Policies to correct balance of payments disequilibrium

Economics A2 · International economic issues. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

Test this topic free All Economics A2 topics

The idea

The balance of payments records all transactions between a country's residents and the rest of the world. It has three parts. The current account covers trade in goods, trade in services, primary income and secondary income. The capital account is small: capital transfers such as debt forgiveness, and sales of assets like patents. The financial account records investment flows and changes in reserves.

The accounts must sum to zero, so a current account deficit is matched by a net inflow on the other two accounts.

To correct a current account deficit a government can cut total spending (expenditure-reducing) or turn spending away from imports towards home output (expenditure-switching).

Rules to remember

Current account balance = balance of trade in goods + balance of trade in services + net primary income + net secondary income.
Primary income: profits, interest, dividends and wages earned across borders. Secondary income: transfers with nothing given in return, such as workers' remittances and aid grants.
Financial account: foreign direct investment, portfolio investment (shares and bonds), other investment (loans, bank deposits) and reserve assets.
Current account + capital account + financial account + net errors and omissions = 0.
Expenditure-reducing: higher taxes, lower government spending, higher interest rates. They cut imports by cutting aggregate demand, so output and jobs also fall.
Expenditure-switching: devaluation or depreciation, tariffs, quotas, export subsidies. They change relative prices.
Supply-side policies improve competitiveness and the current account, but only in the long run.

Common mistake

Students record profits sent abroad by a foreign-owned firm in the financial account. The original investment is a financial account item, but the profit flow is primary income in the current account.

Worked example

A country has a goods deficit of $40bn, a services surplus of $25bn, net primary income of −$10bn and net secondary income of +$5bn. Its capital account surplus is $2bn and net errors and omissions are zero. What is the financial account balance?

Current account = −40 + 25 − 10 + 5 = −$20bn.
Current + capital = −20 + 2 = −$18bn.
The three accounts sum to zero, so the financial account = +$18bn.

Answer: A financial account surplus (net inflow) of $18bn.

Ask about this

Type what you are stuck on. The helper finds the explanation, worked examples and the notes to read, free and instant.

Read the full notes

Keep going

← Effectiveness of policy options Exchange rates →Take a Economics A2 test