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

This guide follows 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). It covers section 3.4.2.1, the balance of payments. Section 3.4 is the extra International A2 content, so this material sits beyond the International AS.

All countries, firms and figures in this guide are made up for teaching and are not real data. Exchange rate determination and financial markets belong to the other parts of 3.4.2, so they are not taught here.

Use the OxfordAQA A-level Economics hub and the printable checklist to track progress. Then work through the revision notes and the practice questions. The earlier guide on the current account and conflicts between objectives covers what drives the current account. To find weak spots first, try the free 10-minute diagnostics.

What you must be able to do

Specification point	What it means for you
Current, capital and financial accounts	Say what each records and how they fit together. A detailed knowledge of the capital and financial accounts is not required.
Deficits and surpluses and their significance	Explain causes, financing and consequences, and judge how serious they are
FDI and portfolio investment	Define both and distinguish them
Consequences of investment flows	Weigh benefits and costs for the country receiving and the country sending funds
Policies, expenditure-switching and expenditure-reducing	Explain how each works and why elasticities decide how well it works
Effects on other policy objectives	Evaluate the side effects of correcting a deficit or surplus

The specification adds that you should understand the significance of elasticities of demand and supply in judging policy effectiveness. A formal understanding of the Marshall-Lerner condition is not required. Quantitative skills in section 3.5 (percentages, elasticity, index numbers and real terms) are used throughout.

The three accounts

The balance of payments is a statement of the payments that pass between a country’s residents and everyone abroad during a year or quarter. A payment received from abroad is a credit and a payment sent abroad is a debit.

• Current account: exports and imports of goods and of services, primary income (wages, profits, interest and dividends earned across borders) and secondary income (transfers such as gifts, aid and remittances).
• Capital account: small transfers of capital and the sale or purchase of non-produced assets.
• Financial account: flows of money for investment, such as FDI, portfolio investment and bank lending.

Presentation differs between sources. Here the financial account shows net inflows as positive, so the accounts add to zero once a balancing item (net errors and omissions) is included. Check which sign convention your textbook uses.

Worked example 1: Country K’s balance of payments

Figures are in billions of K-units, and GDP is 650.

Item	Credits	Debits	Balance
Goods	180	228	-48
Services	70	40	+30
Primary income	30	24	+6
Secondary income	10	24	-14

1. Current account balance = -48 + 30 + 6 - 14 = -26, a deficit.
2. As a share of GDP: -26 / 650 × 100 = -4.0%.
3. The capital account is +2. The financial account has FDI +13, portfolio investment +10 and other flows -2, so it is +21.
4. The accounts so far sum to -26 + 2 + 21 = -3. Net errors and omissions must be +3 to make the total zero.

The central idea: the whole balance of payments always balances. A current account deficit is paid for by net inflows on the capital and financial accounts, meaning foreigners lend to the country or buy its assets. When people say “a deficit”, they usually mean the current account unless told otherwise.

Deficits and surpluses: why they matter

A persistent current account deficit

A deficit is not harmful in itself. It matters through its cause, its size and how it is financed.

• Rising foreign claims. Each year of deficit adds to what the country owes abroad, through new loans and the sale of assets. Interest, profits and dividends then flow out, which worsens the primary income balance in later years.
• Dependence on inflows. If lenders lose confidence, the funds stop. The country may have to raise interest rates to attract money, or let the currency fall, or cut spending sharply.
• Weak competitiveness. A deficit caused by costly or low-quality exports points to a structural problem and lost jobs in traded industries.
• Leakage from demand. Imports exceeding exports reduce AD, other things equal, which can slow growth.

Worked example 2: is a deficit sustainable?

Suppose Country K runs a current account deficit of 4% of GDP every year, and nominal GDP grows 5% a year. After many years, net foreign liabilities settle at deficit / growth = 4% / 5% = 80% of GDP. A steady deficit therefore need not explode, provided growth holds up and lenders keep lending. If growth falls to 2%, the same deficit would head towards 4 / 2 = 200% of GDP. This is a simplified model that ignores changes in asset prices, but it shows why a deficit is judged against income, not in absolute terms.

A persistent surplus

A surplus is not simply good. It can mean weak domestic demand and low consumption. It may lift AD and inflation when exports boom, and it can create tension with trading partners who run the matching deficits. The currency may also be pushed up, which erodes competitiveness.

Evaluation: judge a deficit or surplus by its size relative to GDP, how long it lasts, what causes it (temporary or structural, such as imports of capital goods that raise future output) and how easily it is financed.

FDI and portfolio investment

Foreign direct investment (FDI) is money put into productive assets in another country, for instance by setting up a plant or acquiring a majority share in a company there. The investor takes a lasting interest and some say in how the business is run. Portfolio investment is the purchase of financial assets such as shares and bonds, with no control, in search of a return.

	FDI	Portfolio investment
Aim	Control and long-term presence	Financial return
Time horizon	Long, hard to reverse	Short or long, easy to sell
Stability	Relatively stable	Can reverse quickly
Example	A foreign firm builds a plant	A fund buys government bonds

Consequences for the country receiving investment

• Benefits: extra capital, new technology and management methods, jobs, higher productivity, possibly more exports, tax revenue and a financial-account inflow that funds a current account deficit.
• Costs: profits are sent abroad (a debit on primary income), local firms may be squeezed out, control of key industries may pass overseas, and jobs may disappear if the investor leaves. Large portfolio inflows can push up the exchange rate and then reverse suddenly.

For the country sending funds, investors earn returns that come back as primary income credits and gain access to markets. The cost is less investment and employment at home.

Worked example 3: a foreign plant in Country K

A foreign firm invests 120 million K-units in a plant. Each year it exports 30 million of output, imports 12 million of inputs and sends 10 million of profit abroad.

1. Year of investment: financial account +120 million.
2. Each later year: current account effect = +30 - 12 - 10 = +8 million.
3. The 120 million inflow is a one-off, but it creates a claim on the country. The yearly profit outflow of 10 million continues for as long as the plant operates, and it is already included in the +8 million.

The conclusion is that FDI helps the current account most when it earns export revenue or replaces imports, and less when its profits leave and its inputs are imported. Productivity and employment gains may matter more than the account effect.

Worked example 4: a portfolio reversal

Country K’s current account deficit is 26 billion. Portfolio flows swing from +10 to -6, a swing of 16 billion. Unless other inflows rise, a financing gap of 16 billion opens. It can be met by using foreign exchange reserves, by raising interest rates to attract funds, or by a falling exchange rate. This is why portfolio flows can destabilise an economy that relies on them.

Policies to deal with balance of payments problems

Policies fall into two groups, and the group tells you the mechanism.

	Expenditure-reducing	Expenditure-switching
Idea	Cut total spending so that fewer imports are bought	Move spending from imports to home output
Tools	Higher taxes, lower government spending, higher interest rates	A lower exchange rate, tariffs, quotas, export subsidies
Main risk	Slower growth and higher unemployment	Higher import prices, retaliation, cost-push inflation

Worked example 5: expenditure-reducing policy

In Country K an extra 1 of income adds 0.3 to imports, so the marginal propensity to import (MPM) is 0.3. The government wants to cut imports by 8 billion.

1. Income must fall by 8 / 0.3 = 26.67 billion.
2. With a multiplier of 1.8, AD must be cut by 26.67 / 1.8 = 14.81 billion.

The cut slows the economy. Output falls by far more than the import saving, so correcting the deficit this way is costly when the economy has spare capacity.

Worked example 6: why elasticities decide whether switching works

Country K’s exports are 250 billion and imports are 268 billion (goods and services), so the trade balance is -18. The exchange rate falls 10%. Export prices in K-units stay the same, and import prices in K-units rise 10%.

	Exports	Imports	Balance
Elastic: export PED 1.2, import PED 0.4	250 × 1.12 = 280	268 × 1.10 × 0.96 = 283.01	-3.01
Inelastic: export PED 0.5, import PED 0.2	250 × 1.05 = 262.5	268 × 1.10 × 0.98 = 288.90	-26.40

In the elastic case, the balance improves by about 15. In the inelastic case the balance worsens by about 8.4, because the import bill rises faster than export volume. Elasticities tend to be lower in the short run, since buyers need time to find alternatives, so the balance can worsen before it improves. Supply elasticity matters too: exporters must be able to raise output.

A tariff of 15% on goods imports with import PED 0.8 cuts volume by 0.8 × 15 = 12%. The goods import bill, before tariff, falls from 228 to 228 × 0.88 = 200.64. Retaliation or a lack of home substitutes would weaken this, and higher prices fall on consumers and on firms that import inputs.

Supply-side policies, such as investment in skills and infrastructure, work slowly but lift productivity and quality. They improve competitiveness without cutting living standards, and they raise the elasticity of supply.

Effects on other policy objectives

Policy	Helps	Hurts
Higher taxes, lower spending, higher rates	Lower inflation	Growth, employment, possibly investment
Lower exchange rate	Export-led growth and jobs	Imported inflation, lower real incomes for importers
Tariffs and quotas	Protects domestic jobs	Prices, choice, trade relations, efficiency
Supply-side measures	Growth, productivity	Cost, long delay

For a surplus, the reverse applies: expansionary policy, a higher exchange rate or lower trade barriers reduce the surplus but may raise inflation or hurt exporters.

Evaluation chain. Match the policy to the cause. If the deficit comes from an overheating economy with high inflation, expenditure-reducing policy fixes both problems. If the economy is in recession, the same policy conflicts with growth and employment, and switching or supply-side measures fit better. Ask also how big the deficit is, how elastic trade is and how quickly the policy works.

Common errors

• Saying the balance of payments is in deficit overall. The accounts sum to zero, so say which account.
• Treating every deficit as bad without looking at its cause, size or financing.
• Confusing FDI with portfolio investment, or saying FDI is always better.
• Expecting a weaker currency to fix a deficit automatically. Say what happens if demand is inelastic.
• Listing policies without saying whether they cut spending or switch it.
• Forgetting the side effects on inflation, growth and unemployment.

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.