IB DP Economics: Balance of payments

This guide covers the balance of payments, sub-topic 4.6 of Unit 4 (The global economy). It follows 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 way they balance are for both SL and HL. Everything about exchange rates, persistent deficits and surpluses, correction methods, the Marshall-Lerner condition and the J-curve is HL only and is marked that way.

All countries and figures are invented and illustrative, not real data. The main country is Halvenia, whose currency is the hal, with amounts in billions of hals. Use the revision notes to consolidate and the practice set to test yourself. The course page is IB DP Economics, the printable checklist lists each point, and the free diagnostics show where to start. The exchange rate mechanics used here are in exchange rates.

What 4.6 asks you to do

Content	What you must be able to do	Level
Credits, debits, surplus, deficit	Define them and calculate elements of the balance of payments from data	SL and HL
Components	Describe the current, capital and financial accounts and their items	SL and HL
Interdependence	Explain why the whole balances at zero	SL and HL
Current account and exchange rate	Explain the link and draw a diagram	HL only
Financial account and exchange rate	Explain the link	HL only
Persistent deficit	Evaluate its implications	HL only
Correction methods	Explain and evaluate them	HL only
Marshall-Lerner and J-curve	Explain, with a diagram	HL only
Persistent surplus	Evaluate its implications	HL only

The guide sets the deficit, surplus and effectiveness rows at the evaluation level, so weigh points rather than list them. It describes Paper 2 as a data response paper with some quantitative questions, and HL Paper 3 as a policy paper.

Credits, debits, surplus and deficit

The balance of payments records every payment flowing between a country’s residents and foreign residents in a given period. A credit item brings money into the country, for example an export sale. A debit item sends money out, for example an import purchase. An account has a surplus if credits exceed debits and a deficit if debits exceed credits.

Components of the balance of payments

The current account

Item	What it records	Credit example	Debit example
Balance of trade in goods	Exports minus imports of physical goods	Selling machinery abroad	Buying foreign cars
Balance of trade in services	Exports minus imports of services	A foreign tourist staying in Halvenia	A Halvenian firm paying for foreign software
Income	Earnings on investment and pay across borders	Profit sent home by a Halvenian firm’s overseas factory	Profit sent abroad by a foreign-owned Halvenian factory
Current transfers	Gifts and aid that need no payment back	Remittances sent home by Halvenians working abroad	Government aid given to another country

The capital account

Capital transfers are one-way transfers linked to assets, such as a creditor writing off a debt. Transactions in non-produced, non-financial assets are purchases and sales of things that were not made and are not financial, such as land bought abroad by an embassy or the transfer of a brand name.

The financial account

This guide records a net inflow of financial capital as a credit, so a financial account surplus means more entered than left.

• Foreign direct investment (FDI): buying or building a lasting stake in a business abroad, such as a new factory.
• Portfolio investment: buying shares or bonds without seeking control.
• Reserve assets: the central bank’s stock of foreign currency and gold. A fall in reserves is a credit, because the central bank is supplying foreign currency to the market.
• Official borrowing: borrowing by the government or central bank from abroad. A net inflow of borrowing is a credit.

Worked example 1: calculating from data

Halvenia’s figures, in billions of hals:

Item	Credits	Debits	Balance
Goods	420	465	-45
Services	130	95	+35
Income	60	82	-22
Current transfers	18	30	-12
Current account			-44
Capital transfers	7	4	+3
Non-produced, non-financial assets	3	5	-2
Capital account			+1

Current account = -45 + 35 - 22 - 12 = -44, a deficit of 44. Capital account = +3 - 2 = +1, a small surplus. GDP is 1,100, so the current account deficit is 44 / 1,100 = 4.0% of GDP.

Interdependence between the accounts

Every transaction has two sides. A Halvenian importer buys machinery worth 10: that is a debit on the current account. The importer pays, and the seller ends up holding hals or hal-denominated assets: that is a matching credit on the financial account. Because every debit has a matching credit, the balance of payments as a whole is zero:

current account + capital account + financial account = 0

So a deficit on one account is matched by a surplus on another. Talk of a deficit “in the balance of payments” really means a deficit on a particular account, usually the current account.

Real statistics carry a small balancing item for measurement error. The guide does not list it, so ignore it here.

Worked example 2: finding the financial account

Using example 1:

Current account + capital account = -44 + 1 = -43
Financial account must be         = +43

Suppose the components are FDI +18, portfolio investment +14 and official borrowing +5. Then reserve assets = 43 - (18 + 14 + 5) = +6. A credit of 6 on reserve assets means reserves fell by 6. Halvenia financed its deficit with foreign investment, foreign borrowing and a draw on reserves.

The current account and the exchange rate (HL only)

Draw the market for the hal: exchange rate (foreign currency per hal) on the vertical axis, quantity of hals on the horizontal axis.

Rate
 |  D (hals demanded: exports, inflows)
 |   \             /
 |    \           /
R1 - - -\- - - - /- - - -   excess supply of hals
 |       \       /            = deficit pressure
Re - - - - -X- - - - - -
 |         /     \
 |        /       \
 |  S (hals supplied: imports, outflows)
 +------------------------------ Quantity of hals

Foreign buyers need hals to pay for exports, so the demand curve falls to the right. Halvenians sell hals to pay for imports, so the supply curve rises. Re is the equilibrium rate. If the rate is held at R1, above Re, the supply of hals exceeds demand. This is the pressure a current account deficit creates.

In a floating system, the rate falls towards Re. The fall in the hal makes Halvenian goods cheaper for foreign buyers and foreign goods dearer for Halvenians, which tends to narrow the deficit. The link runs both ways. A current account surplus has the opposite effect: demand for hals shifts right and the rate rises.

The financial account and the exchange rate (HL only)

Financial flows also create demand and supply on the same diagram. A net inflow of FDI or portfolio investment raises the demand for hals, shifting D to the right and causing appreciation. A net outflow raises the supply of hals and causes depreciation. A rise in Halvenia’s interest rates tends to attract portfolio investment, so it supports the currency. A fall in confidence has the opposite effect.

A current account deficit can last only while the financial account supplies enough inflows to cover it. If investors lose confidence, inflows shrink and the hal falls sharply.

Implications of a persistent current account deficit (HL only)

Area	Possible implication	Evaluation
Exchange rates	Downward pressure on the currency	Helpful if it restores competitiveness; harmful if it raises import prices sharply
Interest rates	May need to rise to attract inflows	Raises borrowing costs for firms and households
Foreign ownership of domestic assets	FDI and portfolio inflows transfer ownership to foreigners	Brings capital and skills, but profits then flow out as income debits
Debt	Official and private borrowing builds up	Depends on whether the borrowing funds productive investment
Credit ratings	Lenders may judge the country riskier	A downgrade raises the cost of future borrowing
Demand management	Limits expansionary policy, since faster growth pulls in imports	May force a choice between growth and external balance
Economic growth	Imports of capital goods can raise future growth	A deficit driven by consumption does not

Judge a deficit by its size relative to GDP, its duration, how it is financed and what the imports are used for. A 4.0% deficit financed by FDI in new factories is less worrying than one financed by short-term borrowing for consumption.

Methods to correct a persistent current account deficit (HL only)

• Expenditure switching moves spending from imports to domestic output. Examples are tariffs, quotas, export subsidies and a deliberate depreciation or devaluation.
• Expenditure reducing cuts total demand, and so imports. Examples are tax rises, spending cuts and dearer borrowing.
• Supply-side policies raise productivity and quality, which improves competitiveness over time. Examples are investment in education, infrastructure and research.

Effectiveness depends on the case. Expenditure switching can bring retaliation. Depreciation raises import prices and works only if demand responds enough, as the next section shows. Expenditure reducing works quickly on imports but costs output, jobs and growth. Supply-side policies avoid those costs but are slow and expensive. Pair each method with the cause: weak competitiveness needs supply-side policy, whereas a consumption boom may respond to expenditure reducing. See supply-side policies, fiscal policy and types of trade protection.

The Marshall-Lerner condition and the J-curve effect (HL only)

The Marshall-Lerner condition says a depreciation improves the current account only if the price elasticities of demand for exports and for imports, taken as positive numbers, total more than 1.

Worked example 3

Halvenia’s exports of goods and services are 400 and imports are 440, so the balance is -40. The hal depreciates by 10%. Assume export prices in hals are unchanged, so foreign buyers see a 10% price fall, and import prices in foreign currency are unchanged, so Halvenians see a 10% price rise.

Case A: export elasticity 0.9, import elasticity 0.7. The sum is 1.6, which is above 1.

Export volume up 0.9 x 10% = 9%      Exports = 400 x 1.09 = 436.00
Import volume down 0.7 x 10% = 7%    Imports = 440 x 1.10 x 0.93 = 450.12
New balance = 436.00 - 450.12 = -14.12

The deficit narrows from 40 to 14.12.

Case B: export elasticity 0.4, import elasticity 0.3. The sum is 0.7, below 1.

Exports = 400 x 1.04 = 416.00
Imports = 440 x 1.10 x 0.97 = 469.48
New balance = 416.00 - 469.48 = -53.48

The deficit widens from 40 to 53.48.

The J-curve

Demand is usually less elastic in the short run, because contracts are fixed and buyers take time to switch. Case B describes the short run and Case A the longer run. The balance therefore falls at first, then recovers, tracing a J shape.

Current account balance
 |
 |                              /
 |                            /   <- better than the start
Start - - - -\- - - - - - /- - - - - -
 |            \        /
 |             \____/   <- trough (worse than the start)
 |        depreciation occurs at the left
 +------------------------------------ Time

Mark the starting balance, the trough and the point where the curve crosses back above the start.

Implications of a persistent current account surplus (HL only)

Area	Possible implication
Domestic consumption and investment	Output sold abroad is not used at home, so consumption and investment may be lower than they could be
Exchange rates	Strong foreign demand pushes the currency up, which hurts exporters
Inflation	Export demand adds to aggregate demand and may raise prices; an appreciating currency makes imports cheaper, which works the other way
Employment	Export industries support jobs, but appreciation can cost jobs in them
Export competitiveness	Appreciation raises export prices abroad and can erode the surplus

A surplus is not simply success. Weigh jobs, export growth and foreign assets against weak domestic spending and a rising currency. See also benefits of international trade.

Common errors

• Writing that the balance of payments can be in deficit overall. The total is zero, so name the account.
• Treating a fall in reserves as a debit. In this guide’s convention it is a credit.
• Drawing a currency diagram without labelled axes, curves and equilibrium.
• Claiming depreciation must cure a deficit, ignoring elasticities and time lags.

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).