What is the balance of payments?
The balance of payments records all money flows between the residents of one country and the rest of the world over a period of time, usually one year. It includes payments for goods, services, income, transfers and financial transactions.
The current account is one part of the balance of payments. It records trade in goods, trade in services, primary income and secondary income.
Simple idea
- When money enters the country from exports or income received from abroad, it is recorded as a credit.
- When money leaves the country to pay for imports or income paid abroad, it is recorded as a debit.
- The current account balance shows whether these flows give a surplus or a deficit.
1. The four parts of the current account
The current account has four main sections. Students should learn the meaning of each section and be able to give examples.
| Part of the current account | Meaning | Examples |
|---|---|---|
| 1. Trade in goods Visible balance | This records exports and imports of physical goods. The visible balance is visible exports minus visible imports. | Cars, oil, food, clothing, phones, machinery and raw materials. |
| 2. Trade in services Invisible balance | This records exports and imports of services. The invisible balance is service exports minus service imports. | Tourism, transport, banking, insurance, education, consulting and online services. |
| 3. Primary income | This records income earned from work and investments between countries. It is usually calculated as income received from abroad minus income paid abroad. | Wages earned by workers abroad, profits, dividends and interest from overseas investments. |
| 4. Secondary income | This records transfers of money where no good or service is exchanged in return. | Foreign aid, remittances sent by workers to families, gifts, grants and pension transfers. |
Visible trade
Physical goods that can be seen and transported across borders.
Invisible trade
Services sold to or bought from people and firms in other countries.
Primary income
Income from employment and investments across borders.
Secondary income
Transfers such as aid and remittances with no direct exchange of goods or services.
2. How to calculate the current account balance
The current account balance is found by adding the balances of the four parts.
Current account balance = trade in goods balance + trade in services balance + primary income balance + secondary income balance
| Current account item | Exports / credits ($bn) | Imports / debits ($bn) | Balance ($bn) |
|---|---|---|---|
| Trade in goods | 140 | 180 | −40 |
| Trade in services | 85 | 60 | +25 |
| Primary income | 30 | 45 | −15 |
| Secondary income | 20 | 10 | +10 |
| Current account balance | −20 | ||
Calculation method
Step 1: calculate each balance: credits minus debits.
Step 2: add the four balances together: −40 + 25 − 15 + 10 = −20.
Step 3: because the final answer is negative, Country A has a current account deficit of $20bn.
3. Current account deficit and current account surplus
Current account deficit
A current account deficit occurs when money leaving the country through the current account is greater than money entering the country.
Simple meaning: the country spends more on imports, income payments and transfers than it receives from exports, income and transfers.
Current account surplus
A current account surplus occurs when money entering the country through the current account is greater than money leaving the country.
Simple meaning: the country earns more from exports, income and transfers than it spends abroad.
4. Causes of a current account deficit
A country may have a deficit when exports are weak or imports are high.
Exports may fall if domestic goods are expensive, poor quality, less fashionable, or if other countries are in recession.
Imports may rise if consumers have higher incomes, imported goods are cheaper, or domestic firms cannot produce enough goods.
- High inflation can make exports more expensive and less competitive.
- An appreciation of the currency can make exports dearer and imports cheaper.
- Weak domestic industries may cause consumers and firms to depend more on imported goods.
5. Consequences of a current account deficit
| Consequence | Explanation |
|---|---|
| Reduced demand | If people buy more imports and fewer domestic goods, demand for domestic output may fall. |
| Unemployment | Lower demand for domestic goods can reduce production and employment in local firms. |
| Lower standard of living | If the deficit leads to economic problems, incomes and access to goods and services may fall. |
| Increased borrowing | A country may need to borrow from abroad or attract foreign investment to finance the deficit. |
| Lower exchange rate | High demand for imports can increase the supply of the domestic currency, causing it to depreciate. |
6. Causes of a current account surplus
Exports may rise if goods are competitive, good quality, cheaper than foreign rivals, or demanded by growing overseas markets.
Imports may fall if domestic firms produce good substitutes, incomes are lower, or imports become expensive.
7. Consequences of a current account surplus
| Consequence | Explanation |
|---|---|
| Higher employment | Strong export demand can increase production and create jobs in export industries. |
| Higher standard of living | More output and employment can raise incomes and improve living standards. |
| Inflationary pressure | If export demand is very high, total demand may rise too quickly and push prices up. |
| Higher exchange rate | Foreign buyers need the country’s currency to buy exports, so demand for the currency may rise. |
Important exam point
A deficit is not always harmful and a surplus is not always perfect. The effect depends on the cause, the size of the imbalance and how long it continues. In exams, explain the likely effect and then link it to jobs, prices, growth or living standards.
8. Policies to achieve balance of payments stability
Balance of payments stability means avoiding large, persistent current account deficits or surpluses that may damage the economy. Governments can use several policies.
| Policy | How it can help | Possible issue |
|---|---|---|
| Fiscal policy | A government can reduce taxes or increase spending to support firms, improve infrastructure and help exporters. If imports are too high, it can use contractionary fiscal policy to reduce consumer spending and import demand. | Contractionary fiscal policy may reduce economic growth and employment. |
| Monetary policy | Higher interest rates can reduce spending on imports. Lower interest rates may reduce the exchange rate, making exports cheaper and imports more expensive. | Interest-rate changes can also affect inflation, borrowing and investment. |
| Supply-side policy | Education, training, investment, better technology and improved infrastructure can make domestic firms more productive and competitive. This can increase exports and reduce reliance on imports. | These policies often take a long time to work. |
| Protection measures | Tariffs, quotas and rules can reduce imports and protect domestic industries. This may improve the current account in the short run. | Protection can raise prices, reduce choice and lead to retaliation from other countries. |
Easy exam method
- Define the current account or state whether there is a deficit or surplus.
- Explain the cause: exports, imports, income flows or transfers.
- Use a clear chain of reasoning, such as: higher imports → more money leaves the country → current account deficit worsens.
- Link the effect to employment, exchange rates, inflation, borrowing or living standards.
- For policy questions, explain how the policy affects exports or imports.
9. Quick revision summary
- Balance of payments: record of transactions between a country and the rest of the world.
- Current account: trade in goods, trade in services, primary income and secondary income.
- Deficit: more money leaves than enters through the current account.
- Surplus: more money enters than leaves through the current account.
- Main policy aim: improve export competitiveness and avoid excessive dependence on imports.