 300 × 0.04 = 12; after 575 × 0.04 = 23

Rising interest payments widen the primary income deficit, which makes the deficit harder to shrink. If nominal GDP grows 4% a year and the deficit stays at 5.0% of GDP (55 ÷ 1,100), liabilities converge on 5.0 ÷ 4 = 125% of GDP.

5. Measuring competitiveness (3a)

International competitiveness is the ability to sell goods and services abroad and resist imports at home. Three measures:

• Relative productivity: output per worker (or per hour) in one country compared with another.
• Relative unit labour costs (ULC): labour cost per unit of output, compared in a common currency. ULC = total labour cost ÷ output. A rise relative to rivals means worsening competitiveness.
• Relative export prices: an index of one country’s export prices divided by rivals’, in a common currency.

Worked example 5. Country A: output 900 with 30 million workers. Country B: output 720 with 27 million.

Output per worker A = 900 ÷ 30 = 30
Output per worker B = 720 ÷ 27 = 26.67
Relative productivity = 30 ÷ 26.67 = 112.5% (A is 12.5% higher)

Worked example 6. In Country A wages per unit of labour rise 6% and productivity rises 2%. In Country B wages rise 3% and productivity 2.5%.

ULC A: 1.06 ÷ 1.02 = 1.0392 → +3.92%
ULC B: 1.03 ÷ 1.025 = 1.0049 → +0.49%
Relative ULC = 1.0392 ÷ 1.0049 = 1.0342 → A worse off by 3.4%
If A's currency falls 4%: 1.0342 × 0.96 = 0.9928 → 0.7% better

A depreciation can offset poor cost performance, but only temporarily if wages then rise to compensate.

Worked example 7. Country A’s machine exports sell for 5,000 cu. At 1 cu = 2.0 foreign currency units (fc) the foreign price is 5,000 × 2.0 = 10,000 fc. A rival sells at 9,500 fc. If A’s currency falls to 1 cu = 1.8 fc, the foreign price becomes 5,000 × 1.8 = 9,000 fc, so A now undercuts the rival by 500 fc, a 5.3% lower price (500 ÷ 9,500). Non-price factors still decide whether buyers switch.

6. Factors influencing competitiveness (3b)

Factor	Link
Productivity	Higher output per worker lowers ULC at a given wage
Quality of human capital	Skills raise productivity and the ability to make higher-value goods
Exchange rate	A higher rate raises export prices abroad
Wage and non-wage costs	Pay, employer contributions, energy and land costs raise unit costs
Regulations	Compliance costs and delays raise costs; weak rules can reduce quality
Infrastructure	Reliable transport, power and broadband cut delivery times and costs
Non-price factors	Design, reliability, branding, after-sales service and innovation allow sales at higher prices

7. Measures to increase competitiveness (3c)

Measure	Chain of reasoning	Evaluation
Education and training	Better skills → higher productivity → lower ULC	Long time lag; cost; skills may emigrate
Investment incentives	More capital per worker → output per worker up	Cost to taxpayers; some investment would have happened anyway
Privatisation and deregulation	Competition and lower costs → efficiency	Monopoly risk; short-term job losses
Reducing the exchange rate	Lower foreign-currency export prices	Dearer imports, inflation, retaliation; effect depends on elasticities
Trade liberalisation	Cheaper inputs and more competition	Some industries collapse; adjustment costs

Judgement: policies that raise productivity are slow but durable; a lower exchange rate is quick but fades if costs then rise.

8. Why competitiveness matters (3d)

Advantages: more exports and output, a smaller deficit, more jobs, FDI attracted, higher incomes and a lower risk of currency crises.

Problems of uncompetitiveness: a persistent deficit, falling output and unemployment in traded sectors, lower FDI, weaker growth, and pressure on the currency.

Evaluation: competitiveness can be built on low wages, which may lower living standards. A strong currency can reflect competitiveness, not harm it.

Common errors

• Calling the capital and financial accounts “the capital account” only.
• Treating a deficit as bad in every case: borrowing for productive investment can be sound.
• Comparing ULC without a common currency.
• Confusing relative productivity with growth in productivity.
• Writing “export prices fall” when only the foreign-currency price changes.
• Listing measures with no evaluation.

Official syllabus

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2, June 2018, Pearson Education Limited: section 4.3.3, statements 1 (a-d) and 3 (a-d).