Contents: 9 sections
1. Why this topic matters
AS Level covered the current account and how a deficit might be corrected. A2 adds three things that carry most of the marks:
- the full structure of the accounts, including the capital and financial accounts, and why the whole thing balances by construction;
- the Marshall-Lerner condition, which states the elasticity requirement for a depreciation to work at all; and
- the J-curve, which explains why a depreciation makes a deficit worse before it makes it better.
Those last two are the difference between asserting that a depreciation corrects a deficit and explaining when and how quickly it does.
2. Structure of the accounts
2.1 The three accounts
- Current account. Trade in goods, trade in services, primary income (compensation of employees and investment income such as profits, interest and dividends), and secondary income (transfers such as remittances and aid).
- Capital account. Relatively small: capital transfers and the acquisition or disposal of non-produced, non-financial assets such as patents.
- Financial account. Direct investment, portfolio investment, other investment and reserve assets. This records changes in ownership of financial assets.
2.2 Why the balance of payments always balances
Every transaction has two entries. A country importing more goods than it exports must finance the difference, by borrowing, by selling assets or by running down reserves. Those financing flows appear in the financial account.
So a current account deficit is matched by a financial account surplus, and the accounts sum to zero apart from errors and omissions.
This is a definitional truth, and it produces the most common confusion in the topic. When people speak of a balance of payments deficit, they almost always mean a current account deficit, since the overall balance is zero by construction. Being explicit about which balance is meant is worth marks in itself.
2.3 What a current account deficit means
A current account deficit means a country is consuming more than it produces, and is financing that by acquiring liabilities to foreigners or selling assets to them.
Whether this is a problem depends on why it is happening, which is the next section.
3. Is a deficit a problem?
Treat this as a set of conditions rather than a verdict.
3.1 When a deficit is less concerning
- It finances investment rather than consumption, so the imported capital goods raise future productive capacity and future export earnings.
- It is cyclical, reflecting strong domestic growth that will moderate.
- It is financed by long term inflows such as foreign direct investment, which are stable and bring the benefits of 11.1.
- The country issues a reserve currency, so financing is readily available.
- It is small relative to GDP and stable.
3.2 When a deficit is more concerning
- It finances consumption, so no future income stream is created to service the liabilities.
- It is structural, reflecting a persistent loss of competitiveness rather than the cycle.
- It is financed by short term portfolio flows, which can reverse suddenly. This is the classic sudden stop that precipitates a currency crisis.
- It requires running down reserves, which is finite.
- It is large and growing relative to GDP, so the stock of external liabilities compounds.
Note the parallel with the national debt conditions of 10.2: what matters is what the borrowing funded and how it is financed, not the headline number.
4. Expenditure switching: depreciation
4.1 The intended mechanism
A depreciation makes exports cheaper in foreign currency and imports dearer in domestic currency. Demand switches towards domestic goods, so export volumes rise and import volumes fall, improving the current account.
4.2 The Marshall-Lerner condition
The improvement is not automatic. Whether the current account improves depends on elasticities.
The Marshall-Lerner condition: a depreciation improves 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 1.
PEDx plus PEDm greater than 1
The reasoning. A depreciation changes both prices and quantities, and they work in opposite directions on the value of trade:
- Export volumes rise, which raises export revenue. But each unit earns less foreign currency, which lowers it.
- Import volumes fall, which lowers the import bill. But each unit costs more in domestic currency, which raises it.
If demand is sufficiently responsive, the volume effects dominate and the current account improves. If demand is inelastic, the price effects dominate and the current account worsens.
4.3 Worked illustration
Suppose PEDx is 0.3 and PEDm is 0.4. The sum is 0.7, which is less than 1, so the condition fails.
A 10 per cent depreciation:
- export volumes rise about 3 per cent while each unit earns 10 per cent less foreign currency, so export revenue in foreign currency falls;
- import volumes fall about 4 per cent while each unit costs 10 per cent more, so the import bill in domestic currency rises.
The current account deteriorates. Depreciation is the wrong instrument for this economy, at least in the short run.
Now suppose PEDx is 0.8 and PEDm is 0.7, summing to 1.5. The condition holds, volume effects dominate, and the same depreciation improves the current account.
This is precisely why the condition must be stated rather than assumed.
4.4 The J-curve
Elasticities are lower in the short run than in the long run, because:
- contracts are already signed at agreed prices and quantities;
- buyers take time to find alternative suppliers;
- consumers take time to change habits; and
- producers take time to expand capacity to meet new export demand.
So immediately after a depreciation the Marshall-Lerner condition typically fails, and the current account worsens. As elasticities rise over the following months and quarters, the condition comes to hold, and the balance improves, eventually exceeding its starting point.
Plotted against time, the current account traces a J shape: an initial dip, then a rise through the original level.
The policy implication is important and frequently examined: a government that depreciates and judges the result after six months will conclude the policy failed, when it may simply be at the bottom of the J.
5. Expenditure reducing: deflationary policy
Contractionary fiscal or monetary policy reduces aggregate demand, so income falls, and imports fall with it through the marginal propensity to import of 9.1.
- Advantage: it works whatever the elasticities, since it reduces imports through income rather than price.
- Disadvantage: it reduces output and raises unemployment, so it corrects the external balance by sacrificing the internal one. That is the conflict of 10.1 in its sharpest form.
Worked illustration. An economy with MPM of 0.25 needs to cut imports by $5 billion. Income must fall by 5 divided by 0.25, which is $20 billion. With a multiplier of 2, the required fiscal contraction is $10 billion. The employment cost of that contraction is the price of the external correction.
6. Supply-side measures
The long run answer, and the one that avoids the conflict.
Raising productivity, improving education and training, investing in infrastructure and encouraging innovation raise non-price competitiveness and lower unit costs. Exports rise without a fall in the exchange rate and without deflating demand.
- Advantage: improves the current account, growth and employment together, so it advances several objectives at once, as noted in 10.1.
- Disadvantage: slow, and costly in the short run.
6.1 Protection
Tariffs and quotas reduce imports directly, but they invite retaliation, raise costs for domestic firms using imported inputs, protect inefficiency, and reduce world welfare. They address the symptom rather than the cause and are generally the weakest option.
7. Integrated analysis and common traps
7.1 A complete chain
A country has a current account deficit of 6 per cent of GDP, largely financed by short term portfolio inflows. It depreciates its currency by 15 per cent.
Short run: contracts are fixed and buyers cannot switch quickly, so elasticities are low and the Marshall-Lerner condition fails. Import costs rise immediately in domestic currency while export volumes have not yet responded, so the deficit widens. This is the descending part of the J-curve. Imported inflation also rises, which may prompt higher interest rates.
Medium run: as contracts expire and buyers adjust, elasticities rise, the condition comes to hold, export volumes rise and import volumes fall, so the deficit narrows and then improves beyond its starting point.
Evaluation: the strategy depends on the country being able to finance the deficit during the dip, which is precisely what short term portfolio financing makes uncertain, since those flows may reverse exactly when the deficit is widening. It also depends on having spare capacity to expand export production; without it, higher export demand raises prices rather than volumes and the improvement never arrives. Pairing depreciation with supply-side measures addresses that second constraint.
7.2 Common examination errors
- Saying the balance of payments is in deficit without specifying the current account.
- Asserting a depreciation improves the current account without stating Marshall-Lerner.
- Getting the condition wrong, for example requiring each elasticity to exceed 1 rather than their sum.
- Describing the J-curve without explaining why short run elasticities are low.
- Forgetting that expenditure reducing policies work through income and therefore cost employment.
- Treating a current account deficit as automatically bad, without asking what it funded and how it is financed.
- Forgetting that a current account deficit is matched by a financial account surplus.
8. Paper 3 and Paper 4 mastery
Paper 3 tests: classifying a transaction into the correct account, stating the Marshall-Lerner condition, identifying the shape and cause of the J-curve, and calculating the income change required to cut imports by a given amount.
Paper 4 asks how a persistent deficit should be corrected. The strong structure classifies the deficit first, cyclical or structural and how financed, then assesses expenditure switching with Marshall-Lerner and the J-curve, expenditure reducing with its employment cost, and supply-side with its time lag, then concludes by matching the instrument to the diagnosis. A structural deficit caused by poor competitiveness is not solved by deflating demand, and saying so is the judgement the question is looking for.
9. Final checklist
A fully prepared learner can:
- name the three accounts and classify transactions into them;
- explain why the balance of payments balances by construction;
- explain what a current account deficit means in real terms;
- state at least four conditions under which a deficit is more concerning and four under which it is less;
- explain the expenditure switching mechanism of a depreciation;
- state the Marshall-Lerner condition precisely as a sum exceeding 1;
- explain why the current account worsens when the condition fails, using both price and volume effects;
- explain the J-curve and give at least three reasons short run elasticities are low;
- explain expenditure reducing policy and calculate the income change needed from the MPM;
- explain why supply-side measures avoid the internal and external conflict; and
- match the correction instrument to the diagnosis rather than recommending one in general.