OxfordAQA International AS and A-level Economics: Current account and conflicts (9640)

This guide follows the OxfordAQA International AS and A-level Economics specification (version 1.2), sections 3.2.3.4 (the balance of payments on current account) and 3.2.3.5 (possible conflicts between macroeconomic policy objectives). Section 3.2 is International AS content; the specification gives May/June 2021 as the first International AS series and May/June 2022 as the first for the International A-level. Every figure below is invented for illustration, and Country A does not exist.

Use it with the revision notes and the practice set. The course hub is OxfordAQA A-level Economics and the printable list is the economics checklist. Related pages: measurement of macroeconomic performance and macroeconomic performance notes. To find weak spots first, try the free diagnostics.

What you must be able to do

Section	Outcome
3.2.3.4	Explain why international trade matters to an economy
3.2.3.4	State that the balance of payments records a country’s financial transactions with the rest of the world
3.2.3.4	Name the four parts of the current account and say what a deficit and a surplus mean
3.2.3.4	Analyse how productivity, inflation, the exchange rate and activity at home and abroad affect the balance
3.2.3.5	Explain how growth may affect the environment, income distribution, unemployment and the budget balance
3.2.3.5	Relate negative and positive output gaps to joblessness and price pressures
3.2.3.5	Use AD/AS to analyse conflicts in the short and long run, and say how policy might reconcile them

The specification notes that the current account is only one part of the balance of payments. The other parts belong to a later unit, so they are not taught here.

Why international trade matters

Trade lets a country buy goods it cannot make, or can only make at high cost. Specialising and selling abroad gives access to larger markets, so firms can lower average costs, and competition from imports pushes domestic firms to improve quality. Exports are also a component of aggregate demand, so they affect output and jobs.

There are risks. An economy that relies on a few export markets is exposed to a downturn abroad. Import competition can close firms and cause structural unemployment in the affected industries.

The balance of payments and the current account

The balance of payments is a record of a country’s financial transactions with the rest of the world. The current account has four parts.

Part	What it records	Credit (money in)	Debit (money out)
Trade in goods	Physical products	Exports of goods	Imports of goods
Trade in services	Intangibles such as transport, tourism, finance	Exports of services	Imports of services
Primary income	Income from employment and from investments abroad	Residents’ earnings from abroad	Payments to foreign owners and workers
Secondary income	Transfers with nothing received in return, such as remittances and aid	Transfers received	Transfers sent

The balance on each part is credits minus debits. A surplus means total credits exceed total debits. A deficit means debits exceed credits. The trade balance is the balance on goods plus services.

Worked example 1: a current account

Country A, in billions of A-units, with GDP of 1,600.

Part	Credits	Debits	Balance
Goods	240	275	-35
Services	95	60	+35
Primary income	48	62	-14
Secondary income	12	30	-18

1. Trade balance = -35 + 35 = 0.
2. Current account balance = -35 + 35 - 14 - 18 = -32, a deficit of 32 billion A-units.
3. As a share of GDP: -32 / 1,600 × 100 = -2.0%.

Trade in goods and services balances here, yet the account is in deficit because of income flows. Read each line separately before judging the total. A deficit is not automatically harmful. It is more worrying when large and lasting, and when the cause is poor competitiveness. Imports of machinery that lift future output are a milder case.

Factors that influence the current account

Productivity

Higher productivity lowers unit labour costs, which lets firms cut prices or raise quality. Unit labour cost = wage cost per worker / output per worker.

Worked example 2. A Country A firm pays 30,000 A-units per worker, and each worker makes 1,500 units a year, so unit labour cost is 30,000 / 1,500 = 20. Wages rise 4% to 31,200 and output per worker rises 10% to 1,650. New cost = 31,200 / 1,650 = 18.91, a fall of 5.5%. If this holds across exporters, goods become more price competitive, so exports rise and imports may fall.

Inflation

If prices rise faster at home than abroad, domestic goods become relatively dearer, other things equal.

Worked example 3. Country A’s price index rises from 100 to 108. Its main partner’s rises from 100 to 102. With the exchange rate unchanged, relative prices = 108 / 102 = 1.0588, so Country A’s goods are 5.9% dearer relative to the partner’s. Export volumes fall and imports are favoured, which tends to worsen the balance.

The exchange rate

When the currency depreciates, foreign buyers pay less for exports, while home buyers pay more for imports. The balance improves only if demand responds strongly enough.

Worked example 4. A machine costs 12,000 A-units. At 1 A-unit = 0.50 foreign units (F), foreign buyers pay 6,000 F. After depreciation to 1 A-unit = 0.40 F they pay 4,800 F, which is -20%.

An imported item costs 50 F. At the old rate it costs 50 / 0.50 = 100 A-units. At the new rate it costs 50 / 0.40 = 125 A-units, which is +25%.

Now add elasticities. Suppose foreign demand for the machine has PED = -1.5. A 20% price fall raises quantity demanded by 1.5 × 20 = 30%. Foreign-currency revenue changes by 0.80 × 1.30 = 1.04, up 4%. Revenue in A-units rises 30%, since the A-unit price is unchanged.

Suppose home demand for the import has PED = -0.6. A 25% price rise cuts quantity by 0.6 × 25 = 15%. Spending in A-units = 1.25 × 0.85 = 1.0625, up 6.25%. Inelastic import demand means the import bill rises at first, so the balance can worsen before it improves. The effect grows with time as buyers switch, and the improvement is larger when the two demands are elastic.

Economic activity at home and abroad

Rising incomes at home raise spending on imports. Rising incomes abroad raise demand for exports. Income elasticity of demand (YED) measures the size of the response: %ΔQ = YED × %Δincome.

Worked example 5. Country A’s imports of goods have YED = 1.8 and home income rises 3%, so imports rise 5.4%: 275 × 1.054 = 289.85. Its exports have YED = 1.2 and partners’ income rises 2%, so exports rise 2.4%: 240 × 1.024 = 245.76. The goods balance moves from -35 to 245.76 - 289.85 = -44.09, a worsening of 9.09. Growth at home draws in imports faster than growth abroad lifts exports.

Possible conflicts between objectives

Policy objectives include growth, low inflation, low unemployment, a sustainable budget balance, a balanced current account, a fair distribution of income and protection of the environment. Pursuing one can damage another.

The AD/AS picture

Axes: price level (vertical) and real GDP (horizontal). LRAS is a vertical line at normal capacity, Y(f). SRAS slopes upward and AD slopes downward. Equilibrium is where AD cuts SRAS.

Where AD cuts SRAS	Real GDP compared with Y(f)	Result
To the left of LRAS	Below	Negative output gap
On LRAS	Equal	No gap
To the right of LRAS	Above	Positive output gap

LRAS is vertical at the normal capacity level of output. A positive output gap is real GDP above productive potential. A negative output gap is real GDP below it. A negative gap is linked to cyclical unemployment and spare capacity, so inflationary pressure is weak. A positive gap means firms and workers are stretched, so wages and prices are pushed up. Imports are also drawn in, so the gap can widen a current account deficit.

Worked example 6. Potential output is 1,000. Real GDP of 1,020 gives a gap of +2.0%. Real GDP of 960 gives a gap of -4.0%.

Growth and its side effects

Growth that comes from higher AD is faster than growth in capacity, so it can overheat. Growth that comes from supply-side improvements shifts LRAS right and avoids most of the inflation conflict. Four side effects matter.

• Environment. More output usually means more resource use and emissions. In Country A output rises 4% while emissions per unit of output fall 2%, so total emissions change by 1.04 × 0.98 = 1.0192, a rise of 1.9%. Cleaner technology slows the damage but may not reverse it.
• Distribution. Suppose the poorest 40% have income 200, the middle 40% have 400 and the richest 20% have 400, so total income is 1,000. After growth they get 206, 416 and 432: rises of 3%, 4% and 8%, with total income 1,054 (+5.4%). The richest 20% share goes from 40.0% to 40.99%, and the poorest 40% share falls from 20.0% to 19.54%. Average income rose, yet inequality widened.
• Unemployment. Output grows 3% while output per worker grows 3.5%. Labour needed changes by 1.03 / 1.035 = 0.9952, a fall of 0.5%. This is growth without job creation. Faster growth usually lowers cyclical unemployment, but not if productivity rises as fast.
• Budget balance. Suppose tax is 35% of GDP and spending is 380 when GDP is 1,000, so the deficit is 380 - 350 = 30, or 3.0% of GDP. GDP rises to 1,030 and tax revenue to 360.5. Spending on benefits falls 4, so spending is 376. The deficit is 376 - 360.5 = 15.5, or 1.5% of 1,030. Growth narrowed the deficit because tax revenue rose and benefit spending fell.

Inflation, unemployment and the current account

In the short run, expanding AD to cut unemployment moves the economy along SRAS, raising the price level. Cost-push shocks, such as a rise in world commodity prices, shift SRAS left, which raises prices and cuts output together. Any policy response then trades one objective against another. Higher interest rates cut inflation but reduce spending and jobs, and may raise the exchange rate, which hurts exports.

Reconciling conflicts

In the short run, policymakers can use different instruments for different aims, or accept a trade-off. In the long run, supply-side policies such as education, training and investment shift LRAS right. They can raise output and lower unemployment without adding to inflation, and a higher-productivity economy competes better abroad.

Evaluation chain. State the conflict, then explain it with AD/AS, then judge: how big is the spare capacity, how fast does the economy adjust, and is the shock temporary? A conflict is sharper when the economy is near full capacity.

Common errors

• Calling a goods deficit a current account deficit. Add all four parts.
• Saying the whole balance of payments is in deficit when only the current account is. Name the part you mean.
• Treating depreciation as an automatic cure. State the elasticity condition.
• Saying growth always reduces unemployment or always widens inequality. Give the condition.
• Confusing deflationary policy with deflation. Deflationary policy reduces AD.

Official syllabus

OxfordAQA International AS and A-level Economics (9640), specification version 1.2, first teaching September 2020, published by OxfordAQA: sections 3.2.3.4 and 3.2.3.5.