Balance of Payments: IB Economics 4.6 notes

What the balance of payments records

The balance of payments (BoP) is a record of all monetary transactions between a country's residents and the rest of the world over a period. It is divided into three accounts: the current account, the capital account, and the financial account. Money coming in is a credit; money going out is a debit.

The BoP is central to the key concept of interdependence: it shows how a country's trade, income and investment flows connect it to the world economy.

The current account

The current account is the most examined component. It has four parts: the balance of trade in goods (exports minus imports of physical goods), the balance of trade in services (tourism, banking, shipping and similar), primary income (net income from abroad, such as wages, interest, profits and dividends earned by residents overseas minus those paid to foreigners), and secondary income (net current transfers such as foreign aid and remittances with nothing given in return).

A current account surplus means credits exceed debits; a deficit means the reverse. The current account is the part most closely tied to net exports and therefore to aggregate demand.

The capital and financial accounts

The capital account is small: it records capital transfers (such as debt forgiveness) and transactions in non-produced, non-financial assets (for example the sale of patents or copyrights). Students often confuse it with the financial account, so keep them separate.

The financial account records cross-border transactions in financial assets: foreign direct investment (buying or building productive assets abroad), portfolio investment (buying foreign shares and bonds), reserve assets held by the central bank, and other flows. Inflows of investment are credits; investment going abroad is a debit.

Why the accounts balance

By construction the overall balance of payments sums to zero: every credit has a matching debit somewhere. If a country runs a current account deficit (it buys more goods, services and income from abroad than it sells), it must finance that gap by a matching surplus on the financial account, by attracting foreign investment, borrowing, or running down reserves.

So a current account deficit is mirrored by a financial account surplus, and vice versa. In practice a balancing item (net errors and omissions) is added because data is imperfect, but conceptually the three accounts plus that item must equal zero.

Current account deficits: causes, consequences, remedies

Causes of a persistent current account deficit include low international competitiveness (high relative costs or inflation), a strong or overvalued exchange rate, high domestic demand pulling in imports, and structural weakness in export industries. The United States and the United Kingdom have run long-running current account deficits financed by financial-account inflows.

Consequences can include reliance on foreign borrowing or asset sales, downward pressure on the currency, and possible loss of confidence, though a deficit driven by strong investment inflows can be sustainable. Remedies fall into three groups: expenditure-switching policies (a depreciation or protection to switch demand toward domestic goods), expenditure-reducing policies (tighter fiscal or monetary policy to cut demand for imports, at the cost of lower growth), and long-run supply-side policies to raise productivity and competitiveness.

Current account surpluses and the exchange-rate link

A surplus is not automatically 'good'. A large persistent surplus (Germany, China at times) can reflect strong competitiveness but may also mean weak domestic demand, over-reliance on exports, and it invites trade tensions with deficit partners. Norway's oil-funded surplus, channelled into its sovereign wealth fund, shows a surplus used sustainably.

There is a two-way link with exchange rates. Under a floating system a current account deficit tends to increase the supply of the currency (to buy imports), which can depreciate it, and a cheaper currency should in time narrow the deficit by making exports cheaper. This self-correcting mechanism is weaker under fixed rates and depends on elasticities.

Marshall-Lerner and the J-curve (HL)

The Marshall-Lerner condition states that a currency depreciation (or devaluation) will improve the current account only if the sum of the price elasticity of demand for exports and the price elasticity of demand for imports is greater than one (PEDx + PEDm > 1). If demand for exports and imports is jointly inelastic, a depreciation can worsen the balance instead.

The J-curve describes the time path. Immediately after a depreciation the current account often worsens, because import prices rise at once while export and import quantities are slow to adjust (contracts are fixed and demand is inelastic in the short run). Over time, as quantities respond and the Marshall-Lerner condition comes to hold, the balance improves and rises above its starting point, tracing a J shape.

How this is examined

• Get the components exactly right: the current account has four parts (trade in goods, trade in services, primary income, secondary income). Misplacing income or transfers is a common lost mark.
• State the balancing identity clearly: a current account deficit is matched by a financial account surplus, so the overall BoP sums to zero; do not say a deficit means the BoP 'does not balance'.
• HL Paper 3 may test Marshall-Lerner numerically or ask you to draw and explain the J-curve; give the condition PEDx + PEDm > 1 and explain the short-run worsening before the long-run improvement.
• For evaluation of remedies, classify them as expenditure-switching, expenditure-reducing, or supply-side, and weigh each against growth and inflation trade-offs with a named country example.

Key terms

balance of paymentscurrent accounttrade deficittrade surplusmarshall lerner conditionnet exports