What you'll learn
- What the balance of payments records and why it must balance overall.
- Why countries run current account deficits or surpluses, including structural causes.
- How to calculate and interpret the terms of trade index.
- How to evaluate the impacts of imbalances and the main policy responses.
1. The basic idea: money flows between countries
When UK households buy imported cars, money flows out of the UK. When overseas customers buy UK financial services, money flows into the UK. The balance of payments is the record of these flows.
Balance of payments
The balance of payments is a record of all economic transactions between residents of one country and the rest of the world over a period of time, usually one year.
The balance of payments is mainly split into the current account and the capital/financial accounts. For Eduqas, you do not need detailed knowledge of every sub-component, but you do need the core logic.
The diagram shows the key accounting idea: a current account deficit must be matched by net inflows elsewhere in the balance of payments.
The current account
Current account
The current account records trade in goods and services, plus flows of income and transfers between a country and the rest of the world.
A current account surplus means inflows from exports, income and transfers are greater than outflows. A current account deficit means outflows are greater than inflows.
Why the balance of payments sums to zero
Overall, the balance of payments must sum to zero because every international transaction has two sides. If the UK buys more from abroad than it sells, that deficit must be financed somehow — for example, through foreign investors buying UK assets, lending to UK firms, or depositing money in UK financial institutions.
The accounting identity
A current account deficit is not “unpaid for”. It is matched by capital/financial inflows. A current account surplus is matched by capital/financial outflows.
Calculating a current account balance and matching flow
Suppose a country has exports and income received of £740bn, and imports and income paid of £830bn.
- Add the inflows: exports and income received are £740bn.
- Add the outflows: imports and income paid are £830bn.
- Calculate the current account balance: £740bn minus £830bn gives -£90bn, so the country has a current account deficit of £90bn.
- If we ignore statistical errors, the capital/financial accounts must show a matching net inflow of £90bn to keep the overall balance of payments equal to zero.
Thinking a deficit means the country has run out of money
A current account deficit means outflows on the current account exceed inflows, not that the country cannot pay. The key evaluation question is how the deficit is financed and whether it is sustainable.
2. Causes of current account deficits and surpluses
A country’s current account position is shaped by its competitiveness, exchange rate, industrial structure and global trading conditions.
Productivity and factor costs
Productivity means output per unit of input, such as output per worker per hour. If firms are highly productive, their unit labour costs — labour cost per unit produced — may be lower. This can make exports more price competitive.
Factor costs are the costs of inputs such as labour, land, energy and raw materials. If a country has high wages but low productivity growth, its exports may become relatively expensive, causing exports to fall and imports to rise.
For example, Germany’s strong manufacturing base and high productivity have helped it maintain export strength, while the UK has often run a goods trade deficit partly because it imports many manufactured goods.
Exchange rates
The exchange rate is the price of one currency in terms of another. If the pound appreciates, for example from £1 = 1.25to£1=1.25 to £1 = 1.25to£1=1.35, UK exports become more expensive for US buyers and US imports become cheaper for UK consumers. This may worsen the UK current account.
If the pound depreciates, exports become cheaper abroad and imports become more expensive in the UK. This may improve the current account, but not always immediately.
The J-curve shows why a depreciation can initially worsen the current account before improving it later.
Depreciation is not an instant cure
A weaker currency improves the current account only if export and import quantities respond strongly enough over time. In the short run, import prices may rise before consumers and firms can switch suppliers.
Industrial structure and comparative advantage
Comparative advantage
A country has comparative advantage in producing a good or service if it can produce it at a lower opportunity cost than another country.
Countries with strong export industries may run surpluses. For example, economies with advanced manufacturing, high-value technology or globally competitive services can generate large export earnings.
The UK often earns significant income from services such as finance, insurance, education and consulting, but this can be offset by a deficit in goods trade.
Commodity prices
A commodity is a raw material or primary product, such as oil, gas, copper, wheat or coffee. For commodity exporters, rising global prices can improve the current account. For commodity importers, rising prices can worsen it.
For example, the 2022 global energy price shock worsened the trade position of many energy-importing economies because imported gas and oil became more expensive.
Protectionist policies
Protectionism means government policies that restrict trade, such as tariffs, quotas or regulations. If another country imposes tariffs on your exports, your current account may worsen. If your government restricts imports, the current account may improve in the short run, but this can raise prices and provoke retaliation.
Brexit-related trade frictions are useful UK application: extra paperwork and regulatory barriers may reduce trade volumes in both directions, so the current account effect is not automatically positive or negative.
3. Terms of trade
Terms of trade
The terms of trade compare a country’s export prices with its import prices. They show how many imports a country can buy with a given quantity of exports.
The formula is:
Terms of trade index=export price indeximport price index×100\text{Terms of trade index}=\frac{\text{export price index}}{\text{import price index}}\times 100Terms of trade index=import price indexexport price index×100An index number compares a value with a base year, where the base is set at 100. A terms of trade index above 100 means export prices have risen relative to import prices since the base year. This is called an improvement in the terms of trade.
Calculating the terms of trade index
Suppose a country’s export price index is 112 and its import price index is 125.
- Substitute the data into the formula: Terms of trade index=112125×100\text{Terms of trade index}=\frac{112}{125}\times 100Terms of trade index=125112×100.
- Calculate the index: 112125×100=89.6\frac{112}{125}\times 100=89.6125112×100=89.6.
- Interpret the result: the terms of trade have deteriorated compared with the base year, because 89.6 is below 100.
- Apply it to the current account: imports are now relatively expensive compared with exports, so the current account may worsen, especially if demand for imports is price inelastic.
Terms of trade and the current account are not the same thing
An improvement in the terms of trade does not automatically improve the current account. Higher export prices can raise export revenue, but they may also reduce export volumes if overseas demand is price elastic.
4. Structural deficits and surpluses
Structural current account deficit
A structural current account deficit is a persistent deficit caused by underlying features of the economy, rather than a temporary event in the economic cycle.
A temporary deficit might happen because domestic demand is booming, so consumers buy more imports. A structural deficit is deeper: it may reflect weak productivity, lack of export capacity, dependence on imported energy, or an industrial structure focused on sectors with limited export growth.
A structural surplus is the opposite: a persistent surplus caused by long-term competitiveness, high saving, strong export industries or restrained domestic consumption.
Spotting structural causes
If a deficit continues during both booms and slowdowns, it is more likely to be structural. If it appears mainly during a boom, it may be cyclical because high incomes pull in imports.
5. Impacts of current account deficits and surpluses
A current account deficit is not automatically bad, and a surplus is not automatically good. You need to evaluate the cause, duration and financing.
Possible impacts of a deficit
A deficit can reduce aggregate demand because imports are a leakage from the circular flow. Since net exports are part of aggregate demand, a negative net export position can reduce growth, all else equal.
A large deficit may also put downward pressure on the exchange rate. If investors become less willing to finance the deficit, the currency may depreciate, making imports more expensive and adding to inflation.
However, a deficit can be sustainable if it is financed by stable, productive investment.
Foreign direct investment
Foreign direct investment is investment by overseas firms or individuals into productive assets, usually involving a lasting ownership stake or control.
A deficit financed by foreign direct investment into factories, infrastructure or technology may support future growth. A deficit financed by short-term borrowing or hot money — financial flows that move quickly between countries chasing higher returns — may be more risky.
Possible impacts of a surplus
A surplus can raise aggregate demand, support employment in export industries and increase foreign currency reserves. It may also make the country a net creditor to the rest of the world.
But persistent surpluses can create problems too. The economy may become over-dependent on overseas demand, face trade tensions, or under-consume domestically. Countries such as China and Germany have sometimes been criticised for large surpluses contributing to global imbalances.
Evaluating two current account deficits
Country A and Country B both have current account deficits of 5% of GDP.
- Compare the causes: Country A imports capital equipment during rapid industrial development, while Country B imports consumer goods because domestic firms are uncompetitive.
- Compare the financing: Country A attracts long-term foreign direct investment, while Country B relies on short-term portfolio flows that could leave quickly.
- Judge sustainability: Country A’s deficit may be more sustainable because investment can raise future productive capacity and exports.
- Reach a balanced conclusion: the size of the deficit matters, but its cause and financing are more important for evaluation.
6. Policies to reduce a sustained current account deficit
Exchange rate policies
A government may try to reduce the value of its currency. A devaluation is an official reduction in a fixed or managed exchange rate. A depreciation is a fall in a floating exchange rate.
A weaker currency makes exports cheaper and imports more expensive, which may improve the current account. But the J-curve matters: the deficit may worsen first if import prices rise before trade volumes adjust.
Deflationary policies
Deflationary policies reduce aggregate demand. Examples include higher interest rates, higher taxes or lower government spending. Lower domestic demand reduces imports, which can improve the current account.
The drawback is that these policies may reduce economic growth and increase unemployment. This is why Keynesian economists are often cautious about using demand reduction as a cure for external deficits.
Confusing deflationary policy with deflation
Deflationary policy means reducing aggregate demand. It does not necessarily mean the price level is falling.
Supply-side reforms
Supply-side policies aim to increase productive capacity and competitiveness. Examples include investment in education, infrastructure, research and development, energy security, planning reform and incentives for business investment.
These are often the best long-run solution to a structural deficit because they target the underlying cause: weak competitiveness. The drawback is that they take time and may be expensive.
Protectionism
Protectionist measures such as tariffs and quotas can reduce imports. This may improve the current account in the short run.
However, protectionism raises prices for consumers and firms, reduces choice, may protect inefficient industries and risks retaliation from trading partners. It may also breach trade agreements.
Choosing policies for a sustained deficit
Suppose the UK has a sustained current account deficit caused by weak goods export competitiveness and high imported energy costs.
- Identify the cause: because the problem is structural, a simple short-run cut in demand may reduce imports but will not fix weak export capacity.
- Assess exchange rate policy: a weaker pound could help exporters, but it may raise the cost of imported energy and worsen inflation during a cost-of-living squeeze.
- Assess supply-side reform: investment in skills, infrastructure, innovation and domestic renewable energy could improve competitiveness and reduce import dependence over time.
- Make a judgement: a supply-side strategy is likely to be stronger in the long run, but may need temporary support from demand management if the deficit becomes hard to finance.
In the exam
- Define the account clearly, then explain the accounting link: a current account deficit is matched by capital/financial inflows.
- For causes, build chains of reasoning: productivity, costs, exchange rates, commodity prices, protectionism and comparative advantage all affect exports and imports.
- For evaluation, avoid saying “deficit bad, surplus good”. Judge sustainability using the cause, size, duration and type of financing.
- For policy questions, compare short-run demand reduction with long-run supply-side reform, and mention risks such as inflation, unemployment, retaliation and the J-curve.
Check yourself
- Why must the overall balance of payments sum to zero?
- How could a deterioration in the terms of trade affect the current account?
- Why might two countries with the same current account deficit face very different risks?
