DP Economics HL 4.6 Balance of Payments

DP Economics HL 4.6 Balance of Payments - Full notes

RevisionPrep

DP Economics HL | 4.6 Balance of Payments

DP ECONOMICS · UNIT 4: THE GLOBAL ECONOMY

4.6

Balance of Payments

Full notes for HL · IB-style

Contents

1	What the balance of payments records
2	The current account
3	The capital and financial accounts
4	Why the balance of payments balances
5	Current account deficits: causes and consequences
6	Policies to correct a current account deficit
7	Current account surpluses
8	The Marshall–Lerner condition and the J-curve (HL only)
9	Structure of the balance of payments
10	The current account in detail
11	Calculating the current account balance
12	The financial account
13	Why the BOP balances
14	Causes of current account deficits
15	Consequences of persistent deficits
16	Policies to correct a current account deficit
17	Current account surpluses
18	Exchange rates and the BOP
19	Marshall–Lerner condition (HL)
20	Mixed review: worked problems
21	Additional exam-style practice
22	Remittances
23	BOP data analysis
24	Global imbalances
25	Common misconceptions and links
26	Exam-style question with markscheme
27	Check your understanding
28	Summary and topic map

These are full teaching notes. Read each section in order, try the Think about it question before you read on, and do every Quick check before moving to the next section.

Before you start

Rate yourself on each statement now, and again after you've worked through the notes. Shade R (not yet), A (getting there) or G (confident).

I can…	R	A	G
explain the structure of the balance of payments: current, capital and financial accounts
calculate the balances on each account from data
explain why the balance of payments must balance
explain the causes and consequences of persistent current account deficits
evaluate expenditure-switching, expenditure-reducing and supply-side policies to correct a deficit
explain the consequences of persistent current account surpluses
explain the Marshall–Lerner condition and the J-curve

Section 8 (Marshall–Lerner and the J-curve) is Additional Higher Level content. Every other section is common to SL and HL.

Guiding questions

How do we record all the money flowing in and out of a country? Is a current account deficit a sign of weakness? Why might a currency depreciation make the trade balance worse before it gets better?

How this topic is examined

The balance of payments is examined through calculations (Paper 2: calculate the current account balance from components) and through essays on the causes, consequences and policies for current account deficits.

Remember the sign convention: money coming in is a credit (+), money going out is a debit (−). At HL, the J-curve and Marshall–Lerner condition are standard evaluation points for depreciation as a policy.

Command term	What the examiner wants
Define	the precise meaning, ideally in the IB wording, in one or two sentences
Draw / Sketch	a fully labelled diagram with every axis, curve, equilibrium and change labelled
Explain	a causal chain linked to economic theory, usually supported by a diagram
Analyse	break a situation into its parts and trace the effects of each
Evaluate / Discuss	weigh up arguments, question assumptions and reach a justified conclusion using real-world examples
Calculate	add credits and subtract debits for each account, showing signs

How to use these notes

Each section teaches one part of the syllabus in full. You'll see these boxes throughout; each has one job:

Box	What it's for
Think about it	a question to get you thinking before a section; the answer comes in the section
Key point	the one idea you must not forget
Common mistake	an error examiners see every year, and how to avoid it
In the real world	where the economics shows up outside the classroom
Try this	something quick you can do yourself to test the idea
Worked example	full solutions with IB-style marks (M1 method, A1 answer, R1 reasoning)
Quick check	short questions to test yourself at the end of each section

1 What the balance of payments records

A record of every financial flow between a country and the rest of the world.

Think about it

When an Indian software company sells services to a US bank, and when a US company builds a factory in India, money flows into India. Are these the same kind of flow?

The balance of payments is a record of all transactions between the residents of a country and the rest of the world over a period, usually a year. Every transaction that brings money into the country is a credit (+); every transaction that sends money out is a debit (−).

The balance of payments has three accounts: the current account, the capital account and the financial account. Together, by the rules of accounting, they always sum to zero (Section 4).

Quick check

1. What does the balance of payments record?

2. Is buying an import a credit or a debit?

Answers: 1. all transactions between residents and the rest of the world 2. a debit

2 The current account

Trade in goods and services, plus income flows.

The current account records four types of flow.

Trade in goods (visible trade): exports and imports of physical goods. The balance of trade in goods is exports of goods minus imports of goods.

Trade in services (invisible trade): exports and imports of services such as tourism, banking, insurance, transport, education and software.

Primary income: income earned from abroad by residents (wages, interest, profits and dividends on foreign investments) minus income paid to foreigners.

Secondary income (current transfers): transfers with nothing given in return, such as remittances from workers abroad to their families, foreign aid and gifts, minus those paid out.

Current account balance = balance of trade in goods + balance of trade in services + net primary income + net secondary income

WORKED EXAMPLE 1 Calculating the current account

In $ bn: exports of goods 350, imports of goods 410, exports of services 120, imports of services 80, primary income credits 30, debits 45, secondary income credits 25, debits 10. Calculate the balance of trade in goods, the balance of trade in services, and the current account balance.

Solution

Goods: 350 − 410 = −60A1

Services: 120 − 80 = +40A1

Primary income: 30 − 45 = −15; secondary income: 25 − 10 = +15M1

Current account = −60 + 40 − 15 + 15 = −$20 bn (a deficit)A1

A current account deficit means that the country is spending more abroad (on imports and income payments) than it earns. A current account surplus means it earns more than it spends.

Quick check

1. List the four components of the current account.

2. Is tourism spending by foreigners in India a credit or debit for India?

Answers: 1. goods, services, primary income, secondary income 2. credit (export of services)

3 The capital and financial accounts

Flows of investment and assets.

The capital account is small. It records capital transfers such as debt forgiveness and migrants' transfers of assets, and the purchase or sale of non-produced, non-financial assets such as patents, copyrights and land bought by foreign embassies.

The financial account records flows of investment. Foreign direct investment (FDI) is investment that gives a lasting interest and control, such as building a factory or buying a controlling stake in a firm abroad. Portfolio investment is buying shares and bonds without control. Other investment includes bank loans and deposits. Reserve assets are changes in the central bank's holdings of foreign currency and gold.

Inflows of investment into the country are credits; outflows are debits. A country that runs a current account deficit must finance it with a surplus on the financial account: it borrows from abroad or sells assets to foreigners.

Account	Records	Examples
Current	trade and income	exports, imports, profits, remittances
Capital	capital transfers; non-produced assets	debt forgiveness, patents
Financial	investment and reserves	FDI, shares and bonds, bank loans, central bank reserves

Quick check

1. Distinguish FDI from portfolio investment.

2. How is a current account deficit financed?

Answers: 1. FDI gives control; portfolio does not 2. by a financial account surplus: borrowing or selling assets

4 Why the balance of payments balances

Every flow out must be matched by a flow in.

Every international transaction has two sides. If a country imports more than it exports, it must pay for the difference somehow: by borrowing from abroad, selling assets to foreigners or running down its reserves. Each of these appears as a credit on the financial account. So:

Current account + capital account + financial account + errors and omissions = 0

In practice, the figures never add up exactly because of measurement problems, so a balancing item called net errors and omissions is included.

Common mistake

Saying 'a country has a balance of payments deficit'. The overall balance of payments always balances. A country can have a current account deficit, offset by a financial account surplus.

Quick check

1. Why must the balance of payments balance?

2. What are net errors and omissions?

Answers: 1. every transaction has an offsetting entry 2. a balancing item for measurement errors

5 Current account deficits: causes and consequences

A deficit is not always a problem, but a large, persistent one can be.

5.1 Causes

Strong domestic growth: high incomes raise demand for imports. Loss of competitiveness: high relative inflation, low productivity or an overvalued exchange rate make exports dear and imports cheap. Low saving and high consumption, or high government spending. Structural factors: dependence on imported energy or capital goods, or a narrow export base. Large income payments to foreign investors.

5.2 Consequences of persistent deficits

Rising foreign debt or sale of domestic assets to foreigners, with future interest and profit payments flowing out.

Downward pressure on the exchange rate: the supply of the currency exceeds demand. A depreciation can cause imported inflation.

Higher interest rates may be needed to attract financial inflows, which can slow growth.

Vulnerability to a sudden stop: if foreign investors lose confidence and stop lending, the country may face a currency crisis.

But a deficit is not always harmful. If it finances investment in productive capacity (imports of machinery), it can raise future growth and export capacity. And for a rapidly growing developing economy, borrowing from abroad can be sensible. What matters is the size, persistence and cause of the deficit, and how it is financed.

Quick check

1. Name three causes of a current account deficit.

2. Why might a deficit financed by FDI be less risky than one financed by short-term loans?

Answers: 1. strong growth, low competitiveness, low saving, structural dependence 2. FDI is long-term and cannot be withdrawn quickly

6 Policies to correct a current account deficit

Switch spending, reduce spending, or raise competitiveness.

Expenditure-switching policies aim to switch spending from imports to domestically produced goods. Examples: protection (tariffs, quotas), and depreciation or devaluation of the currency, which makes exports cheaper and imports dearer. Problems: protection invites retaliation (4.3); depreciation causes imported inflation and may take time to work.

Expenditure-reducing policies aim to reduce total spending, and so spending on imports. Examples: contractionary fiscal policy (higher taxes, lower government spending) and contractionary monetary policy (higher interest rates). Problems: they reduce growth and raise unemployment, and higher interest rates may cause the currency to appreciate.

Supply-side policies aim to improve competitiveness in the long run: raising productivity through education, infrastructure and investment, and reducing costs. They address the root causes but take a long time.

Policy type	Examples	Main drawback
Expenditure switching	depreciation, tariffs	inflation, retaliation, time lags
Expenditure reducing	higher taxes, higher interest rates	slower growth, unemployment
Supply-side	education, infrastructure, R&D	long time lags; cost

Quick check

1. Give an example of an expenditure-switching policy.

2. Why do expenditure-reducing policies conflict with growth?

Answers: 1. depreciation or tariffs 2. they reduce AD, output and employment

7 Current account surpluses

Surpluses bring advantages, and some problems too.

A current account surplus means a country earns more abroad than it spends. Germany, China and the Netherlands have run large surpluses. Surpluses allow a country to build up foreign assets and reserves, providing security.

But persistent surpluses can have drawbacks: they reflect low domestic consumption (lower living standards than possible), they put upward pressure on the exchange rate, and they cause tension with trading partners, whose deficits are the mirror image. Countries with large surpluses are often encouraged to raise domestic demand.

8 The Marshall–Lerner condition and the J-curve (HL only)

A depreciation improves the current account only if demand is elastic enough, and only after a delay.

HL only

This section is Additional Higher Level content. SL students do not need it.

A depreciation makes exports cheaper and imports dearer. But whether export revenue minus import spending actually improves depends on price elasticities. The Marshall–Lerner condition states that a depreciation will improve the current account only if the sum of the price elasticities of demand for exports and imports is greater than 1 (in absolute terms): |PEDx| + |PEDm| > 1.

If demand for exports and imports is inelastic, a depreciation raises the domestic currency cost of imports more than it raises export volumes, and the deficit worsens.

In the short run, demand is usually inelastic: contracts are already signed, buyers take time to find alternatives, and producers need time to expand. So immediately after a depreciation, the current account often worsens: import spending rises because each import costs more, while export volumes respond slowly. Over time, as elasticities rise, the Marshall–Lerner condition is met and the current account improves. The path traces a J-curve.

Figure 1. The J-curve: after a depreciation, the current account first worsens, then improves as demand becomes more elastic.

WORKED EXAMPLE 2 Marshall–Lerner

A country's price elasticity of demand for exports is 0.4 and for imports 0.3 in the short run, rising to 0.9 and 0.7 in the long run. Will a depreciation improve the current account in each period?

Solution

Short run: 0.4 + 0.3 = 0.7 < 1, so the current account worsensA1 R1

Long run: 0.9 + 0.7 = 1.6 > 1, so it improvesA1 R1

This matches the J-curveR1

Quick check

1. State the Marshall–Lerner condition.

2. Why does the current account worsen at first after a depreciation?

Answers: 1. sum of export and import PEDs > 1 2. demand is inelastic in the short run

9 Structure of the balance of payments

Three accounts.

The balance of payments records all transactions between residents and the rest of the world. It has three accounts: the current account, the capital account and the financial account. In principle, the current account balance is offset by the capital and financial accounts, so the BOP sums to zero (with errors and omissions).

Account	Main components
current account	trade in goods, trade in services, primary income, secondary income
capital account	capital transfers, sale of non-produced assets (patents)
financial account	FDI, portfolio investment, reserve assets

10 The current account in detail

Four parts.

Trade in goods (visible trade); trade in services (tourism, finance); primary income (wages, interest, profits, dividends from abroad); secondary income (current transfers such as remittances and foreign aid).

WORKED EXAMPLE 3 Classifying (standard)

Classify: (a) profits sent home by a foreign-owned firm; (b) remittances from workers abroad; (c) tourist spending.

Solution

(a) primary income (debit); (b) secondary income (credit)A1

11 Calculating the current account balance

Adding the components.

Current account balance = balance of trade in goods + balance of trade in services + net primary income + net secondary income.

Item	$ bn
exports of goods	320
imports of goods	360
exports of services	140
imports of services	95
net primary income	−15
net secondary income	−8

WORKED EXAMPLE 4 Current account (exam level)

Calculate the balance of trade in goods, the balance of trade in services and the current account balance.

Solution

Goods: −40; services: +45A1 A1

Current account = −40 + 45 − 15 − 8 = −$18 bnA1

12 The financial account

Investment flows.

The financial account records foreign direct investment (buying controlling stakes or building factories), portfolio investment (shares and bonds), other investment (loans, bank deposits), and changes in reserve assets.

Quick check

1. Distinguish FDI from portfolio investment.

Answers: 1. FDI: long-term controlling interest; portfolio: buying shares/bonds without control

13 Why the BOP balances

Every transaction has two sides.

A current account deficit must be financed by a capital and financial account surplus (borrowing from abroad or selling assets). A current account surplus means the country accumulates claims on the rest of the world.

WORKED EXAMPLE 5 Financing (standard)

Explain how a country finances a current account deficit.

Solution

Inflows on the financial account: borrowing or selling assets to foreignersR1

Or running down reservesR1

14 Causes of current account deficits

Why deficits arise.

Causes include: strong domestic demand drawing in imports, low competitiveness (high costs or inflation), an overvalued currency, low productivity, and dependence on imported energy or capital goods.

WORKED EXAMPLE 6 Causes (exam level)

Explain two causes of a current account deficit.

Solution

Rapid growth raises demand for importsR1

Overvalued exchange rate makes exports uncompetitiveR1

15 Consequences of persistent deficits

Is it a problem?

Persistent deficits can increase foreign debt, cause currency depreciation, require higher interest rates to attract inflows, and reduce credit ratings. However, deficits financed by productive FDI may be sustainable.

Quick check

1. When might a current account deficit be less of a concern?

Answers: 1. when financed by FDI that raises future productive capacity

16 Policies to correct a current account deficit

Expenditure switching and reducing.

Expenditure-switching policies (depreciation, protection) switch spending from imports to domestic goods. Expenditure-reducing policies (contractionary fiscal and monetary policy) reduce total spending, including on imports. Supply-side policies improve competitiveness in the long run.

WORKED EXAMPLE 7 Policies (exam level)

Evaluate contractionary fiscal policy as a way to reduce a current account deficit.

Solution

Lower incomes reduce spending on importsR1

But reduces growth and raises unemploymentR1

17 Current account surpluses

Can surpluses be a problem?

Persistent surpluses may reflect weak domestic demand, cause currency appreciation pressures, create tensions with trading partners and lead to accumulation of foreign assets that may lose value.

In the real world

Germany has had large current account surpluses, often above 6% of GDP in the 2010s, leading to criticism from trading partners.

Quick check

1. Give one possible problem of a persistent surplus.

Answers: 1. trade tensions or weak domestic consumption

18 Exchange rates and the BOP

Links.

A current account deficit increases supply of the currency, tending to cause depreciation, which may help correct the deficit (floating system). Capital inflows increase demand for the currency.

Quick check

1. How can a floating exchange rate help correct a deficit?

Answers: 1. deficit leads to depreciation, making exports cheaper and imports dearer

19 Marshall–Lerner condition (HL)

Elasticities matter.

A depreciation improves the current account only if the sum of the price elasticities of demand for exports and imports exceeds 1. If demand is inelastic, export revenue rises little while import spending rises.

WORKED EXAMPLE 8 Condition (exam level)

PEDx = 0.4 and PEDm = 0.5. Will a depreciation improve the current account?

Solution

Sum = 0.9 < 1M1

No: the condition is not metA1

20 Mixed review: worked problems

Bringing the ideas together.

WORKED EXAMPLE 9 Mixed problem (exam level)

A country's current account deficit is $18 bn. Explain how this could appear in the other accounts.

Solution

Financial account surplus of about $18 bnR1

Foreigners buy domestic assets or lend to residentsR1

21 Additional exam-style practice

Paper 1 and Paper 3.

WORKED EXAMPLE 10 Paper 1 part (b) (exam level)

Evaluate policies to reduce a persistent current account deficit. [15]

Solution

Expenditure switching and reducing explainedR1 R1

Supply-side policies for competitivenessR1

Costs and time lags; judgementR1 R1

22 Remittances

Income from migrants.

Remittances from workers abroad are a large source of secondary income for many developing countries (over 20% of GDP in some). They support households but may make economies dependent on conditions abroad.

Quick check

1. In which account are remittances recorded?

Answers: 1. current account, secondary income

23 BOP data analysis

Reading tables.

When analysing BOP data, identify the sign of each balance (surplus or deficit), express balances as % of GDP for comparison, and look for trends over time.

WORKED EXAMPLE 11 Percentage (standard)

A current account deficit of $18 bn with GDP of $600 bn is what % of GDP?

Solution

18/600 × 100M1

= 3%A1

24 Global imbalances

Surpluses and deficits worldwide.

Some countries run persistent surpluses (China, Germany) while others run deficits (USA, UK). Global imbalances were a factor in the build-up to the 2008 financial crisis.

Quick check

1. Why must world current account balances sum to zero in principle?

Answers: 1. one country's exports are another's imports

25 Common misconceptions and links

Students often think…	Actually…
the balance of payments can be in deficit overall	it always balances; the current account can be in deficit
all current account deficits are harmful	it depends on size, persistence, cause and financing
a depreciation always improves the current account	only if demand is elastic enough, and after a delay
FDI appears in the current account	it is in the financial account; profits from it are primary income

How 4.6 connects to the rest of the course

Topic	Connection
4.5 Exchange rates	depreciation and the current account
4.2 and 4.3 Protection	expenditure switching
3.5 and 3.6 Demand management	expenditure reducing
3.7 Supply-side policies	long-run competitiveness

26 Exam-style question with markscheme

Try this under exam conditions (about 18 minutes) before reading the markscheme.

Figure 2. Current account components for a country.

Text A. The country's deficit on trade in goods reflects heavy imports of energy and machinery. Some economists argue the currency should be allowed to depreciate; others warn this would raise inflation.

(a) Calculate the current account balance using the data. [2]

(b) Explain how the deficit is financed. [2]

(d) Evaluate depreciation as a way to reduce the deficit. [6]

Markscheme

Part	Answer	Marks
(a)	−60 + 40 − 15 + 15	M1
	= −$20 bn	A1
(b)	financial account surplus	R1
	borrowing / FDI / portfolio inflows	R1
(c)	rising foreign debt / asset sales	R1
	explanation	R1
	pressure on the exchange rate / vulnerability	R1
	explanation	R1
(d)	exports cheaper, imports dearer	R1
	but imported inflation	R1
	depends on elasticities (Marshall–Lerner, J-curve)	R1
	retaliation unlikely; competitiveness may be temporary	R1
	supply-side alternatives	R1
	justified judgement	R1

Examiner's comments. In (d), the best answers weighed the improvement in competitiveness against imported inflation and the elasticities of demand.

27 Check your understanding

Section A: multiple choice

1. The current account includes

A. trade in goods and services B. FDI C. purchases of shares D. central bank reserves

2. Remittances from workers abroad are recorded as

A. primary income B. financial account C. secondary income D. capital account

3. FDI inflows are recorded in

A. the current account B. the financial account C. the capital account D. primary income

4. A current account deficit must be financed by

A. a current account surplus B. higher exports only C. lower taxes D. a financial account surplus

5. An expenditure-switching policy is

A. higher income taxes B. a devaluation C. higher interest rates D. cutting government spending

6. An expenditure-reducing policy is

A. raising interest rates B. imposing tariffs C. depreciation D. export subsidies

7. Interest received on foreign investments is

A. secondary income B. trade in services C. capital account D. primary income

8. Exports of goods 100, imports of goods 130; the balance of trade in goods is

A. 30 B. 230 C. −30 D. −130

9. The Marshall–Lerner condition requires the sum of the PEDs for exports and imports to be

A. less than 1 B. equal to 0 C. negative D. greater than 1

Section B: structured

10. Explain the components of the current account. [4]

11. Explain why a current account deficit may not be a problem. [4]

12. Compare expenditure-switching and expenditure-reducing policies. [6]

13. Explain the J-curve. [4]

Answers

1. A 2. C 3. B 4. D 5. B 6. A 7. D 8. C 9. D

10. Goods, services, primary income, secondary income, with examples.

11. Financing investment that raises future exports; FDI financing; small and temporary deficits.

12. Switching: depreciation/tariffs (inflation, retaliation); reducing: fiscal/monetary tightening (growth, unemployment).

13. Inelastic short-run demand worsens the balance after depreciation; elasticities rise; Marshall–Lerner met; improvement.

28 Summary and topic map

Idea	Remember
Current account	goods, services, primary income, secondary income
Capital account	capital transfers, non-produced assets
Financial account	FDI, portfolio, other investment, reserves
Identity	CA + KA + FA + errors = 0
Deficit causes	growth, competitiveness, low saving, structure
Policies	switching, reducing, supply-side
Surpluses	low consumption, currency pressure, tension
HL	Marshall–Lerner: PEDx + PEDm > 1; J-curve

Before the exam, make sure you…

•use credit (+) and debit (−) signs carefully
•place FDI in the financial account
•explain that the overall balance of payments balances
•evaluate deficits by size, cause and financing

Balance of Payments on one page

Cover this page with a sheet of paper and try to rebuild it from memory. Whatever you can't recall is what to revise next.

Figure 3. Topic map for Balance of Payments.

revisionprep.comIB-style notes · question bank · mock papers