Current Account of the Balance of Payments: five questions to try now
Real past-paper questions, the answer key from the mark scheme, and the explanation that goes with it. No account needed to answer them.
Question 1
A government decides to devalue the country’s currency to remove the deficit on its current account of the balance of payments. What is the most likely reason why this would not work?
Answer: D.
Devaluation works by making exports cheaper abroad and imports dearer at home, so that buyers on both sides switch. That whole mechanism depends on buyers being ABLE to switch. If the country's main trading partners maintain high trade barriers, its cheaper exports still meet tariffs and quotas at the border, so the extra sales never materialise and the deficit stays. That is D. A is a reason the policy WOULD work, since a competitive advantage is exactly what devaluation is meant to create. C is likewise a reason for success: elasticities summing to more than one satisfies the Marshall-Lerner condition, which is the standard test for whether devaluation improves the current account. B concerns the capital and financial accounts, which is a separate part of the balance of payments and does not determine whether devaluation fixes the CURRENT account.
Question 2
Which policy, adopted by a government with the intention of reducing the rate of inflation, might cause a greater deficit on the balance of payments?
Answer: A.
The question is looking for a policy that cools inflation through one channel while damaging the external position through another. A stronger exchange rate does this cleanly: cheaper imports hold the domestic price level down, but the same movement makes exports dearer for foreign buyers and imports better value for domestic ones, so export volumes fall, import volumes rise and the current account deficit widens. Higher taxes on consumer incomes cut disposable income and therefore spending on imports as well as on domestic goods, so the trade position tends to improve rather than worsen. Higher interest rates work on inflation by squeezing domestic demand, and that squeeze includes demand for imports, so the direct effect on the balance of payments is favourable. Higher subsidies to domestic producers lower their costs and make them more competitive against imports at home and against rivals abroad, which again helps the balance of payments rather than harming it.
Question 3
A country has a deficit on the current account of the balance of payments.
What would be expected to increase the deficit?
Answer: A.
The correct answer is A: an appreciation of the exchange rate.
Appreciation raises the foreign-currency price of the country's exports and lowers the domestic-currency price of its imports. Foreign buyers therefore purchase fewer exports, and domestic buyers purchase more imports. Export revenue falls while import expenditure rises, so a current account deficit gets larger. This is the price mechanism working against the trade balance.
Why the other options are wrong:
Appreciation raises the foreign-currency price of the country's exports and lowers the domestic-currency price of its imports. Foreign buyers therefore purchase fewer exports, and domestic buyers purchase more imports. Export revenue falls while import expenditure rises, so a current account deficit gets larger. This is the price mechanism working against the trade balance.
Why the other options are wrong:
- B, an increase in domestic productivity, lowers unit costs. Domestic goods become more competitive against foreign rivals both at home and abroad, which narrows the deficit.
- C, import quotas, caps the volume of imports allowed in, cutting import expenditure and so reducing the deficit.
- D, subsidies to domestic firms, lowers their costs and prices, letting them win sales from imported goods and compete better in export markets, again narrowing the deficit.
Question 4
What would cause an immediate increase in the deficit in a country’s balance of payments on the current account?
Answer: B.
The current account records the value of goods and services traded plus income and transfer flows, so anything that raises the money spent on imports widens the deficit at once. Imported raw materials becoming more expensive does exactly that, and because industry cannot switch inputs quickly, the volume bought hardly falls in the short run, so the import bill rises almost in proportion to the price. Wages earned by nationals working abroad are a credit under primary income, money flowing into the country, so more of them improves the current account rather than worsening it. Greater foreign ownership of domestic companies is recorded on the financial account when the shares change hands, and its current account effect comes later and indirectly as profits are remitted abroad. Higher government spending on education is a domestic transaction that appears nowhere on the current account, whatever it may eventually do to imports through higher incomes.
Question 5
A country’s balance of payments current account is in deficit. How can this be restored to equilibrium, assuming the Marshall-Lerner condition holds?
Answer: D.
To close a current account deficit you need domestic goods to compete better against imports and abroad. Subsidising domestic producers lowers their costs and does exactly that, and with the Marshall-Lerner condition holding the improved price competitiveness feeds through to the trade balance. A moves the wrong way, a stronger currency makes exports dearer. B boosts disposable income and sucks in MORE imports. C changes the primary income balance by definition rather than correcting the underlying trade position.
What this practice covers
These questions are drawn from past CIE 9708 papers. You answer, you find out immediately whether you were right, and you get the reasoning for the correct option and for each distractor. Wrong answers go to a mistakes locker so you can come back to exactly those.
Practice is free. You need an account only so your progress and your mistakes are still there next time.
What examiners see students get wrong here
These are the errors that cost marks on current account of the balance of payments, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- Calling every import a debit in the goods account: imported services belong in services.
- Treating the trade balance as the current-account balance.
- Putting dividends and interest in trade in services: they are primary income.
- Putting remittances in primary income without checking whether they are transfers.
- Ignoring negative signs in calculations.
- Saying a deficit means the country has “no money”.
- Saying a current-account deficit is the same as government debt.
- Assuming all deficits reduce AD and all surpluses raise welfare.
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Current Account of the Balance of Payments revision notes.