IB DP Economics: Balance of payments – Revision Notes

These notes condense sub-topic 4.6, Balance of payments, for the final weeks of revision. They follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. The accounts, their components and the zero balance are for SL and HL. The exchange rate links, persistent deficits and surpluses, correction methods, the Marshall-Lerner condition and the J-curve are HL only. For full explanations read the study guide.

Countries and figures are invented. Test yourself with the practice set, tick points on the printable checklist, use the IB DP Economics hub and try the free diagnostics.

Key definitions

Term	Meaning
Balance of payments	Record of payments flowing between a country’s residents and foreign residents in a period
Credit item	A transaction that brings money into the country
Debit item	A transaction that sends money out
Surplus on an account	Credits exceed debits
Deficit on an account	Debits exceed credits
Balance of an account	Credits minus debits

The three accounts

Account	Items	Typical credit	Typical debit
Current	Trade in goods, trade in services, income, current transfers	Export sale, tourist spending, profits received, remittances received	Import purchase, firm paying for foreign services, profits sent out, aid given
Capital	Capital transfers; non-produced, non-financial assets	Debt written off for the country; sale of a brand name to a foreign firm	Debt the country writes off; purchase of a foreign brand name
Financial	FDI, portfolio investment, reserve assets, official borrowing	Foreign firm builds a factory; foreign purchase of bonds; fall in reserves; new foreign loan to government	Domestic firm builds abroad; domestic purchase of foreign shares; rise in reserves; repaying a foreign loan

Convention in this guide: a net inflow of financial capital is a credit, and a fall in reserves is a credit.

Method: calculating from data

1. Work out each item’s balance as credits minus debits.
2. Add the four current account items for the current account balance.
3. Add the two capital account items for the capital account balance.
4. Financial account = minus (current account + capital account).
5. Find any one missing financial item by subtracting the known ones from the financial account total.
6. State whether each balance is a surplus or a deficit, with units.

Worked reminder (Pelmora, billions of pels)

Item	Credits	Debits	Balance
Goods	180	205	-25
Services	60	38	+22
Income	25	31	-6
Current transfers	9	14	-5
Current account			-14
Capital account (+2 and -1)			+1

Financial account = -(-14 + 1) = +13. If FDI is +9, portfolio investment +5 and official borrowing -2, then reserve assets = 13 - (9 + 5 - 2) = +1, so reserves fell by 1.

Why the total is zero

• Each transaction has two sides, so every debit has a matching credit.
• Current account + capital account + financial account = 0.
• A deficit on one account is matched by a surplus on another.
• “Deficit in the balance of payments” should always name the account.

Must-know distinctions

Pair	Difference
FDI and portfolio investment	FDI is a lasting stake such as a factory; portfolio investment is shares or bonds without control
Current transfers and capital transfers	Current transfers are gifts such as remittances and aid; capital transfers are one-way and linked to assets, such as debt write-offs
Reserve assets and official borrowing	Reserves are foreign currency and gold held by the central bank; official borrowing is government or central bank borrowing from abroad
Expenditure switching and expenditure reducing	Switching redirects spending to home output; reducing cuts total demand

HL only: currency market links

Current account and exchange rate. Foreign demand for exports creates demand for the currency, and imports create supply of it. A deficit means supply of the currency exceeds demand at the going rate, so it tends to fall. A lower rate then cuts export prices abroad and lifts import prices. A surplus has the opposite effect.

Financial account and exchange rate. Net inflows raise demand for the currency and cause appreciation. Net outflows raise supply and cause depreciation. A higher interest rate tends to attract portfolio inflows.

Diagram steps:

1. Axes: exchange rate on the vertical axis, quantity of the currency on the horizontal axis.
2. Draw demand falling to the right and supply rising.
3. Mark the equilibrium rate.
4. Show the rate held above equilibrium to illustrate deficit pressure, or shift a curve to show a financial flow.
5. Label every curve and rate.

HL only: persistent deficit

Area	Link
Exchange rates	Downward pressure on the currency
Interest rates	May rise to attract inflows
Foreign ownership of assets	Inflows hand ownership abroad; future profits flow out
Debt	Borrowing builds up and interest must be paid
Credit ratings	Greater perceived risk, higher borrowing costs
Demand management	Expansion pulls in imports, so policy is constrained
Growth	Capital goods imports can help; consumption-led deficits do not

Evaluate by size relative to GDP, duration, how it is financed and what imports are used for.

HL only: correction methods

Method	Examples	Strength	Limit
Expenditure switching	Tariffs, quotas, subsidies, depreciation	Acts on imports and exports quickly	Retaliation; higher import prices; depends on elasticities
Expenditure reducing	Tax rises, spending cuts, dearer borrowing	Cuts imports quickly	Lower output, jobs and growth
Supply-side policies	Education, infrastructure, research	Lasting competitiveness without sacrificing demand	Slow, costly, uncertain

Match the method to the cause. Weak competitiveness points to supply-side policy; excess spending points to expenditure reducing.

HL only: Marshall-Lerner and the J-curve

• Marshall-Lerner condition: a depreciation improves the current account only if, ignoring signs, the two price elasticities (exports and imports) add up to more than 1.
• J-curve: demand is less elastic in the short run, so the balance dips first, then recovers as elasticities rise.

Reminder: exports 160, imports 200, balance -40. A 10% depreciation with export elasticity 0.5 and import elasticity 0.4 (sum 0.9):

Exports = 160 x (1 + 0.5 x 0.10) = 168.00
Imports = 200 x 1.10 x (1 - 0.4 x 0.10) = 211.20
New balance = 168.00 - 211.20 = -43.20

The deficit widens, as the sum is below 1.

HL only: persistent surplus

Area	Link
Domestic consumption and investment	Output sold abroad is not available at home
Exchange rates	Upward pressure on the currency
Inflation	Export demand adds to demand, but a stronger currency lowers import prices
Employment	Export jobs, but appreciation can cost some
Export competitiveness	Appreciation raises export prices abroad

Quick self-test

1. Define a debit item.
2. Name the three accounts of the balance of payments.
3. Is a fall in a central bank’s reserves a credit or a debit in the financial account?
4. A country has goods exports of 90 and imports of 110, and services exports of 40 and imports of 25. Calculate the balance of trade in goods and in services.
5. The current account is -30 and the capital account is +4. Calculate the financial account balance.
6. Explain why the balance of payments as a whole sums to zero.
7. (HL only) In a floating system, which way does a current account deficit tend to push the exchange rate?
8. (HL only) State the Marshall-Lerner condition.
9. (HL only) Export elasticity is 0.6 and import elasticity is 0.3. Will a depreciation improve the current account?
10. (HL only) Give two expenditure reducing policies.
11. (HL only) State one effect of a persistent surplus on the exchange rate.

Answers

1. A transaction that sends money out of the country, such as an import purchase.
2. Current, capital and financial accounts.
3. A credit.
4. Goods: 90 - 110 = -20 (deficit). Services: 40 - 25 = +15 (surplus).
5. -(-30 + 4) = +26.
6. Every transaction has a credit and a matching debit, so the accounts together sum to zero.
7. Downward, since supply of the currency exceeds demand.
8. A fall in the currency helps the current account only when the export and import price elasticities of demand, ignoring signs, total more than 1.
9. No. The sum is 0.9, below 1, so the balance would worsen.
10. Any two of a rise in income tax, cuts in public spending, a rise in interest rates.
11. Upward pressure, because foreign demand for the currency exceeds the supply of it.

Where marks are usually lost

• Calling the balance of payments “in deficit” without naming an account.
• Reversing credits and debits, so balances take the wrong sign.
• Getting the sign of the financial account wrong when finding it from the other two accounts.
• Giving a figure with no units or no statement of surplus or deficit.
• Treating FDI and portfolio investment as the same thing.
• Drawing a currency diagram with unlabelled axes or curves.
• Assuming depreciation always helps, without elasticities or the time lag.
• Listing implications of a deficit with no judgement of size, cause or financing.
• Describing correction methods without saying which cause each one fits.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization (February 2020), sub-topic 4.6 Balance of payments (includes HL only sub-topics).