Current Account of the Balance of Payments
Economics revision notes · Cambridge (CIE) · 0455
1. What the current account is
The balance of payments is a record of all the money flowing into and out of a country in its dealings with the rest of the world over a period. Its most-tested part is the current account, which records flows arising from trade, income and transfers.
A flow that brings money into the country (an export, income earned abroad, money sent home) is a credit. A flow that takes money out (an import, income paid abroad, money sent overseas) is a debit.
2. The structure of the current account
The current account has four parts.
- . Exports and imports of physical goods, such as cars, oil, food and machinery. Exports are credits; imports are debits.
- . Exports and imports of services, such as tourism, banking, insurance, shipping and education. Selling these to foreigners is a credit; buying them from abroad is a debit.
- . Income from lending, investing or working abroad, such as interest, profit, dividends and wages, set against the same kinds of income paid out to foreigners.
- . Transfers for which nothing is given in return, such as foreign aid and workers' remittances sent between countries.
Common exam question
Which part of the current account a flow belongs to
Question: Say which part of the current account records a given flow, or what one part measures (1 mark, multiple choice).
Sort each flow by what the money is for. Goods and services are trade; foreign tourists' spending in the country is a service export. Interest, profits, dividends and wages from abroad are primary income. Money given with nothing in return (aid, cash workers send to family abroad, contributions to international organisations) is secondary income. Set in 4 of the 13 multiple-choice papers, once as the formula: the current account is the four balances added together.
The wrong options are the neighbouring parts: primary income beside a remittance, factor income or net exports beside secondary income. Money invested in assets abroad is not in the current account at all. Asked in 1 of the 11 structured papers, as two components to name from a fact file: the scheme credited the two listed there and accepted "invisibles" for trade in services.
Calculating the balance
The current-account balance = total credits − total debits across all four parts.
If credits exceed debits, the country has a current-account surplus; if debits exceed credits, it has a current-account deficit. The same arithmetic applies to a single part: for trade in goods alone, exports minus imports gives a trade surplus or trade deficit in goods. So a country can run a deficit on trade in goods while running a surplus on services or income, and the overall current-account balance combines all four parts.
Common exam question
Calculating a balance and reading its change
Question: Calculate the current account balance, or the balance on one part of it, from given figures, or say which balance improved (1 mark).
Take credits minus debits for each part, then add the parts, keeping every sign: a negative total is a deficit. Set in 5 of the 13 multiple-choice papers. The wrong options come from slips: the right size with the wrong sign, a services deficit added as a surplus, money leaving counted as coming in, or every item added regardless of direction.
For which balance improved: a deficit shrinking towards zero is an improvement, while a growing deficit and a falling surplus are deteriorations. On a chart, the trade balance can improve while imports rise, if exports rise by more.
Asked in 1 of the 11 structured papers, as the sum of a fact file's two balances: the answer was negative, and the scheme also took it without the dollar sign or in the local currency.
Worked example
Working out a current account balance
The table shows one year's international transactions for a country.
| Item | $ million |
|---|---|
| Exports of goods | 480 |
| Imports of goods | 530 |
| Exports of services | 150 |
| Imports of services | 90 |
| Interest and profits received from abroad | 40 |
| Interest and profits paid abroad | 65 |
| Foreign aid received | 20 |
| Money sent home by foreign workers living in the country | 35 |
| Spending by a foreign firm on building a factory in the country | 120 |
Calculate the balance on trade in goods and the current account balance, and say whether each is a surplus or a deficit.
Solution:
- Trade in goods: 480 − 530 = −$50m, a deficit of $50 million
- Trade in services: 150 − 90 = +$60m
- Primary income: 40 − 65 = −$25m
- Secondary income: the aid is a credit and the money the foreign workers send home is a debit, so 20 − 35 = −$15m
- The factory spending is investment, not trade, income or a transfer, so it is left out
- Current account: −50 + 60 − 25 − 15 = −$30m, a deficit of $30 million
Counting the factory spending as a credit would turn this into a $90m surplus, and counting the workers' money as coming in would give a $40m surplus.
Exam tip
Define a deficit in money terms
To define a trade in goods deficit, say that spending on imported goods is greater than the revenue earned from exported goods. The mark scheme gives both marks for that and only one for saying that imports exceed exports, so write it in values. A surplus is the reverse, and adding services, income and transfers gives the current account version.
3. Causes of a deficit or surplus
The balance changes whenever the value of what a country sells abroad changes relative to what it buys.
Causes of a current-account deficit
- Low international competitiveness. If domestic goods are more expensive or lower quality than foreign rivals, exports fall and imports rise. This can come from high relative inflation, low productivity or a high exchange rate.
- Strong domestic demand. When incomes and spending are high, people buy more imports, widening the deficit.
- A high exchange rate. A strong currency makes exports dear abroad and imports cheap at home, worsening the trade balance.
- Reliance on imported essentials. A country that must import much of its food, fuel or raw materials runs a structural import bill.
Causes of a current-account surplus
The opposite conditions: high competitiveness from low costs, high productivity or a low exchange rate; weak domestic demand that holds imports down; or a strong base of exports such as commodities, manufactured goods or services like tourism and finance.
Common exam question
Why the current account improves or worsens
Question: Analyse how higher productivity or technology can improve the current account, or why a country may buy more imports (4–6 marks).
Build a chain that ends on the balance: productivity or technology lowers costs, so prices fall or quality rises; exports become more competitive, so demand and export revenue rise; spending on imports falls. Each link earns a mark: do not stop at "more competitive". Asked in 4 of the 11 structured papers.
For more imports, credited causes include cheaper imports (a stronger currency, lower foreign costs), higher incomes, removed tariffs or quotas, and materials it lacks; naming them alone was capped at three marks. A 4-mark data version paired the oil price with an oil exporter's balance: say they move together, cite years, and explain that inelastic demand makes dearer oil raise export revenue.
Set in 1 of the 13 multiple-choice papers: the key for a bigger surplus was lower export prices; the rest work the other way.
4. Consequences of a deficit or surplus
A deficit or surplus affects GDP, employment, inflation and the exchange rate, and neither is automatically good or bad.
Consequences of a deficit
- GDP and employment. Spending on imports rather than home-produced goods means lower demand for domestic output, which can reduce GDP and raise unemployment.
- The exchange rate. A persistent deficit raises the supply of the currency on the FX market (residents selling it to buy imports), which tends to cause the currency to depreciate.
- Inflation. The effect works both ways. That same leakage of spending abroad takes demand out of the economy, easing demand-pull pressure on prices. But the depreciation a persistent deficit tends to cause makes imported food, fuel and raw materials dearer, adding to cost-push (imported) inflation. Which effect dominates depends on how far the currency falls and how import-dependent the economy is.
- Financing the gap. The country must cover the deficit by borrowing from abroad or selling assets, building up debt and interest payments. A large, prolonged deficit can become hard to finance.
A deficit is not always harmful: if it arises because firms are importing capital goods that will raise future output, it can support long-run growth.
Consequences of a surplus
- GDP and employment. Strong net exports raise demand for domestic output, supporting GDP and employment.
- Inflation and the exchange rate. Strong export demand can add to demand-pull inflation, and the surplus tends to push the currency up, which can later reduce competitiveness.
- Living standards and trade relations. A surplus means more goods leave the country than come in, and those exports could have been consumed at home; trading partners running matching deficits may also complain or retaliate.
Common exam question
Whether more exports or a bigger surplus helps
Question: Discuss whether or not an increase in exports, or a bigger current account surplus, will benefit an economy or raise living standards (8 marks).
Asked in 1 of the 11 structured papers, and the specimen mark scheme sets the surplus version. Both are levels-marked: one-sided development stays in Level 2 (3–5 marks); Level 3 (6–8) needs both sides developed.
Why it might: export revenue rises and the current account improves, lifting total demand, output and jobs; higher wages let households consume more, and extra tax revenue can fund education and healthcare. A rising currency also makes imports cheaper.
Why it might not: exported goods are lost to home consumers (the opportunity cost) and shortages can follow; extra demand brings demand-pull inflation that some incomes lag behind; resources get used up; a rising currency can reverse the export gains; and shocks abroad hit harder. Each point is credited once: the same point reversed on the other side earns nothing.
5. Policies to achieve balance-of-payments stability
A government worried about a large current-account deficit (or an excessive surplus) can use several policies. They aim either to switch spending away from imports and toward exports, or to reduce total spending.
- Trade restrictions. Tariffs and quotas on imports reduce import spending and protect the trade balance, but trading partners may retaliate and reduce the country's exports, so the gain may be smaller than hoped.
- Allowing or encouraging a lower exchange rate. A depreciation makes exports cheaper abroad and imports dearer at home, narrowing a deficit, though it also raises import prices and can add to inflation.
- Reducing total demand (contractionary fiscal or monetary policy). Higher taxes or interest rates cut spending, including on imports, but this also slows growth and can raise unemployment.
- Supply-side policies. Improving productivity, skills and quality makes a country's goods more competitive, raising exports and reducing imports over the long run. This avoids the costs of the other policies but works slowly.
Common exam question
Which policy cuts a current account deficit
Question: Choose the policy most likely to reduce a current account deficit (1 mark, multiple choice).
The keyed option either cuts spending on imports or makes exports more competitive: letting the currency depreciate, tightening an import quota, or spending on infrastructure that raises productivity. Set in 3 of the 13 multiple-choice papers.
The wrong options mostly push the balance the other way: cutting income tax (more spending, some of it on imports), removing or cutting tariffs, and cutting subsidies to exporters or to domestic producers. Read the verbs closely: lowering a quota lets fewer imports in, while lowering a tariff lets more in. One item set a higher interest rate beside the productivity measure, and the productivity measure was keyed; a higher rate does cut spending at home, but it also tends to push the currency up, which makes exports dearer.
Most governments combine measures: demand-side or exchange-rate policy for a quick effect on the deficit, and supply-side policy to improve competitiveness over time. Each policy has a cost (retaliation, inflation, slower growth or a long time-lag), so the right choice depends on why the imbalance exists and how urgent it is.