Syllabus points
- Explain the structure of the balance of payments accounts.
- Distinguish the current account from the capital and financial accounts.
- Explain the causes and consequences of a persistent current account deficit.
- Evaluate policies to correct a current account imbalance.
Structure of the accounts
The balance of payments records all transactions between a country's residents and the rest of the world over a period. It has two main parts:
| Account | Records |
|---|---|
| Current account | Trade in goods, trade in services, primary income (investment income, wages), secondary income (transfers, remittances) |
| Capital and financial account | Foreign direct investment, portfolio investment, reserve assets, capital transfers |
Because every transaction is double-entered, the accounts must balance overall: a current account deficit is financed by a matching surplus on the capital and financial account (borrowing from abroad or selling assets).
Causes of a current account deficit
- Loss of international competitiveness — high relative inflation, low productivity, or an overvalued exchange rate.
- Strong domestic growth — rising incomes pull in more imports.
- Structural weakness — over-reliance on a narrow export base, or a shrinking manufacturing sector.
Consequences of a persistent deficit
- Financing burden: the deficit must be funded by borrowing or selling domestic assets, so future income payments flow abroad.
- Rising external debt and vulnerability to a sudden stop in capital inflows.
- Downward pressure on the exchange rate, since supply of the currency exceeds demand.
- Lower AD and employment if the deficit reflects imports displacing domestic output.
However, a deficit is not automatically harmful — if it finances imported capital goods that raise future productive capacity, it can support long-run growth.
Policies to correct a deficit
| Policy | Mechanism | Limitation |
|---|---|---|
| Expenditure-reducing (contractionary fiscal/monetary) | Lower AD reduces import demand | Costs output and employment |
| Expenditure-switching (depreciation, tariffs) | Shifts spending from imports to domestic goods | Depends on elasticities; risks retaliation and inflation |
| Supply-side (productivity, skills, innovation) | Raises long-run competitiveness | Long time lags, costly |
The Marshall–Lerner condition states that a depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports exceeds one. This is the analytical link to the J-curve.
Worked example
A country records exports of $180bn, imports of $220bn, net primary income of −$5bn and net secondary income of +$3bn. The current account balance is 180 − 220 − 5 + 3 = −$42bn — a deficit that must be financed by a surplus on the capital and financial account.
Common exam mistakes
- Saying the balance of payments "is in deficit" — the overall account always balances; it is the current account that can be in deficit.
- Assuming a current account deficit is always a problem, regardless of what it finances.
- Forgetting the Marshall–Lerner condition when arguing that depreciation fixes a deficit.
Exam technique
Identify which account and which component is in imbalance, explain the cause, then evaluate correction policies against their output, inflation and time-lag costs.
Quick revision
- Current account (trade, income, transfers) + capital/financial account = balances overall.
- Deficit causes: uncompetitiveness, strong growth, structural weakness.
- Consequences: financing burden, external debt, currency pressure.
- Correction: expenditure-reducing, expenditure-switching, supply-side; mind Marshall–Lerner.