Policies to Correct Imbalances in the Current Account: 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
The demand for a country’s exports is price elastic.
If it is experiencing a deficit on the current account of its balance of payments, which combination of policies is most likely to correct the deficit?
Answer: D.
The correct answer is D: keep the interest rate unchanged, depreciate the exchange rate, and increase the standard rate of income tax.
Two mechanisms have to work together. First, depreciation makes exports cheaper in foreign currency and imports dearer at home. The question states that demand for exports is price elastic, which is the condition that makes this work: a given percentage fall in the foreign-currency price raises export volumes by a larger percentage, so export revenue rises. (Where demand is inelastic, depreciation can widen a deficit, the Marshall–Lerner condition.) Second, raising income tax cuts households' disposable income, which reduces consumption and with it spending on imports. Expenditure switching and expenditure reduction together shrink the deficit.
Why the other options are wrong:
Two mechanisms have to work together. First, depreciation makes exports cheaper in foreign currency and imports dearer at home. The question states that demand for exports is price elastic, which is the condition that makes this work: a given percentage fall in the foreign-currency price raises export volumes by a larger percentage, so export revenue rises. (Where demand is inelastic, depreciation can widen a deficit, the Marshall–Lerner condition.) Second, raising income tax cuts households' disposable income, which reduces consumption and with it spending on imports. Expenditure switching and expenditure reduction together shrink the deficit.
Why the other options are wrong:
- A appreciates the currency, which makes exports dearer and imports cheaper, the wrong direction entirely, and cuts interest rates, which stimulates import demand.
- B gets the exchange rate right but cuts income tax, boosting disposable income and therefore import spending, which works against the depreciation.
- C leaves the exchange rate unchanged, so no expenditure switching occurs, and cuts income tax, raising import demand. The interest rate rise would dampen demand, but it also tends to attract capital inflows and push the currency up.
Question 2
A country is experiencing a deficit on the current account of its balance of payments.
Which policy decision could reduce the deficit?
Answer: D.
The correct answer is D: an increase in import tariffs.
A tariff is a tax on imports, so it raises their domestic price. Consumers respond by switching towards domestically produced substitutes and buying fewer imported goods overall. Lower import expenditure directly reduces the current account deficit. This is expenditure switching, and it is the most direct of the four options.
Why the other options are wrong:
A tariff is a tax on imports, so it raises their domestic price. Consumers respond by switching towards domestically produced substitutes and buying fewer imported goods overall. Lower import expenditure directly reduces the current account deficit. This is expenditure switching, and it is the most direct of the four options.
Why the other options are wrong:
- A, lower income tax rates, raises disposable income. Households spend part of the increase on imports, so the deficit widens.
- B, an increase in the exchange rate, means appreciation. That makes imports cheaper and exports dearer, worsening the deficit. Be careful with the phrasing here: "increase in exchange rates" sounds like strengthening the economy, but a stronger currency damages the trade balance.
- C, higher government spending, adds to aggregate demand. Part of the extra spending leaks into imports, so again the deficit grows.
Question 3
What is most likely to lead to a persistent surplus in a country’s current account of its balance of payments?
Answer: B.
The correct answer is B: an undervalued exchange rate.
An undervalued currency holds the price of exports below what market forces would set, so foreign buyers find the country's goods persistently cheap, while imports are persistently expensive for domestic buyers. Export volumes stay high, import volumes stay suppressed, and the current account runs a surplus. The word "persistent" is the clue: because the undervaluation is maintained, typically by a central bank buying foreign currency, the competitive advantage does not erode, so the surplus continues year after year rather than correcting itself.
Why the other options are wrong:
An undervalued currency holds the price of exports below what market forces would set, so foreign buyers find the country's goods persistently cheap, while imports are persistently expensive for domestic buyers. Export volumes stay high, import volumes stay suppressed, and the current account runs a surplus. The word "persistent" is the clue: because the undervaluation is maintained, typically by a central bank buying foreign currency, the competitive advantage does not erode, so the surplus continues year after year rather than correcting itself.
Why the other options are wrong:
- A, a low domestic savings rate, means households consume a high share of income, which raises import spending and pushes the current account towards deficit. High-surplus economies typically have high savings rates.
- C, protectionist policies by other countries, blocks this country's exports from foreign markets. That reduces export revenue and works against a surplus. Read the direction carefully, protectionism by this country would help its balance, but the option says other countries.
- D, low investment income from abroad, reduces primary income credits, again working against a surplus.
Question 4
Which policy is most likely to reduce a balance of payments deficit without causing inflation?
Answer: C.
The correct answer is C: higher interest rates.
The question sets two conditions: cut the deficit, and do it without adding to inflation. Higher interest rates raise the cost of borrowing and the reward for saving, so consumption and investment fall. Lower domestic demand means fewer imports, which narrows the current account deficit. Because the policy works by reducing aggregate demand, it lowers rather than raises the price level. A higher interest rate also tends to attract capital inflows, which supports the currency and keeps import prices down.
Why the other options are wrong:
The question sets two conditions: cut the deficit, and do it without adding to inflation. Higher interest rates raise the cost of borrowing and the reward for saving, so consumption and investment fall. Lower domestic demand means fewer imports, which narrows the current account deficit. Because the policy works by reducing aggregate demand, it lowers rather than raises the price level. A higher interest rate also tends to attract capital inflows, which supports the currency and keeps import prices down.
Why the other options are wrong:
- A, decreased import quotas; that is, tighter quotas, does reduce imports, but restricting supply pushes up the domestic price of the goods concerned, and domestic producers facing less competition can raise prices too. Inflationary.
- B, depreciation, reduces the deficit but raises the domestic price of every import, including raw materials and components, feeding straight into cost-push inflation. This is the most tempting wrong answer because the first half of it works.
- D, decreased import tariffs, would make imports cheaper and so increase import volumes, widening the deficit. It fails the first condition outright.
Question 5
Which policy would not be an argument for the use of import tariffs?
Answer: D.
The correct answer is D: they may lead to retaliation by trading partners.
The question asks which is not an argument for tariffs. Retaliation is the central argument against them: if one country imposes tariffs, its trading partners are likely to respond with tariffs of their own, so the first country's exporters lose market access. The initial gain to import-competing industries is offset by losses in export industries, and both countries end up with less trade and less specialisation than before.
Why the other options are arguments in favour:
The question asks which is not an argument for tariffs. Retaliation is the central argument against them: if one country imposes tariffs, its trading partners are likely to respond with tariffs of their own, so the first country's exporters lose market access. The initial gain to import-competing industries is offset by losses in export industries, and both countries end up with less trade and less specialisation than before.
Why the other options are arguments in favour:
- A, revenue raising, is a genuine advantage, especially for developing economies where goods crossing a border are easier to tax than incomes are.
- B, improving the current account, follows because tariffs reduce import volumes, cutting the import expenditure that drives a deficit.
- C, improving the terms of trade, works when a large importing country's tariff forces foreign suppliers to absorb part of the tax by lowering their prices. The importing country then pays less per unit imported relative to what it earns per unit exported.
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 policies to correct imbalances in the current account, taken from our own topic notes. Read them before you practise and you will recognise the traps in the questions.
- “Current-account stability means zero”. A stable position need not be exactly balanced every year.
- Treating every deficit as harmful. The cause, use of resources, size and persistence matter.
- Using the whole balance of payments. AS Topic 6.5 focuses on the current account, not detailed financial- and capital-account accounting.
- Assuming higher interest rates must improve the current account. Lower import demand can be offset by appreciation and weaker exports.
- Assuming lower government spending increases exports. It may reduce imports, but it does not automatically create export demand or capacity.
- Treating protectionism as costless. Retaliation, imported-input costs, inflation and efficiency losses may offset the benefit.
- Treating supply-side policy as immediate. Its major effects are often long term.
- Using devaluation, Marshall–Lerner or the J curve as compulsory AS analysis. Exchange-rate policy belongs to A Level Topic 11.1, while Marshall–Lerner and J-curve analysis belong to A Level Topic 11.2.
Revise it first
If any of the above is unfamiliar, work through the notes before practising: Policies to Correct Imbalances in the Current Account revision notes.