OxfordAQA International AS and A-level Economics: The balance of payments (9640) – Revision Notes

These revision notes condense section 3.4.2.1 of the OxfordAQA International AS and A-level Economics (9640) specification, version 1.2 (International AS exams from May/June 2021, International A-level exams from May/June 2022). Section 3.4 is the extra International A2 content. Read the study guide.

All countries and figures here are made up. Go to the OxfordAQA A-level Economics hub, the printable checklist and the practice questions. To find weak spots, use the free 10-minute diagnostics.

The accounts at a glance

Account	Records
Current	Goods, services, primary income, secondary income
Capital	Small capital transfers and non-produced assets
Financial	Investment flows: FDI, portfolio investment, bank lending
Net errors and omissions	The balancing item

• Credits are money in. Debits are money out.
• The whole balance of payments sums to zero. “A deficit” normally refers to one account, usually the current account.
• A current account deficit is financed by net inflows on the capital and financial accounts (borrowing, or sales of assets to foreigners).
• Detailed knowledge of the capital and financial accounts is not required.

Key calculations

Calculation	Rule
Balance on an item	Credits - debits
Current account	Goods + services + primary income + secondary income
Share of GDP	Balance / GDP × 100
Missing item	Net errors and omissions = -(current + capital + financial)
Import fall needed	Fall in income = fall in imports / marginal propensity to import
AD cut needed	Fall in income / multiplier
Steady-state foreign liabilities	Deficit as % of GDP / nominal growth rate in %
Volume response	% change in quantity = elasticity × % change in price

Method in steps: a lower currency and the trade balance

1. Write the starting export and import values.
2. Export value in home currency rises by export volume change, since home-currency prices are unchanged.
3. Import value = old value × (1 + price rise) × (1 - volume fall).
4. Compare the new balance with the old one.
5. Comment on elasticities and time lags.

Small reminder: exports 90, imports 100, currency falls 8%. Export PED 1.5, import PED 0.5. Exports = 90 × 1.12 = 100.8. Imports = 100 × 1.08 × 0.96 = 103.68. New balance = -2.88, an improvement of 7.12 from -10.

Deficits and surpluses

	Deficit	Surplus
Possible causes	Uncompetitive exports, fast growth at home, strong currency, foreign slowdown	Competitive exports, low home spending, weak currency, foreign boom
Significance	Rising foreign claims, income flowing out, confidence risk, leakage from AD	Weak consumption, inflation risk, tension with partners, pressure for a higher currency
Less serious when	Small, temporary, financed by stable inflows, imports raise future output	Reflects temporary commodity booms or high saving put to good use

Judge by size relative to GDP, duration, cause and ease of financing.

FDI and portfolio investment

	FDI	Portfolio investment
What	Real operations abroad with control	Shares and bonds, no control
Stability	Long-term, hard to reverse	Can leave quickly

• Benefits to the recipient: capital, technology, jobs, productivity, exports, tax revenue, financing of a deficit.
• Costs to the recipient: profit outflows, loss of control, local firms squeezed, volatility from portfolio flows, exchange rate swings.
• For the sending country: returns come back as primary income, and firms reach new markets, but investment and jobs may be lost at home.
• Profit outflow = investment × rate of return. For example, 80 million × 7% = 5.6 million a year on primary income debits.

Policies

Type	Tools	Mechanism	Side effects
Expenditure-reducing	Tax rises, spending cuts, dearer borrowing	Lower income, so fewer imports	Lower growth, higher unemployment, lower inflation
Expenditure-switching	Lower exchange rate, tariffs, quotas, export subsidies	Move spending from imports to home goods	Imported inflation, retaliation, higher prices
Supply-side	Skills, infrastructure, innovation	Improve quality and cost competitiveness	Slow and costly

• Elasticities decide effectiveness. If demand for exports and imports is price elastic, switching works. If inelastic, the import bill can rise more than exports, so the deficit gets worse first. Low supply elasticity limits export growth.
• A formal Marshall-Lerner condition is not required.
• For a surplus, use the reverse: expansionary policy, a higher exchange rate or fewer trade barriers.

Evaluation chain for any policy

1. Say what it does to the balance of payments, and how.
2. Say what it does to growth, inflation, unemployment and equality.
3. Check the economy’s position: spare capacity or overheating?
4. Check elasticities and time lags.
5. Reach a judgement about which policy fits this cause, and why.

Side effects of correcting a deficit

Policy	Helps	Hurts
Higher taxes, lower spending, higher rates	Inflation falls	Growth, employment, investment
Lower exchange rate	Exports and jobs	Import prices and inflation, real incomes
Tariffs and quotas	Protected home jobs	Prices, choice, efficiency, trade relations
Supply-side measures	Growth and productivity	Cost and long delay

For a surplus, expansionary policy or a higher currency reduces the surplus but can raise inflation or hurt exporters.

Chains of reasoning to learn

• Deficit to lost confidence: persistent deficit, then more borrowing and asset sales, then larger income outflows, then doubts among lenders, then higher interest rates or a falling currency, then lower growth.
• Spending cut: higher taxes, lower disposable income, lower consumption and imports, smaller deficit, but lower output and more unemployment.
• Currency fall: cheaper exports and dearer imports, then a change in volumes that depends on elasticities, then a change in the balance, with imported inflation as a side effect.
• FDI inflow: capital and technology, higher productivity and exports, but profit outflows later.

Must-know distinctions

• Expenditure-reducing cuts total demand. Expenditure-switching changes where demand goes.
• Deficit on one account versus the whole balance of payments, which always sums to zero.
• FDI (control, long-term) versus portfolio (financial, mobile).
• Short-run elasticities (low) versus long-run elasticities (higher).

Quick self-test

1. Country R has goods -30, services +12, primary income -9, secondary income +5, all in billions of R-units, and GDP of 400. Find the current account and its size as a percentage of GDP.
2. The capital account is +1 and the financial account is +19. Find net errors and omissions.
3. Give two ways in which FDI differs from portfolio investment.
4. Imports rise 0.25 for each 1 rise in income. Imports must fall by 6. By how much must income fall? With a multiplier of 2, by how much must AD fall?
5. A 20% tariff is placed on imports with price elasticity of demand 0.5. Find the change in import volume. If the pre-tariff import bill was 150, find the new bill before tariff.
6. Classify as expenditure-reducing or expenditure-switching: (a) a rise in interest rates, (b) export subsidies.
7. A deficit equal to 3% of GDP is run each year with nominal growth of 6%. Find the long-run foreign liabilities as a share of GDP.
8. An investor puts 80 million into a plant and earns a 7% return that is sent home. Find the yearly effect on primary income.
9. Give one reason why a currency fall may worsen the trade balance at first.
10. Give one conflict between correcting a deficit by cutting spending and another macroeconomic objective.

Answers

1. Current account = -30 + 12 - 9 + 5 = -22. As a share of GDP: -22 / 400 × 100 = -5.5%.
2. -22 + 1 + 19 = -2, so net errors and omissions = +2.
3. FDI involves control and a long-term presence, whereas portfolio investment is a financial holding with no control. FDI is harder to reverse, whereas portfolio investment can leave quickly.
4. Income falls by 6 / 0.25 = 24. AD falls by 24 / 2 = 12.
5. Volume falls by 0.5 × 20 = 10%. The bill before tariff is 150 × 0.90 = 135.
6. (a) Expenditure-reducing. (b) Expenditure-switching.
7. 3 / 6 × 100 = 50% of GDP.
8. 80 × 0.07 = 5.6 million a year, a debit on primary income.
9. Short-run demand for imports and exports is inelastic, so the higher import bill outweighs the volume gains.
10. Cutting spending lowers output and raises unemployment, which conflicts with growth and employment.

Where marks are usually lost

• Writing “the balance of payments is in deficit” instead of naming the account.
• Giving a policy list with no explanation of how it changes the balance.
• Describing a currency fall as always beneficial, with no mention of elasticities or time lags.
• Using vague terms such as “bad for the economy” instead of a chain: higher claims abroad, more income outflow, lower confidence.
• Treating FDI and portfolio investment as the same, or ignoring profit outflows.
• Forgetting side effects on inflation, growth and unemployment in an evaluation.
• Reaching no judgement. Strong answers weigh size, cause, elasticities and time horizon, then decide.
• Mixing up the sign of a balance or dividing by the wrong total when finding a percentage of GDP.

Official syllabus

OxfordAQA, International AS and A-level Economics (9640), specification version 1.2, section 3.4.2.1 (the balance of payments), for International AS exams from May/June 2021 and International A-level exams from May/June 2022.